Depending on what type of 401(k) account you have and your age, you may be able to withdraw funds tax-free. However, if you have a traditional 401(k) funded with pretax dollars, or you take a distribution prior to age 59.5, you will likely be required to pay taxes on some or all of your withdrawal.
Traditional Vs. Roth
Any contributions you make to a designated Roth account within your 401(k) plan are made with after-tax funds. This is what distinguishes a Roth account from a traditional 401(k) account. Because you have already paid taxes on your contributions, any amount that you withdraw is tax-free, regardless of your age at withdrawal. However, this only applies to withdrawals of your contributions. Any earnings you withdraw are still subject to your ordinary income tax rate if you withdraw them prior to reaching age 59.5.
Because traditional 401(k) accounts are funded with pretax dollars, you are required to include withdrawals in your taxable income regardless of how old you are when you begin taking distributions. However, if you withdraw funds prior to age 59.5, your withdrawals are also subject to an additional 10% penalty tax. Your distribution may be exempt from taxation and penalty if you meet the criteria for a hardship withdrawal or for one of the few exceptions to the early distribution rules.
Example
Assume you have contributed $50,000 to your 401(k) and have accumulated an additional $15,000 in earnings. At age 50, you wish to withdraw $25,000. For the sake of simplicity, assume all your taxable income is subject to a 25% tax rate.
If you have a Roth account, which makes distributions from contributed funds before earnings, you can withdraw $25,000 tax- and penalty-free because you have already paid taxes on those funds. In fact, you can withdraw up to $50,000 tax-free, but you must pay income tax and a 10% penalty tax on any withdrawal exceeding this amount. Most retirement plans make distributions comprised of both contributions and earnings, so some of your withdrawal may be taxable regardless of the amount. Once you reach age 59.5, all withdrawals are tax-free.
If you have a traditional account, you are required to pay 25% income tax, in addition to a 10% penalty tax, on the full amount of the distribution. In total, you would have to pay $8,750 in taxes, effectively reducing your withdrawal to $16,250.