If you have a traditional 401(k), you will haveto pay taxes when you take a 401(k) distribution. That 401(k) money is subject to ordinary income tax. The amount you pay is based onyour tax bracket, and if you’re younger than 59½, add a 10% early withdrawal penalty in most cases. That could put your tax rate in the top 37% bracket.
To pay taxes now rather than later, you may choose a Roth 401(k) or a Roth IRA, but we wanted to know how financial advisors assist customers reduce their tax burden on a normal 401(k) payout. We inquired, and they provided us with several suggestions for lowering your taxed burden and avoiding the 20% obligatory withholding. Continue reading to see how you can profit right now.
- Certain strategies exist to alleviate the tax burden on 401(k) distributions.
- Net unrealized appreciation and tax-loss harvesting are two strategies that could reduce taxable income.
- Rolling over monthly installments to an IRA eliminates the plan administrator’s automatic tax withholding.
- Instead of withdrawing assets, consider deferring plan payments (if you are still working) and Social Security benefits, or borrowing from your 401(k).
- The CARES (Coronavirus Aid, Relief, and Economic Security) Act of 2020 gave some tax relief to persons with coronavirus-affected retirement savings, including 401(k)s. The majority of the perks have subsequently expired.
How Are 401(k) Distributions Taxed?
401(k) distributions are taxed as regular income depending on your annual income. Distributions from retirement funds and pensions, as well as any other earnings, are included in this income. As a consequence, when you take a 401(k) payout, you should be mindful of your tax bracket and how the distribution may affect it. Any 401(k) payout you take will raise your annual earnings and, if you’re not cautious, may push you into a higher tax rate.
Whether you eventually owe 20% of your income or not, a mandated withholding of 20% of a 401(k) withdrawal is required to satisfy federal income tax. Rolling over the part of your 401(k) that you want to take into an IRA allows you to access the money while avoiding the 20% obligatory withdrawal. Another strategy to mitigate the danger of being pushed into a higher tax bracket is to sell tax losses on underperforming assets.
Deferring Social Security is another strategy to reduce your tax burden when withdrawing from your 401(k). Social Security payments are normally not taxed until the recipient’s total yearly income reaches a certain threshold. A hefty 401(k) withdrawal might sometimes bring the recipient’s income beyond the limit.
Here’s a look at these and other strategies for lowering the taxes you must pay when you take cash from your 401(k) (k)
1. Explore Net Unrealized Appreciation (NUA)
If you hold company stock in your 401(k), you may be entitled for net unrealized appreciation (NUA) treatment if you distribute it to a taxable bank or brokerage account. When you do this, you must still pay income tax on the initial purchase price of the stock, but the capital gains tax on the stock’s appreciation will be reduced.
Instead of leaving your money in your 401(k) or a conventional IRA, consider shifting it to a taxed account. (You should also think carefully before rolling over corporate shares.) Because this method may be somewhat sophisticated, it may be preferable to obtain the assistance of a professional.
2. Use the “Still Working”Exception
Most individuals are aware that they must begin taking required minimum distributions (RMDs) at the age of 72, even if they have a Roth 401(k) (k).Please keep in mind that the RMD age was raised from 7012 to 72 at the end of 2019 as part of the 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act. However, if you are still working when you reach that age, these RMDs do not apply to your current employer’s 401(k) (see item 8, below).
In other words, you may retain the money in the account and earn interest on them while deferring any tax consequences. Keep in mind that the IRS has not explicitly defined what constitutes “still working”; therefore, you would most likely need to be considered employed for the whole calendar year. If you’re thinking of going part-time or any kind of phased retirement, tread cautiously.
There are also drawbacks with this method if you run a business. This exemption is not available if you control more than 5% of the company that sponsors the plan. Also, keep in mind that the 5% ownership restriction covers any share held by a spouse, children, grandkids, or parents, and may increase to more than 5% beyond the age of 72. You can see how difficult this method may become.
3. Consider Tax-Loss Harvesting
Another technique is to sell failing stocks in your normal investing account. This is known as tax-loss harvesting. The losses on the securities negate your 401(k) payout taxes. Tax-loss harvesting, when used appropriately, may offset part or all of an investor’s tax burden on a 401(k) dividend; however, there are limits to this approach, and one must be cautious not to violate the wash-sale rule.
4. Avoid the Mandatory 20% Withholding
When you receive 401(k) payouts, the service provider is obligated to withhold 20% for federal income tax. If this is too much—say, if you only owe 15% at tax time—you’ll have to wait until you submit your taxes to receive that 5% back.
Instead, transfer the 401(k) amount to an IRA account and withdraw the funds from the IRA. There is no statutory 20% federal income tax withholding on IRAs, and you may pay your taxes when you file rather than when you withdraw.
If you borrow from your 401(k) and do not return it, the amount is taxed as if it were a cash payout.
5. Borrow Instead of Withdraw From Your 401(k)
Some plans allow you to borrow against your 401(k) balance. If this is the case, you may be able to borrow from your account, invest the cash, and generate a continuous income stream that lasts beyond the loan’s payback.
The IRS normally permits you to borrow up to 50% of your vested loan total (up to $50,000) with a five-year repayment term. In this instance, you don’t have to pay any taxes or a 10% penalty on this payout. Instead, you must repay this sum in at least quarterly installments during the term of the loan.
Consider the following scenario: You take out a $50,000 loan over five years. Let’s imagine your monthly payment with interest is $900 over this 60-month term. Consider taking your $50,000 principle and investing it in a modest home, apartment, or duplex in the comparatively affordable South. Given that you would be owning this home without a mortgage, assume your monthly net rent is $1,100 after taxes and management costs.
You have basically set up an investing vehicle that will deposit $200 in your pocket each month for the next five years ($1,100 – $900 = $200). After five years, you’ll have completely repaid your $50,000 401(k) loan, but you’ll keep your $1,100 net rent for life! You may also be able to sell that house/apartment/duplex for a profit that exceeds inflation in the future.
Of course, such a plan has financial risk, not to mention the difficulties that come with being a landlord. Before taking such a decision, you should always consult with a financial expert.
The CARES Act increased the amount of 401(k) money eligible for loans from $50,000 to $100,000 in 2020, but only if you were affected by the COVID-19 epidemic.
6. Watch Your Tax Bracket
Because your 401(k) payout is dependent on your tax bracket at the time of distribution, only accept distributions up to the top limit of your tax bracket.
Doing careful tax preparation each year to reduce your taxable income [after deductions] to a minimum is one of the greatest methods to keep taxes to a minimum. Assume you are married and filing jointly. You may remain in the 12% tax rate in 2021 if your taxable income is less than $81,050. You may remain in the 12% tax rate in 2022 if your taxable income is less than $83,550.
You may restrict your 401(k) withdrawals so that they don’t drive you into a higher tax rate (the next one up is 22%) and then take the remaining from after-tax investments, cash savings, or Roth savings if you plan wisely. The same is true for large-ticket retirement expenditures like as vehicle purchases or large vacations: Try to restrict the amount you remove from your 401(k) by combining 401(k) and Roth/after-tax withdrawals.
7. Keep Your Capital Gains Taxes Low
Try to limit your 401(k) withdrawals to the amount of earned income that allows your long-term capital gains to be taxed at 0%. Singles with taxable income up to $41,675 and married filing jointly tax filers with taxable income up to $83,350 may continue to benefit from the 0% capital gains level in 2022. Any sum in excess of this is taxed at the 15% rate.
Retirees may deduct their pension from their yearly spending amount, then compute the taxable component of their Social Security income and deduct it from the remaining balance from the preceding calculation. Subtract their needed minimum distribution if they are above 72. The rest, if any, should come from the retirees’ 401(k) (k).Any additional income required should be derived through long-term capital gain positions in a brokerage account or RothIRA.
8. Roll Over Old 401(k)s
Remember that if you’re still working, you don’t have to collect 401(k) payouts from your current employer. However, if you have 401(k)s or conventional IRAs from past employment, you must take RMDs from those funds.
Roll your past 401(k)s and regular IRAs into your current 401(k) before the year you turn 72 to avoid the obligation. There are several exceptions to this rule, but if you can use this strategy, you may further delay taxable income until retirement, when distributions may be taxed at a reduced rate (if you no longer have earned income).
9. Defer TakingSocial Security
Consider deferring your Social Security payments to reduce your taxable income (after you’ve made a 401(k) withdrawal) and maybe remain in a lower tax bracket. One option is to postpone or defer Social Security payments as part of a tax-advantaged approach that involves transferring some assets to a Roth IRA.
Retirees who can afford to wait receiving Social Security benefits may increase their payments by about a third. If you were born between 1943 and 1954, for example, your full retirement age—the age at which you would get 100% of your benefits—is 66. However, if you wait until age 67, you would get 108% of your age 66 benefit, and at age 70, you will receive 132%. (the Social Security Administration provides thishandy calculator).However, this technique no longer provides any additional benefits beyond the age of 70, and you should still apply for Medicare Part A at the age of 65.
Don’t confuse delaying Social Security benefits with the old “file and suspend” strategy for spouses. The government closed that loophole in 2016.
10. Get Disaster Relief
For people living in areas prone to hurricanes, tornadoes, earthquakes, or other forms of natural disasters, the IRS periodically grants relief with regard to 401(k) distributions—in effect, waiving the 10% penalty within a certain window of time. An example might be during certain severe Florida hurricane seasons. If you live in one of these areas and need to take an early 401(k) distribution, see if you can wait for one of these times.
In addition, there are other events that constitute a hardship and therefore yield an exemption from the 10% penalty. They include economic challenges, such as job loss, the need to pay college tuition, or putting a down payment on a house. Moreover, the CARES Act allowed those affected by the coronavirus outbreak a hardship distribution of up to $100,000 without the 10% penalty those younger than 59½ normally owe.
Account owners also were allowed up to three years to pay the tax owed on withdrawals, instead of owing it in one year. They were also given the choice to repay the withdrawal to a 401(k) and avoid owing any tax—even if the amount exceeded the annual contribution limit. Those who were impacted by the COVID-19 pandemic in 2020 were eligible.
What Are the Rules for a 401(k) Distribution?
You can withdraw money from your 401(k) penalty-free once you turn 59½. The withdrawals will be subject to ordinary income tax, based on your tax bracket. For those under 59½ seeking to make an early 401(k) withdrawal, a 10% penalty is normally assessed unless you are facing financial hardship, buying a first home, or needing to cover costs associated with a birth or adoption.
How Can You Withdraw From a 401(k) Without Penalty?
You can withdraw from a 401(k) distribution without penalty if you are at least 59½. If you are under that age, thepenalty is 10% of the total. There are exceptions for financial hardship, and for certain qualified reasons such as:
- Medical costs for treatment and care that are absolutely necessary
- Purchase price of a primary house
- Tuition and expenses for up to a year’s worth of schooling
- Expenses incurred to avoid foreclosure or eviction
- Burial or funeral expenses
- Certain costs incurred to repair casualty damages to a primary home (such as losses from fires, earthquakes, or floods)
How Long Does a 401(k) Distribution Take?
There is no universal period of time in which you must wait to receive a 401(k) distribution. Generally, it takes between three and 10 business days to receive a check, depending on which institution administers your account and whether you are receiving a physical check or having it sent by electronic transfer to a bank account.
Can I Take a Distribution From My 401(k) While Still Working?
Yes, but any distribution will be taxed as ordinary income and will be subject to the 10% penalty if the person making the401(k) withdrawal is under 59½. The penalty is waived if you qualify as experiencing a hardship.
How Much Tax Do I Pay on a 401(k) Withdrawal?
Your withdrawal is taxed as ordinary income and depends on what tax bracket you fall into for the year. You can withdraw up to $5,000 tax-free to cover costs associated with a birth or adoption.
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal. Keep in mind that these are advanced strategies used by thepros to reduce their clients’ tax burdens at the time of 401(k) distribution. Don’t try to implement them on your own unless you have a high degree of financial and tax knowledge.
Instead, ask a financial planner if any of them are right for you. As with anything with taxes, there are rules and conditions with each, and one wrong move could trigger penalties.
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