The 20% withheld is just so you avoid the possibility of incurring an underpayment penalty. That functions in the same way as your withholding on your W-2 does. If you don't have enough withheld on a W-2 to meet your tax liability for the year, you would owe additional taxes with your return as well.
In other words, it is just an estimate of the total taxes that you may owe. It does not mean that it will cover your entire tax liability for the year. The withdraw gets added to your ordinary income and that is what your tax liability is calculated on.
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