Strategies For Minimizing Taxes When Withdrawing From A Retirement Account

With proper planning, withdrawing funds from a 401(k) or IRA may be done with little tax and penalty implications.

Pay less in taxes.

Since you must still pay taxes on your conventional 401(k) and IRA funds, you cannot withdraw the whole amount for retirement purposes.

Distributions from regular IRAs and 401(k)s are subject to income tax. Withdrawals from a 401(k), an IRA, or any qualified retirement plan are subject to income tax, but there are methods to reduce that hit. These methods can help you minimize the tax you owe when withdrawing money from your retirement account.

Stay away from the hefty early withdrawal fee.

Withdrawals made from a conventional IRA before 59 1/2 are subjected to a 10% early withdrawal penalty and regular income tax. However, if you quit the employer that sponsors your 401(k) at age 55 or later, you can begin withdrawing your money tax-free. You may be eligible to avoid paying the early withdrawal penalty if you take money from your IRA for a specified reason, such as paying off a significant medical expense, funding further education, or buying your first home. 

Your 401(k) will be transferred tax-free.

A 20% income tax penalty will be applied to any 401(k) distributions made upon changing jobs. If the distribution is not deposited into a new retirement account within 60 days, the early withdrawal penalty and income tax may be due. However, if your 401(k) funds are transferred directly to a 401(k) or IRA trustee, you will avoid the tax withholding and the possibility of triggering fines and fees. No income tax is deducted when funds are transferred from one trustee to another.

Keep in mind the aforementioned minimum distributions that must be made.

After age 73, you must begin taking distributions from your standard 401(k) and IRA. In addition to any income tax that would have been owed on the distribution, a penalty of 25% of the amount that should have been withdrawn is imposed for failure to take an RMD. In addition, the penalty might be reduced to 10% if you promptly fix the problem. 

Deferring 401(k) withdrawals from your current employer, but not IRA withdrawals, until you retire if you are still working beyond age 73 and do not own 5% or more of the firm you work for. Commencing January 1, 2033, the minimum age for starting RMDs will be increased to 75.

Don’t make two payouts in a calendar year.

After your 73rd birthday, on April 1 of the following year, you must take your first RMD. By December 31, you must withdraw your second distribution and any future distributions each year. If you wait until April to collect your first RMD, you’ll take two distributions in the same year, which might lead to a hefty tax bill or a higher tax rate. Carefully determine if taking your first and second RMD in different tax years would result in a lower tax liability.

You should begin making withdrawals before you need to.

Though you aren’t required to start withdrawing from a conventional IRA until after age 73, doing so can help you stay in a lower tax band for longer, reducing the total amount of taxes you pay in retirement. Your retirement savings may be subject to a lower tax rate if you withdraw from your 401(k) or IRA in a low-income year, such as the year after you retire before you begin receiving Social Security benefits. Calculate how much you can withdraw from a retirement account if your tax rate is 12%, for example.

Put your IRA money toward a good cause.

Donations of up to $100,000 ($200,000 for couples) each year from an IRA are exempt from federal income tax for retirees 70 1/2 and older. If you want to donate from your IRA, the money must go straight to the charity. Charitable distributions from an IRA can be made to various organizations without requiring you to itemize deductions. The required minimum payout can be met with a gift from your IRA to a qualified charity. Part of your RMD can be given to charity, and you can take the balance as income.

Consider Roth IRAs.

You can benefit from tax-free investment growth and tax-free withdrawals in retirement if you allocate a portion of your retirement funds to a Roth IRA. With a Roth IRA or Roth 401(k), you may defer paying income tax on the growth of your investments and receive them tax-free in retirement if the account is at least five years old, although you won’t get a tax break in the year you contribute. You can also lock in a low tax rate with a Roth IRA if you anticipate paying higher taxes when you retire.

Don’t put tax-favored investments in a retirement account.

Long-term capital gains from investments kept outside of a retirement account are taxed at a lower rate. When you remove the funds from a retirement account, however, you will be subject to the higher regular income tax rate that applies to you. On the other hand, investing in tax-heavy assets such as Treasury inflation-protected securities, corporate and government bonds, and funds that produce short-term capital gains inside a retirement account may result in you paying less overall taxes.