Understanding Taxes on a 401K Withdrawal

Americans hate taxes. It caused a revolution 249 years ago. If there is a common link between the tax revolt of 1776 and today’s resentment, it is probably best expressed in four words. Americans don’t understand taxes.

Lawyers are used to putting clients in the witness box in support proceedings and handing them a copy of their paystub or Form W-2. Having represented the CEOs of publicly traded companies and the homemaker who teaches yoga at the gym, the common thread is that neither pays the slightest attention to what the paystub or W-2 says. After some fumbling, the judge usually looks at counsel for both parties and says: “Counsel let’s take five minutes while you lawyers agree on what I need to know since neither client is helping this along.”

So, just for grins, take a look at your next pay “advice” and if you are baffled you can relax. You are in good and plentiful company.

But if you are in a financial bind where you are borrowing on a credit card at 20% or considering a 401K loan for 8-10%, you need to understand what happens taxwise if you take an outright 401K withdrawal or borrow the money and then lose your job.

First the 401K withdrawal. Let’s assume you need $15,000 and you earn $100,000 a year. If you take the withdrawal, the employer sells $15,000 worth of stocks and/or bonds and sends 20% ($3,000) to Uncle Sam because you have made a “distribution” on which federal income tax is due. A $15,000 withdrawal gets you $12,000 net and a credit with Uncle Sam for the $3,000 sent to him. This analysis is oversimplified but works like this if you took the distribution in 2025.

Income from the job in 2025                          $100,000

Taxable 401K distribution                                  15,000

Total Income                                                        115,000

Standard deduction for single taxpayer     (  15,000)

Taxable Income                                                   100,000

Federal Tax on first  $12,000 is 10%                   1,200

                              Next $36,000 is 12%                   4,320

                              Next $52,000 is 22%                 10,560           Total ordinary fed tax 16,080

Penalty if you are not yet 59.5 years old            1,500                                                                         

Total tax in 2025 (federal)                                                                                                    17,580

Credit for 20% sent to Uncle Sam             (3,000)                                                                                   

This is federal tax only and it assumes no contributions to your 401K in 2025. But social security and the state do not tax your withdrawal. So, what did the $15,000 withdrawal really cost you? You were getting the standard deduction anyway. And rates are graduated. The more you make the higher the tax rate. Your real tax rate on the withdrawal was the 22% marginal rate plus the 10% early withdrawal penalty. Your $15,000 out cost you $4,800 in tax. If you took out much more than the $15,000 you risk being taxed at 24% plus the penalty (10%). But that’s only 2% more; a trifling amount but for the penalty. Yet you must be wary if you are making $200,000 or more as a single filer. Now you are pushing up against 32% rates +10% penalty. And at those rates Uncle Sam will get almost half of whatever you withdraw (i.e., 42%)

Now a bow to my friends in the investment management community. They are the people you will be taking the money from. Vanguard. Fidelity. BlackRock. They will note that you just aren’t paying taxes on your distribution. Your money is now “not invested.”  If you had taken your distribution in January 2023, you not only deprived yourself of the investment but the 24% it would have returned in 2024 if you had been in a SP500 index fund. So, you not only paid $4,800 in tax, you lost out on $3,600 in gains on your retirement portfolio which would continue until retirement day. That’s completely fair. But I would point out to them that if you were borrowing money on a credit card to avoid a retirement withdrawal, you would have paid your buds at Mastercard or Visa $3,000 in interest during 2024. That debate could go on longer than this blog. Your mom, Vanguard, Fidelity, BlackRock and even T. Rowe Price all agree. You never should have gotten in financial trouble in the first place.

A footnote: Many of you can borrow from your 401K. The rates today are 8-10% which beats credit card rates. Your borrow is not taxable but it is also money no longer invested in a portfolio. It’s now an obligation you owe your retirement account. The danger here is that if you lose or quit your job, the borrowed money is due back in 60 days or it is deemed a taxable distribution just as if you withdrew the money.