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Taxing 401(k) withdrawals

Dear Tax Talk,
How are 401(k) withdrawals taxed when you start taking money out of them? Let's say, for example, you have contributed $10,000 (pretax dollars and you never claimed any deductions on your income tax over the years) to your 401(k). Your employer puts in another $5,000 and over the years some of the investments have had dividends that were reinvested. Now you are 60 years old, and your 401(k) is worth $50,000. Do you have a capital gain of $40,000 to pay taxes on if you take all the money out?

Do you have to somehow add up all those dividends that were reinvested? Do you have to have every statement showing every transaction that happened over the 20, 30 or 40 years you have had this 401(k)? What if you don't have them all?

What if you have "rolled over" or consolidated two, three or four of them into one account? Is the taxation different if you take the regular mandatory withdrawals each year? I can't seem to find this information anywhere on the IRS Web site. Is it there somewhere? Is it the same for federal and state taxes? (I live in Missouri.) Thanks.
-- Laura

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Dear Laura,
The definitive IRS guide to understanding income from your pension plan is Publication 575. Generally the bottom line is that all withdrawals from your pension, whether periodic or in lump-sum form, are fully taxable as ordinary income. Pension plan distributions are never capital-gain income regardless of how the funds grew or accumulated in the plan.

The only exception to the full taxation of the plan payments would be if you made post-tax dollar contributions to the plan. You say you only made pretax contributions, which were not deducted on your return. Pretax contributions are actually not deducted on your return but instead reduce the amount of wages that you report as income on your return. Since you do not have post-tax savings in the plan, all of your withdrawals will be taxable. This means that the dividends reinvested and all the plan statements you received do not affect the taxability of the payments, so that they're meaningless to your tax consequences. Or in other words, if you want to, you can throw them out.

If you consolidated your 401(k)s into one or more accounts, you can choose from which account to make withdrawals. But the tax consequences remain the same.

Mandatory withdrawals must begin when you turn 70½ years of age. If you withdraw money prior to this age (but after age 59½), the taxation is the same: It's still ordinary income.

Usually, most states use your federal taxable income as a basis for computing your state taxable income. Unless Missouri provides a special exclusion for pension income, your state income tax consequences would be the same as the federal.

Bankrate.com's corrections policy
-- Posted: Oct. 6, 2005
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