How to Minimize Taxes on 401(k) Withdrawals

Now that you’re finally taking withdrawals from that 401(k) you’ve been contributing to for decades, how are 401(k) withdrawals taxed? Withdrawals—distributions, in retirement-plan speak—require you to pay taxes on what you take out, in most cases, effectively reducing your nest egg. What do you do? Here are several ways to minimize taxes on withdrawals.

Convert to a Roth

One of the easiest ways to lower the amount of taxes you have to pay on 401(k) withdrawals is to convert those funds to a Roth 401(k) or a Roth individual retirement account (IRA). Withdrawals from those accounts are not taxed, as long as they meet the rules for a qualified distribution. Be aware that you’ll have to declare the conversion when you file your taxes.

The big issue with converting your traditional 401(k) to a Roth IRA or Roth 401(k) is the income tax you’ll have to pay on the money you convert. If you’re close to pulling out the money anyway, it may not be worth the cost of converting it. The more money you convert, the more taxes you’ll have to pay. “The longer the money can stay in the Roth before withdrawals begin, the better,” said certified financial planner (CFP) Daniel Sheehan, formerly of Sheehan Life Planning and now head of the social media marketing firm Social Merlin.

Ben Wacek, a CFP with Guide Financial Planning, recommends splitting your assets between a Roth account and tax-deferred account, to share the burden. “Although you will likely pay more taxes today, this strategy will give you the flexibility to withdraw some funds from a tax-deferred account and some from a Roth IRA account in order to have increased control of your marginal tax rate in retirement,” says Wacek.

This format requires several years of planning. For example, the five-year rule requires that you have your funds in the Roth for five years before you begin withdrawals. This might or might not work for you if you’re already 65, about to retire, and suddenly worried about paying taxes on your distributions.

Withdraw Before You Need It

Some of the methods that allow you to save on taxes also require you to take out more from your 401(k) than you actually need. If you can trust yourself not to spend those funds—in other words, save or invest the extra—this can be an easy way to spread out the tax obligation.

“If the person is under 59½ years of age, the IRS allows under Rule 72(t) to take substantially equal distributions over one’s life from a qualified plan without incurring the 10% early withdrawal penalty,” Sheehan says. “However, the withdrawals need to last a minimum of five years. Therefore, someone who is 56 and starts the withdrawals must continue those withdrawals to at least age 61, even though they may not need the money.”

CFP and certified public accountant (CPA) Jamie Block of Mercer Advisors says that if you take out distributions earlier while you’re in a lower tax bracket, you could save on taxes, versus waiting until you’ll have Social Security and possible income from other retirement vehicles. It could all add up to a sudden increase in how much you’re bringing home, and if your spouse is receiving Social Security and has other retirement income too, your joint income might be even higher.

This is when taking money out of a 401(k) at a lower tax bracket—before the required minimum distributions (RMDs) kick in—has its advantages, says Block. That’s because RMDs kick in at age 72. The age for RMDs used to be 70½, but following the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in December 2019, it was raised to 72.

Due to the CARES Act, which the president signed into law on March 27, 2020, RMDs from all 401(k)s and IRAs were suspended for 2020. So if 2020 was when your RMDs were set to begin, you’ve got a bit of a breather in which you may still be in a lower tax bracket.

Gear Up for Your Future Tax Bracket

If you plan ahead and are 59½ or older (and thus not subject to early withdrawal penalties), you can take out just enough money from a 401(k) (or a traditional IRA) that will keep you in your current tax bracket but still lower the amount that will be subject to RMDs when you’re 72. And thanks to the CARES Act, even if you are younger than 59½, you were able to take up to $100,000 out of your 401(k) without having to pay the 10% early withdrawal fee in 2020 if you were impacted by COVID-19.

The goal of this move is to lessen the impact of the RMDs (which are based on a percentage of your retirement account balance and your age) on your tax rate when you have to start getting them.

While you’ll have to pay taxes on the money you withdraw, you can save further by then investing those funds in another vehicle, such as a brokerage account. “Calculate how much can be taken out (if applicable over the required minimum distribution amount) in a particular year before you are subject to a higher tax bracket and take out the extra and invest it in a taxable account,” says Sheehan.

Hold it there for at least a year and you will only have to pay long-term capital gains tax on what it earns. Paying at the capital gains tax rate isn’t the same as getting free money from a Roth IRA, but it’s less than paying regular income tax.

In 2020 under the CARES Act, you were allowed to spread out the taxes you owe over three years; they were not all due in 2020, as they normally would have been.

The Bottom Line

There are several (complicated) options for reducing taxes on 401(k) withdrawals or cushioning their impact on future taxes. Whichever method you choose, it always helps to talk to an advisor to figure out which works best for your individual circumstances.

Source: finance.yahoo.com