Why Are Withdrawals From A 401(k) And IRA Considered Income?

The IRS treats 401(k) and traditional IRA withdrawals as ordinary income for tax purposes because of how these accounts are structured and the tax benefits they provide upfront.

For the longest time, I've believed that most retirees will make less in retirement than while working. However, because any and all withdrawals from a 401(k) or IRA are considered ordinary income, there's a decent chances aggressive savers will make more in retirement than while working.

Here's a breakdown of why this is the case:

1. Contributions To 401(k) and IRA Are Tax-Deferred

When you contribute to a 401(k) or traditional IRA, you're using pre-tax dollars (or receiving a tax deduction for IRA contributions).
This means you didn't pay income tax on that money when you earned it.
The IRS views withdrawals as deferred income—taxes are owed when the money is taken out, regardless of how long it has been growing or compounding.

2. Growth Inside A 401(k) Or IRA Is Tax-Deferred

Investment gains (interest, dividends, capital appreciation) inside these accounts are not taxed annually.
The IRS allows this growth to compound tax-free over time, which provides significant benefits.
However, they tax the entire withdrawal later to recapture the deferred income and gains.

3. IRS Classifies Withdrawals as “Ordinary Income”

Unlike regular investments outside tax-advantaged accounts, 401(k) and traditional IRA withdrawals are taxed as ordinary income instead of at potentially lower capital gains rates. Why?
- Reason 1: Contributions were made with pre-tax dollars.
- Reason 2: It's simpler for the IRS to tax withdrawals as income rather than differentiating between principal and earnings.

4. No Work Is Required, but Tax Rules Are Uniform

The IRS doesn't distinguish between income derived from labor (e.g., salary) and income derived from deferred savings (e.g., retirement withdrawals) for these accounts.
All withdrawals are treated as part of your adjusted gross income (AGI), whether they come from original contributions or years of compounding.

5. It Balances the Benefit of Tax Deferral

Tax-deferred accounts like 401(k)s and IRAs provide an upfront advantage (you pay less tax while working). In exchange, the government collects taxes when you withdraw, often when you're in a lower tax bracket.
This deferred taxation is how the IRS ensures fairness and revenue collection.

6. Comparison to Roth Accounts

Roth IRA or Roth 401(k): Contributions are made with post-tax dollars, so qualified withdrawals (contributions + growth) are tax-free.
This highlights the trade-off:
- Traditional accounts delay taxes until withdrawal, treating the total as income.
- Roth accounts tax contributions upfront, exempting future withdrawals from income tax.

In Summary: 401(k) And IRA Withdrawals Are Considered Income

401(k) and IRA withdrawals are classified as income to:

Recapture deferred taxes on contributions.
Tax growth and earnings that compounded tax-free.
Treat all withdrawals uniformly for simplicity.

Even though no “work” is involved, the IRS is focused on taxing the benefit of compounding that was previously untaxed—essentially reclaiming deferred taxes as part of your total income. Think about 401(k) and IRA withdrawals as “deferred income.” If you do, the reason makes much more sense.

Learn more about maximizing tax-free income and withdrawals for retirement. Taxes are our greatest ongoing liability. Thankfully, there are strategies to minimize our taxes and keep more of our own hard-earned money.

Diversify Your Retirement Investments Into Real Estate

Investing in stocks and bonds in your 401(k) or IRA are classic staples for retirement investing. However, I also suggest diversifying into real estate—an investment that combines the income stability of bonds with greater upside potential.

Consider Fundrise, a platform that allows you to 100% passively invest in residential and industrial real estate. With over $3 billion in private real estate assets under management, Fundrise focuses on properties in the Sunbelt region, where valuations are lower, and yields tend to be higher.

There is a multi-decade demographic shift towards lower-cost areas of the country thanks to remote work. Technology has enabled more people to work from home or anywhere in the world. Post-pandemic, this trend has only accelerated.

I’ve personally invested over $290,000 with Fundrise, and they’ve been a trusted partner and long-time sponsor of Financial Samurai. With a $10 investment minimum, diversifying your portfolio has never been easier.

Fundrise Financial Samurai dashboard 2025

Check Out The Best Financial Planner: Boldin

Withdrawing retirement funds in a tax-efficient way can be daunting, but the Boldin Planner makes it much easier. Built specifically for retirement planning, Boldin offers the best tools to help you navigate this critical stage.

One standout feature is their Roth Conversion tool, which helps you determine how much to convert to potentially save the most on taxes. Ideally, you want a mix of 401(k), IRA, and Roth IRA retirement funds to withdraw from to diversify your tax liability. A snapshot of the tool is below.

If you’re serious about building wealth and retiring comfortably, sign up for Boldin’s powerful financial tools. They offer a free version and a PlannerPlus version for just $120/year—far more affordable than hiring a financial advisor.

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