How Creative Planning Approaches the Tax on 401(k) Withdrawals in Retirement

The 20% withholding is a deposit, not your actual bill

Under IRS regulations, an eligible rollover distribution from a 401(k) paid directly to you carries mandatory 20% federal withholding, and you cannot waive it. The common paraphrase that 'the tax on a 401(k) is 20%' confuses an administrative prepayment with your true annual obligation.

Your real tax bill is calculated on Form 1040. Wages, a pension, traditional IRA and 401(k) distributions, and the taxable portion of Social Security (up to 85%) are combined into gross income. The standard deduction is then subtracted—which is $32,200 for married couples filing jointly or $16,100 for single filers for tax year 2026—and current federal brackets apply strictly to the remaining balance.

In late January, your plan administrator sends Form 1099-R. Box 1 shows your gross distribution, while box 4 reports the federal income tax withheld during the year. That box 4 figure is simply a tax credit applied against the total tax calculated on your return.

A $5,000 monthly draw with $1,000 withheld nets $4,000 per month. That $1,000 is an advance payment toward an annual liability that could easily end up lower.

Do my 401(k) withdrawals count as ordinary income?

Every pre-tax dollar distributed from a traditional 401(k) counts as ordinary income in the calendar year you withdraw it. The IRS taxes these funds at standard paycheck rates rather than preferential long-term capital gains rates, stacking them directly on top of wages, pensions, and taxable investment income.

Each distribution changes several lines on your return at once. It uses up your standard deduction, pushes dollars toward higher brackets, and can make more of your Social Security benefit taxable. It also raises the income Medicare looks at for IRMAA: a large 401(k) draw in 2026 can lift Part B and Part D premiums in 2028.

State taxation varies across the country. Some states exempt retirement plan distributions entirely while others tax them as regular income, so check your state's rules to calculate your total state liability.

A taxable brokerage account behaves quite differently. Selling positions in a brokerage account triggers tax only on realized gains, while spending accumulated cash generates zero new tax. Because of this distinction, the sequence in which you tap your accounts changes your annual tax bill.

Two versions of Arturo and Ivy, one paycheck apart

Consider Arturo and Ivy (hypothetical), ages 62 and 60, who face this exact choice. Arturo just left a utility engineering job, Ivy works part time managing an orthodontic office, they have no pensions, and their youngest child is in college. They hold a $700,000 traditional 401(k) and a $150,000 brokerage account, taking $5,000 per month ($60,000 per year) from Arturo's 401(k), with $12,000 automatically withheld.

With Ivy earning a $30,000 salary, their combined gross income is $90,000. Subtracting the 2026 married filing jointly standard deduction of $32,200 leaves $57,800 in taxable income. Using illustrative brackets (10% on the first $25,000 and 12% on the rest; check current IRS brackets), their tax is $2,500 plus $3,936, totaling $6,436.

Now compare that with Ivy stopping work entirely. Their combined income drops to the $60,000 from Arturo's 401(k), leaving $27,800 after the $32,200 standard deduction. Their tax becomes $2,500 plus $336, which is just $2,836.

While the 401(k) administrator withheld an identical $12,000 in both situations, the actual federal tax bills differ by $3,600 (exactly 12% of Ivy's $30,000 salary). Without Ivy's paycheck, the couple owes roughly 4.7% of their 401(k) draw in federal tax, nowhere near the 20% withheld.

This baseline comparison leaves out state taxes, FICA payroll taxes on Ivy's wages, and potential higher education tax credits for their child. Any of those factors can widen the spread between mandatory withholding and the actual check written to the IRS.

How a $1,800 gross-up error started with bad administrative advice

Grossing up a 401(k) draw on a former employer's word that '20% covers the taxes' pulled $15,000 extra out of Arturo and Ivy's 401(k) in one year and added $1,800 of federal tax. Arturo was told he needed to request $6,250 gross each month to net his desired $5,000 after the $1,250 withholding. Over twelve months, they took out $75,000 instead of $60,000, paying 12% income tax on that unnecessary $15,000 bump.

Because the plan had withheld $15,000 and Ivy's employer withheld $2,000, their total payments reached $17,000 against an actual tax bill of $8,236. A massive refund arrived the following spring, masking the fact that they permanently removed $15,000 from tax-deferred compounding and paid an extra $1,800 to do it.

What happens when you use brokerage cash to cover the withholding gap instead of draining your retirement plan?

Drawing $5,000 gross leaves $4,000 net after the mandatory $1,000 monthly withholding. Arturo and Ivy could spend $1,000 a month, or $12,000 for the year, from the cash in their $150,000 brokerage account. The $7,564 refund that arrives next spring puts most of that back, which leaves about $4,436 of the brokerage cash spent for good.

To prevent this drag, compare your year-to-date box 4 withholding on account statements against a projected annual tax return every September. Anyone uncomfortable running tax projections can have a tax professional run the numbers before making fourth-quarter decisions.

Can I fix too much or too little withholding later in the year?

You can adjust your withholding status late in the year, and the timing rules give retirement distributions a significant structural advantage over regular income. The IRS treats federal tax withheld from retirement accounts as if it was paid evenly across all four calendar quarters, meaning a single adjusted draw in December can neutralize an underpayment from the preceding spring.

Acting too early brings distinct penalties. Taking distributions prior to age 59½ generally triggers a 10% early withdrawal penalty alongside ordinary taxes. A rule allows workers who separate from their employer during or after the year they reach age 55 to take penalty-free distributions, but that relief applies strictly to that specific employer's plan, never to an IRA.

Acting too late invites underpayment penalties. To satisfy IRS safe harbor rules, your annual withholding and quarterly estimates must equal at least 90% of the current year's liability, or 100% of last year's tax (increasing to 110% if your prior-year adjusted gross income exceeded $150,000). Falling short triggers interest charges even if you pay the balance in full by the April filing cutoff.

Sequence errors create permanent tax leaks. Federal brackets apply to the whole calendar year, so a December lump sum is taxed the same as twelve monthly draws of the same total. What raises the bill is taking more pre-tax money in a year than you spend, or selling pre-tax balances while non-taxable cash sits unused. Rolling the funds over to an IRA changes the default withholding rate to 10%, and you can lower it to 0% on Form W-4R.

No investment strategy is guaranteed, and a portfolio can fall in value, sometimes for years. When markets drop and Creative Planning's guardrails call for trimming spending, a smaller 401(k) draw also means less tax. That is one more reason not to gross up a withdrawal in a down year.

Who doesn't pay ordinary rates on every 401(k) dollar?

Retirees holding Roth balances, after-tax non-Roth contributions, or appreciated company stock do not pay ordinary income tax rates across their entire 401(k) balance. These specific assets bypass the default rule and demand separate accounting rules prior to executing any distribution.

After-tax contributions made beyond traditional limits represent tax-free return of basis. While investment growth on those dollars is subject to ordinary tax rates, your original basis comes out completely tax-free. Your custodian identifies this non-taxable recovery in box 5 of Form 1099-R.

Company stock with significant appreciation can qualify for net unrealized appreciation (NUA) rules. Under NUA, the original cost basis is taxed at ordinary rates when distributed, while all embedded growth is taxed at lower long-term capital gains rates when sold, provided the entire account is emptied within a single tax year.

A series of substantially equal periodic payments made over your life expectancy, or over a period of ten years or more, is not an eligible rollover distribution. Those payments follow Form W-4P withholding, not the mandatory 20% rule. Required minimum distributions are also exempt from mandatory 20% withholding; they start at age 73, or age 75 for individuals born in 1960 or later.

Should we run this check before the next withdrawal?

Running this distribution check takes about five minutes with last year's tax return and your recent account statements, immediately showing whether the 20% withholding rate will trigger a massive overpayment or a penalty. Verifying this gap prevents you from needlessly increasing your monthly withdrawal size.

If the 20% withheld from your 401(k) draws already exceeds your projected federal tax for the whole year, don't raise the gross withdrawal to make up the difference. Fill the cash gap from savings or a taxable account, because every extra $1,000 pulled at a 12% bracket costs $120 in tax and leaves the tax-deferred account for good.

Retirees balancing their living costs with market conditions benefit from clear rules:

• Add every projected income stream for the year, including part-time wages, pensions, traditional 401(k) and IRA distributions, and taxable Social Security benefits.
• Subtract the standard deduction for your filing status ($32,200 married filing jointly or $16,100 single for 2026).
• Estimate your total tax and compare it directly to your year-to-date box 4 withholding plus any payroll tax deductions.
• Review your account breakdown to see if any distributions include Roth assets, post-tax basis in box 5, or employer stock eligible for net unrealized appreciation.
• Confirm your exact age against age 59½ and verify whether the age-55 separation exception applies to your departure from service.
• Check your state's tax filing rules regarding private retirement distributions and public pension exemptions.

How Creative Planning checks your withholding before adjusting distributions

At Creative Planning, advisors begin by aligning your projected annual federal income tax against the total tax already withheld across your 401(k) draws and secondary income sources. We look for unnecessary gross-ups where a client withdrew extra pre-tax dollars just to compensate for statutory withholding they did not actually owe.

When flexible spending guardrails signal room to adjust spending upward, Creative Planning calculates the tax on the new distribution at your actual marginal bracket rather than a default 20%. Our team evaluates whether that increase should come from brokerage reserves or the retirement account, documenting every recommendation in your written plan.