Can the government change the tax rates on 401k withdrawals in the future?

Question:

Can the government change the tax rate on 401k withdrawals in the future? I know the government has changed the withdrawal age several times in the past, but can they also change the rate at with 401k withdrawals are taxed?

Answer:

401k contributions are tax deferred. This means that when you make contributions to your 401k this year, your taxable income is reduced in the current tax year. When you withdraw funds from your 401k in the future, the amount you withdraw will be taxed. Under current law, you cannot withdraw 401k funds unless you are 59 1/2 without incurring an early withdrawal penalty. However, there are exceptions for hardship withdrawals which allow you to withdraw funds before 59 1/2 without incurring a penalty.

There is always the chance and probably a likelihood that tax rates increase in the future. 401k withdrawals would be taxed at whatever tax rate applies to them in the year that the withdrawal is taken. Under current law, 401k withdrawals are taxed as ordinary income. Under current tax law, the highest tax bracket is 35%. You may be in a lower taxx bracket so you 401k withdrawals are taxed at a lower rate, say 15% or 25%.

The highest tax bracket was lowered from 39.6% to 35% under the “Bush tax cuts” which President Barack Obama extended until the end of 2012. The maximum tax rate will increase to 39.6% on January 1, 2013 unless Congress acts to extend the tax cuts. Obama is pushing for an extension of those tax cuts for only couples earning less than $250,000 (or individuals earning $150,000). We will have more clarity on that issue as the 2012 election season approaches.

Learn more about how a 401k plan works.

What do you think? Answer below!

6 Responses to Can the government change the tax rates on 401k withdrawals in the future?

  1. bostonianinmo says:

    I’m not aware of any change in the distribution age on 401(k) accounts but maybe I just missed it.

    Congress writes the laws and Congress can change them at any time. The IRS has no authority to change any laws.

  2. jks_mi says:

    The short answer is that congress can change the tax code in anyway it wants as long as it does not violate the Constitution. They also have ratified international tax treaties that have the same effect.

    They can change the rate at which 401k withdrawals, how much you can put in tax deferred. (tax deferred is different than tax free)Currently, there is even a 401k that is not tax deferred (Roth-401k).

    Congress could even decide to get rid of the 401k all together. You will need to remember that because congress can do anything, I doubt they will tax 401k withdrawals more than the regular tax rate and I doubt they will let the contribution limits decrease.

  3. Overtaxed says:

    there are no specific tax rates for 401k’s or ira’s. when you withdraw money from them, the amount is added to your other taxable income and is taxed as ordinary income, ie no special rates for dividends or capital gains. so your tax rate on 401k will depend entirely on your total income situation and the tax brackets in effect in that future period.

  4. growing inside says:

    Yes, Congress can change any of the rules regarding 401-k’s but it is unlikely, since a lot of people would be very upset.

  5. Judy says:

    401K withdrawals are taxed as ordinary income. Congress has the power to change those rates, so yes, they can.

  6. digdowndeepnseattle says:

    Congress sets the tax rates and can change them at any time…they have many times. Mostly though it’s a reduction in the tax rates. While changing the rates will have an impact on 401k distributions, a larger effect would be if they increased the capital gains tax rates and then taxed 401k distributions as capital gains. YUCK!

    Or, even worse…if they decide to tax the income on Roth distributions after all. While not likely, it’s entirely possible though people don’t seem to think so.

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