When it comes to retirement, most of us will need every penny we can get. And while you may owe taxes when you withdraw from your 401(k), planning wisely can help you keep as much of your money as possible.
Here’s a look at how 401(k) withdrawals (a.k.a. distributions) are taxed, and how to minimize the hit on your retirement savings.
How are 401(k) withdrawals taxed?
In general, withdrawals (not loans) from“traditional” 401(k)sOpens in new windowand similar workplace retirement plans are taxed as regular income. That’s because pretax contributions go into the account, and any earnings are tax deferred until you withdraw. As a result, the tax you owe depends on how much income you had during the year, and what tax bracket you’re in once the withdrawal is added to it. (Distributions from an after-taxRoth401(k), however, are tax-free as long as you meet certain criteria.)
If you take money before age 59½, your employer generally must withhold 20% of the withdrawal amount for taxes, no matter what tax bracket you’re in. (Your plan might allow exceptions for“hardship” expensesOpens in new windowsuch as a funeral, medical emergency, or even home purchase.)
Mandatory withholding can happen even if you receive a distribution you plan to roll over to a new retirement account. When you file your taxes for the year you take the money, you’d be refunded any of the 20% you didn’t end up owing. (Read on for how to avoid mandatory withholding.)
Even so, it’s important to withdraw at the right time. Early withdrawals (before 59½) can trigger a 10% 401(k) withdrawal penalty. Once you reach age 73, you’ll usually facerequired minimum distributions (RMDs)each year. If you don’t take your annual RMD, you could owe 25% of what you should have withdrawn as a penalty.
Minimizing 401(k) taxes before retirement
One way to reduce 401(k) taxes is to plan ahead—before you retire. You can almost never withdraw from a traditional 401(k) tax-free, so good strategy can help you minimize your taxes later.
Convert to a Roth 401(k)
If you expect your taxes to be higher in retirement and your plan allows it, you might considerconverting some or all of your traditional pretax 401(k)Opens in new windowinto an after-tax Roth 401(k).
Remember: You fund a Roth account with money you’ve already paid taxes on, but you don’t owe tax on distributions if you hold the account for at least five years and meet other criteria.
The downside: When you convert to a Roth, you’ll have to pay income tax on the amount you convert. That can be a lot of money, all at once. So, decide if it’s worth paying taxes today to avoid a potentially bigger tax bill in retirement—say, if you think you’ll be in a higher tax bracket or expect tax rates to rise by the time you retire. And if you choose to make the move, be sure you’ll have the funds available to pay the tax you’ll owe.
Consider a direct rollover when you change jobs
If you leave your employer, you can avoid income taxes and a penalty by not taking a distribution from your 401(k).
There are afew waysto do this. First—if your former employer allows it—you can simply leave your money in the account. Another option is to roll your 401(k) balance directly into a new retirement account. You can ask your former employer to transfer the balance of your account directly to a new employer’s traditional plan or an IRA. Depending on the plan, you might have (or can ask) to receive a check, usually made out to the new account provider “for your benefit.”In that case, you must deposit the balance into a new retirement account within 60 days to avoid having it classified as a taxable distribution (and subject to mandatory 20% withholding).
Avoid 401(k) early withdrawal
If you need money, consider borrowing from your 401(k) instead of taking an early distribution. These loans often have a term of five years—ample time to repay. And because you’re borrowing from yourself, the interest goes back into your account. (If you’re still working for the 401(k) provider, your loan repayments can come directly from your paycheck, just as your account contributions do.)
Even so, there are risks to borrowing from a 401(k). First, if you can’t repay the loan on time, the balance converts to a distribution, subject to regular income tax and a potential 10% 401(k) early withdrawal penalty (if you’re under 59½). This can also happen if you leave your job—by choice or not—before the loan is paid off; in that case, your full balance would be due within 60 days.
What’s more, a loan could result in a smaller account at retirement time. That’s because the amount you borrow doesn’t earn anything until you return it to your account.
Also note that many employers only allow you to have one loan at a time, so you’d need to pay off your 401(k) loan before getting another from the same account.
Minimizing 401(k) taxes after you hit retirement age
As you get older, try to avoid circ*mstances that could increase your tax bill, such as incurring tax penalties or landing in a higher tax bracket. Some tips:
Take your RMD each year ...
When you reach age 73, you’ll probably have to start taking required minimum distributions (RMDs) every year. If you don’t, you’ll face a tax penalty equal to 25% of what you should have taken.
(Note that starting in 2024, RMDs will only apply to traditional 401(k)s. To avoid current RMDs on a Roth 401(k), you can roll the account over to a Roth IRA.)
But don’t double-dip
Once you’re retired, you can time your first RMD to avoid making two taxable withdrawals in the same tax year. TheIRS ruleOpens in new window: Your first RMD must occur by April 1 of the year after the one in which you turn 73. Your second RMD must happen by Dec. 31 of that same year.
To keep those two RMDs in separate tax years, you don’t have to wait until the following year—let alone April 1—to take that first distribution. Instead, you can take it anytime during the year you hit the minimum age.
(Note that if you were born before July 1, 1949, you had to start taking RMDs after age 70½; if you haven’t, you’ve already faced the tax penalties.)
Keep an eye on your tax bracket
You can plan 401(k) distributions carefully to keep yourself in the lowest possible tax bracket, potentially reducing how much income tax you owe.
For example, you might consider starting 401(k) withdrawals before you have to. This can help if you’re in a lower tax bracket before age 73than you expect to be in later on.
Conversely, if you’re still working after 73, you can delay distributions—but only from your current workplace plan, not those from former employers. (One way around that is to roll old 401(k) money into your current 401(k), if the plan allows it.) This could help ensure that distributions on top of your pay don’t push you into a higher tax bracket.
You can also adjust your distributions based on your income for a given year. In general, you’ll probably avoid withdrawing more than you must each year. But if you have a particularly low-income year, you might choose to take out more than the RMD as long as you can do so whileremaining in a lower tax bracket.
Work with a professional to optimize your taxes
No question, managing your tax bracket can be complicated. So, it’s a good idea to consult a tax advisor about potential strategies. Depending on your situation, for example, you might want to delay the start of Social Security benefits (your lifetime monthly payments will be higher for each year you wait until age 70). There’s also little benefit to keeping tax-advantaged investments, such as municipal bonds, in retirement accounts (which are already tax advantaged).
If you earn too much to contribute to a Roth IRA, a tax loophole called a “backdoor Roth conversion” could enable you to move traditional 401(k) assets to a Roth IRA. You’d owe income tax on the amount you convert, but you could save overall down the road. However, it’s unclear whether this option will continue in the future—Congress is trying to get rid of the backdoor Roth, but the legislation is currently stalled.
Make a qualified charitable distribution
Another option is toroll your traditional 401(k) into a traditional IRAand then make a charitable donation from the account. This is known as a qualified charitable distribution (QCD). Not only is it a way to avoid paying taxes on 401(k) funds, but you can also use up to $100,000 of your direct donations as part of the RMD from your IRA.
(Note that this amount will be adjusted for inflation beginning in 2024.)
Whether you’re planning for retirement or are already there, talk to a tax professional. They can help you make the most of your savings and avoid paying more tax on 401(k) withdrawals than you have to.
Written byMiranda Marquit
Miranda Marquit, MBA, has been covering personal finance and retirement topics for almost two decades. She has appeared in various media outlets, including NPR, Forbes, NextAdvisor, Marketwatch, CNBC, and more.
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