How to Minimize Taxes on 401(k) Withdrawals

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How to Minimize Taxes on 401(k) Withdrawals

How are 401(k) withdrawals taxed now that you’re finally taking withdrawals from that 401(k) to which you’ve been saving for decades? Withdrawals—distributions, in retirement-plan parlance—require you to pay taxes on what you take out, essentially diminishing your nest egg in most situations. What are you going to do? Here are a few strategies for lowering withdrawal taxes.

Key Takeaways

  • Converting to a Roth IRA or Roth 401(k) is one of the simplest methods to reduce the amount of taxes you have to pay on 401(k) withdrawals (k).Withdrawals from such accounts are not subject to taxation.
  • Some ways enable you to save taxes while also requiring you to withdraw more from your 401(k) than you really need.
  • If you prepare ahead of time and are 5912 or older, you may withdraw just enough money from a 401(k) (or conventional IRA) to remain in your current tax rate while lowering the amount due to required minimum distributions (RMDs).

Convert to a Roth

Converting 401(k) assets to a Roth 401(k) or a Roth individual retirement account is one of the simplest methods to reduce the amount of taxes you must pay on 401(k) withdrawals (IRA).Withdrawals from certain accounts are not taxed if they fulfill the requirements for a qualified distribution. Be advised that you must disclose the conversion when filing your taxes.

The main disadvantage of converting your standard 401(k) to a Roth IRA or Roth 401(k) is the income tax you’ll have to pay on the money you’ll be converting. If you’re about to withdraw the money anyhow, the expense of converting it may not be worth it. You’ll have to pay more taxes if you convert more money. “The longer the money can sit in the Roth before withdrawals start, the better,” said Daniel Sheehan, previously of Sheehan Life Planning.

  Tax Break Definition

To share the load, Ben Wacek, a CFP at Guide Financial Planning, suggests spreading your assets between a Roth account and a tax-deferred account. “Although you will most certainly pay higher taxes now, this method will allow you to remove some assets from a tax-deferred account and some from a Roth IRA account in order to have more control over your marginal tax rate in retirement,” Wacek explains.

This structure needs years of preparation. For example, the five-year rule mandates you to keep your assets in the Roth for five years before withdrawing them. If you’re already 65, about to retire, and suddenly concerned about paying taxes on your distributions, this may or may not work for you.

4 Ways To Maximize Your 401(k)

Withdraw Before You Need It

Some of the ways for saving taxes require you to withdraw more from your 401(k) than you really need. If you can trust yourself not to spend those funds—that is, to save or invest the extra—this may be a simple approach to stretch out your tax liability.

“If the individual is under 5912 years old, the IRS permits basically equal withdrawals from a qualified plan during one’s life without incurring the 10% early withdrawal penalty,” Sheehan explains. “However, the withdrawals must endure at least five years.” As a result, someone who begins withdrawals at the age of 56 must maintain withdrawals until the age of 61, even if they do not need the money.”

CFP and certified public accountant (CPA) Jamie Block of Mercer Advisors believes that taking distributions sooner while you’re in a lower tax bracket may save you money on taxes versus waiting until you receive Social Security and other retirement income. It might all add up to a significant rise in your take-home pay, and if your spouse receives Social Security and other retirement income, your combined income could be much greater.

  Marginal Tax Rate: What It Is, How To Calculate It, With Examples

This is when withdrawing money out of a 401(k) before required minimum distributions (RMDs) come in has benefits, according to Block. This is because RMDs begin around the age of 72. RMDs were formerly payable at the age of 7012, but with the passing of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in December 2019, the age was increased to 72.

RMDs from all 401(k)s and IRAs were frozen for 2020 as a result of the CARES Act, which the president signed into law on March 27, 2020. So, if your RMDs were supposed to start in 2020, you have a bit of a reprieve during which you may still be in a lower tax rate.

Gear Up for Your Future Tax Bracket

If you prepare ahead of time and are 5912 or older (and so not subject to early withdrawal penalties), you may withdraw just enough money from a 401(k) (or conventional IRA) to keep you in your current tax bracket while still lowering the amount due to RMDs when you’re 72. And, owing to the CARES Act, you may withdraw up to $100,000 from your 401(k) without having to pay the 10% early withdrawal penalty in 2020 if you were affected by COVID-19.

The purpose of this change is to reduce the effect of RMDs (which are calculated as a percentage of your retirement account balance and age) on your tax rate when you are required to begin receiving them.

While the money you remove will be taxed, you may save even more by investing it in another vehicle, such as a brokerage account. “Calculate how much may be taken out (if appropriate, beyond the statutory minimum distribution amount) in a given year before you are liable to a higher tax rate, and then take the excess and invest it in a taxable account,” Sheehan advises.

  How Does a Tax-Free Exchange Work?

If you keep it for at least a year, you will only have to pay long-term capital gains tax on the profits. Paying capital gains tax is not the same as receiving free money from a Roth IRA, but it is less than paying normal income tax.

Under the CARES Act, you were permitted to stretch out the taxes you owing over three years in 2020; they were not all payable in 2020, as they would have been otherwise.

The Bottom Line

There are various (complex) methods for decreasing or mitigating the effect of 401(k) withdrawals on future taxes. Whatever strategy you select, it is always a good idea to consult with an expert to determine which is ideal for your specific situation.

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