7 Ways to Avoid Paying Taxes On Your 401k Withdrawal
When you take money out of a typical 401(k), the IRS taxes that money as if it were ordinary income. The amount of tax you pay depends on your tax bracket. If you get a bigger dividend, you can expect to pay more tax. If you are under 59 1/2 years old, you may have to pay a 10% penalty on the distribution.
You don't have to pay taxes on the money in your 401k if you roll it over into an IRA or a new employer's 401k (k). If you have at least $1,000 when you leave your job, you can put it into a new retirement plan without paying taxes on it. You can also avoid paying taxes by taking a 401(k) loan instead of a 401(k) withdrawal, giving to charity, or making Roth contributions. If you want to get your 401(k) money without paying taxes, there are some things you can do to avoid or lower your tax burden.
Here's how you can do that.
Read more: When Are Taxes Due? 2023 Filing & Extension Deadlines
Watch Video: How Can I Avoid Paying Taxes On My 401k Withdrawal?
1. Consider Putting Money into a Roth IRA
If you think that your income in your golden years will put you in a higher tax bracket, you might want to move your money to a Roth account. Since this account was opened with money that was earned after taxes, any future withdrawals will not be taxed.
Even though this method doesn't let you completely avoid paying taxes, it does let you pay the tax when you put the money into your account. This way, you can avoid having to pay taxes on money you save in the future. You will not have to pay taxes on the money you get when you retire. A standard 401(k) plan, on the other hand, is paid for with money that has already been taxed, and any future withdrawals will be taxed at the regular income tax rate.
2. Stay in the Lowest Tax Bracket You Can
To pay the least amount of tax when taking money out of your 401(k), try to keep your taxable income at a lower tax rate. Taking distributions up to the top of your tax bracket will keep you from moving into the next tax bracket with a higher tax rate. For example, a 401(k) account holder can reduce the amount of money they have to take out of their account by using a combination of Roth and cash savings along with their 401(k).
Read more: Roth IRA: A Basic Guide
3. Avoid Early Withdrawal Penalty
Depending on your tax rate, you may have to pay income taxes and a 10% early withdrawal penalty on withdrawals made before age 59 1/2. But if you quit your job at age 55 or later, you might be able to take money out of your 401(k) without having to pay a penalty. Even so, the payment will still be subject to the regular income tax for your tax bracket. The IRS says that an employee must have left their job in order to get a distribution without paying a penalty. The "Rule of 55" does not apply to Individual Retirement Accounts or other plans.
Read more: Is The 4% Rule Still Valid?
4. Consider a Loan Instead of a 401(k) Withdrawal
Some 401(k) plans let participants take out loans from their account before they reach the age of retirement. For an employee to be eligible for a 401(k) loan, they may need to meet certain requirements. The employer and plan administrator decide on the specifics of these requirements. As long as the borrower follows IRS rules, neither the borrower nor a lender will have to pay ordinary income tax or an early withdrawal penalty on the loaned amount. The IRS says that a 401(k) participant can borrow up to the lesser of $50,000 or half of the amount in the participant's vested account. All 401(k) loan balances that are higher than this limit will be lost. The borrower must pay back the loan in equal monthly payments over a period of five years.
5. Donate to Charity
If you are 70 and a half years old and don't need the 401(k) payouts for living expenses, you can roll over the money directly into an IRA and give the distribution to a charity that qualifies. This way, you won't have to pay income tax on the money. As long as the donation is less than $100,000 per year, the person with the IRA doesn't have to pay income tax on the money given to charity. If a married couple files their taxes together, one of them can make a second donation of up to $100,000 to charity and still get the tax break. Note that qualified charitable distributions can only be taken from IRAs, not 401(k)s.
Read more: A 401k or A Roth 401k? Which Is Better?
6. Don't Take Your Social Security Until Later
If you have taken money out of your 401(k), putting off your Social Security benefits could help you keep your taxable income in a lower tax bracket. If you take both payouts at once, your taxable income goes up, which means you have to pay more taxes. Wait to get social security payments until you are 70 years old if the money you take out of your 401(k) is enough to cover your costs. This method not only lowers the tax you pay when you take money out of your 401(k), but it can also boost your social security benefits by up to 28%. This method will work if you wait to start getting social security payments until you are 65 to 67 years old.
7. Get Aid for Emergencies
The IRS sometimes makes exceptions for people who live in areas that are prone to hurricanes, tornadoes, and other natural disasters. If you are under 59 years old when these bad things happen, you may be able to get the 10% early withdrawal penalty waived. The IRS also looks at other situations that qualify as a hardship, such as having to pay for education costs, losing your job, or having to make a down payment on a mortgage for your main home. During the COVID-19 pandemic, the CARES law let people get up to $100,000 without having to pay the 10% early withdrawal penalty.
Read more: 4 Retirement Tools You Should Be Using
The Bottom Line
One of the best ways to pay less tax on your 401(k) withdrawal is to delay your Social Security payments, roll over your existing 401(k)s, set up IRAs to avoid the 20% federal income tax, and keep your capital gains taxes low. Remember that these are complicated methods that experts use to help their clients pay less tax when they take money out of their 401(k). Don't try to use them on your own unless you know a lot about money and taxes.
Ask a financial advisor at Vincere Wealth if any of them might be a good alternative for you. Taxes have rules and laws just like everything else, and if you break one, you could be fined.
Check out my money podcast “The Happy Hour Money Podcast” where my partner ,Isaiah Douglass, and I talk about everything finance!
Books I Recommend:
- The Intelligent Investor by Benjamin Graham and Jason Zweig
- Your Score by Anthony Davenport
- What Works on Wall Street by James P. O'Shaughnessy
- I Will Teach You to be Rich by Ramit Sethi
- The Millionaire Next Door by Thomas J. Stanley
- Rich Dad, Poor Dad by Robert Kiyosaki
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