How are 401(k) withdrawals taxed?
When you take distributions from a regular or traditional 401(k), they are treated as normal income and subject to income tax. Since your contributions to traditional 401(k) were paid with pre-tax dollars, you are liable to pay taxes when you start taking your distributions.
When you withdraw money from your traditional 401(k), the IRS considers the withdrawal as ordinary income and taxed as such. Therefore, the tax you pay on your withdrawal will depend on your tax bracket; the higher the distribution, the higher the tax payable will be. Moreover, if you withdraw from your 401(k) before you reach 59 ½ years, you may also be charged a 10% penalty on the distribution.
However, with a Roth 401(k), your distributions have a different tax treatment. Since your contributions to a Roth 401(k) are made with after-tax dollars, it’s unlikely that you’ll be taxed on your distributions, that is, if it’s a qualified distribution. A qualified Roth 401(k) distribution is when:
- your Roth account has sufficiently “aged” – it should meet the five-year aging rule
- you are old enough to make a withdrawal without a penalty – you can receive a tax-free distribution treatment once you reach the age of 59½
How can I withdraw from my 401(k) without paying taxes?
If you want to get your 401(k) money without paying taxes, here are a few strategies that you can use to reduce or eliminate the tax burden on your 401(k) withdrawals. Read on.
- Keep your tax bracket low.Keep your taxable income in a lower tax bracket when you take 401(k) withdrawals to reduce your tax bill. You can do this by withdrawing from your 401(k) up to your upper limit. This will help you avoid falling into the next tax bracket, which has a higher tax rate. For example, if you and your spouse’s income is below $81,050 (12% tax bracket), an income above $81,051 pushes you into a higher tax bracket (22% tax rate), resulting in a higher tax bill.
You can limit the 401(k)-withdrawal amount by taking a combination of 401(k) and other sources such as your cash savings or Roth savings.
- Consider moving your savings to Roth.If you anticipate that your earnings in retirement will fall in a higher tax bracket, consider moving the savings to a Roth account. This can be done at once or over a period of years – therefore speading the tax burden. A lot of people use this multi year method to co-incide wth the five year rule. Since after-tax dollars fund Roth, your withdrawals in retirement will be free of tax.
- Consider borrowing from a 401(k) instead of withdrawing. Most 401(k) plans allow employees to take a loan from their 401(k) balance, up to 50% of their vested account balance or a maximum limit of $50,000, before they attain retirement age. The borrowed amount is not subjected to ordinary income and doesn’t attract an early withdrawal penalty if it follows the IRS guidelines. However, the borrower must repay the loan within five years by making regular and equal loan payments for the term of the loan. Any amount not paid in the five-year timeframe will be considered a deemed distribution and subjet to income tax and depending upon the person’s age, also subject to the 10% IRS penalty.
- Defer taking your Social Security benefitsIf you have already made a 401(k) withdrawal, consider deferring your Social Security benefits to ensure that you remain in a lower tax bracket. If you take both distributions at the same time, your taxable income increases, making your tax bill higher. Also, every year you defer taking your Social Security payments increases your benefit by approximately 8%.
- Avoid early withdrawal penalty. When you withdraw from your 401(k) before age 59 ½, you are subjected to a 10% early withdrawal penalty plus income tax. Even if you qualify for a penalty-free 401(k) withdrawal ( if you leave your current employer at age 55 or later), your distribution will still be considered as ordinary income, and you will be taxed. So try to avoid making an early withdrawal from your 401(k).
- Donate your distribution to a qualifying charity.If you are 72 years (soon to be changed to 73)you must take the required minimum distributions (RMDs) from your 401(k). If you don’t need the RMDs to pay for your expenses, you can avoid paying tax by rolling over your funds to an IRA and donating the distribution to a qualifying charity.
- Rollover your 401(k) into another 401(k) or IRA.If you are still working, you need to know that you don’t have to take 401(k) distributions at your current employer. But if you have old 401(k)s with your previous employers, you will have take RMDs from these accounts once you reach age 72. If you want to avoid taking RMDs without being taxed, roll over your 401(k)s with your previous employers into your current 401(k) before you turn 72. This way, you can defer taxable income until retirement. By then, your distributions may fall in a lower tax bracket, if you don’t have any earned income.
- Get disaster relief. When disaster strikes, the IRS offers 401(k) distributions relief to people residing in areas prone to disasters like tornadoes, hurricanes, and other forms of natural disasters. If you are below 59 ½ years and make an early 401(k) withdrawal, you can get a 10% early withdrawal penalty waiver.
The IRS also offers a waiver in case of hardship withdrawals such as putting a downpayment for your primary residence mortgage, difficulty in paying college tuition, job loss, etc. For example, during the COVID-19 pandemic, the CARES act allowed people to take a hardship distribution of up to $100,000. This withdrawal did not incur the 10% penalty for early withdrawals.
- Consider tax-loss harvesting.Tax-loss harvesting is selling underperforming securities from your investment portfolio. The losses you incur on your securities offset the taxes on your 401(k) distribution. If you exercise this correctly, tax-loss harvesting can offset all or some of your tax burden generated through a 401(k) withdrawal.
The Bottom Line
These are some very good strategies for avoiding or reducing income taxes on your 401(k) withdrawal. However, these are advanced strategies used by financial experts to reduce the tax burden of their clients. If you want to implement these strategies, don’t go ahead unless you have a high degree of financial and tax knowledge. The best thing you could do is seek help from a financial expert to ensure that you are using the right strategy to reduce or avoid your tax bills.
My goal is to assist clients/investors in their quest for financial freedom and creating generational wealth through one on one consultation and an abundance of online tools to educate. For the past 5 years I have been a private pension plan consultant with Self Directed Retirement Plans working directly with my partner Rick Pendykoski (owner).