You’ve invested in a 401(k). made contributions for decades and are ready to withdraw. But now you’re having to pay taxes on what you’re taking out, effectively reducing your nest egg. What to 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’ll have to pay on 401(k) withdrawals is to convert that amount to a taxable account like a Roth IRA or Roth 401(k). Be aware that you’ll have to declare the conversion when you file your taxes. (For more, see: An Introduction to the Roth 401(k) .)
The big issue with converting your traditional 401(k) to a Roth IRA or Roth 401(k) is the taxes you’ll have to pay. If you’re close to pulling the money out, it may not be worth it to convert 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 of Sheehan Life Planning.
CFP Ben Wacek of Wacek Financial Planning recommends splitting your assets between a taxable 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,” he said. This format requires several years of planning ahead. If you’re 60 and suddenly worried about paying taxes on your withdrawals, it may not make sense to convert your funds. But if you’re in your 30s, it might be better to bite the bullet now instead of later. (For more, see: Tax Treatment of Roth IRAs .)
Withdraw Before You Need It
Some of the methods that allow you to save on taxes also require you to take out more money from your 401(k) than you actually need. If you can trust yourself not to spend more than you need, this can be an easy way to spread out the tax obligation. “If the person is under 59 1/2 years of age
the IRS allows under Regulation T to take substantially equal distributions over one's life from a qualified plan without incurring the 10% early withdrawal penalty,” Sheehan said. “However, the withdrawals need to last a minimum of 5 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 F. Block of Wealth Design Retirement Services said if you take out distributions earlier while you’re in a lower tax bracket, you could save on taxes versus waiting when you’ll have social security and possible income from other retirement vehicles. For some people, this means a sudden increase in how much they’re bringing home. Depending on if you’re married, if your spouse is receiving social security and has other retirement income, your joint income might be even higher. “This is when taking out money out of a 401(k) before age 70 1/2 at a lower tax bracket has its advantages,” she said. (For more, see: How Do I Calculate My Social Security Break-Even Age? )
Find Another Tax Vehicle
If you plan ahead, you can take out money and invest in another taxable vehicle. Hold it there for at least a year and you will only have to pay long-term capital gains tax rates on it (typically lower than what you’d pay if you used the money as income).
“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,” Sheehan said. “Remember to then hold it there for at least a year before taking it out to avail yourself of the long-term capital gains rate versus the short-term rate.” (For more, see: An Overview of Retirement Plan RMDs .)
The Bottom Line
There are several options to reduce taxes on 401(k) withdrawals. Whichever method you choose, it always helps to talk to an advisor to figure out which works best for your individual circumstances. (For more, see: Is It Ever Wise to Make Early Withdrawals from Your 401(k)? )