While taxes are inevitable, no one wants to pay more to Uncle Sam than they have to. There are many (legal) ways to lower your tax bill and some of them apply to work-sponsored retirement plans. Here are some options to explore if you’re looking to reduce taxes on your 401(k) withdrawals.
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Taxes on 401(k) plans and how to reduce them
The taxes you pay on a 401(k) are income taxes. When you pay the taxes, however, depends on your account type: Roth or traditional. For a Roth 401(k), you make contributions with money that’s already been taxed. Then, any qualified distributions are tax-free.
Traditional 401(k) accounts work the opposite way: Your contributions are made before taxes are withheld and your withdrawals are taxed as ordinary income.
Both types of accounts can charge early withdrawal penalties, too.
There are ways to lower the taxes you pay on a 401(k) — but, before using any of these strategies, it could be worth checking in with your tax or financial advisor first. An expert can help you determine if it’s a good move for your particular situation and how to do it correctly.
1. 401(k) rollover
A common move to save on taxes in the long run is to rollover funds from a traditional 401(k) into a Roth account when you leave a job. You can either roll the funds directly into a Roth IRA, or put the money into a Roth 401(k) if your new company offers one.
Taxes are due on the converted amount in the year of the rollover, which increases your tax bill for that year. Yet, “this strategy may decrease your future tax bill and potentially prevent you from jumping up a tax bracket when it comes time,” said Regina McCann Hess, a certified financial planner (CFP) and author of “Super Woman Wealth: How To Become Your Own Financial Hero.”
Roth accounts are also favorable in that the earnings grow tax-free and you don’t have to worry about required minimum distributions (RMDs).
2. Convert your 401(k) now
If long-term tax savings sounds great, but you’re happy with your current employment, you may be able to move the funds into your employer’s Roth 401(k) using an in-plan Roth conversion.
A tax expert can help you time the move — remember that taxes are due on the converted funds in the year of the conversion.
“Investors may have some income-light years where their tax rate is lower than in other years,” said Kevin M. Curley II, a CFP and a wealth advisor at Global Wealth Advisors. “This would be a good time to convert a portion of their 401(k) and save on taxes.”
3. Convert your 401(k) after retirement
It’s also possible to convert your 401(k) after you retire. This move can be especially good if your retirement income is lower than your working income.
“You can use this as an opportunity to move portions of your traditional 401(k) money into [a Roth IRA] each year at a lower tax bracket. Then, if the money stays in the Roth for at least five years, you can avoid paying tax on the converted money and its growth.” Said McCann Hess.
4. Avoid withdrawing before retirement
If you withdraw from your 401(k) before the age of 59 ½, you could be on the hook for taxes and withdrawal penalties:
Traditional 401(k): The penalty is calculated as 10% of the distribution amount, plus the income taxes due on the withdrawal.
Roth 401(k): You can always withdraw contributions you made to a Roth IRA without tax or penalty, even before retirement. However, Roth accounts must be at least five years old before you can withdraw earnings tax-free.
If you are under 59 ½ and the account has not been open for at least five years, you will owe income taxes and a 10% penalty on the earnings you withdraw.
5. Borrow instead of withdraw from your 401(k)
If you need to withdraw early from your retirement savings, taking a 401(k) loan may be less costly than a hardship withdrawal. You’ll need to be currently employed by the company that administers the plan, and you’ll have to check whether these loans are allowed.
Once you get the green light, you can typically borrow up to 50% of the balance in your 401(k), up to a maximum of $50,000. Then, you’ll have five years to repay the funds with interest. All of the money (including interest) goes back into the account.
A 401(k) loan doesn’t come with taxes and penalties (as long as you repay the funds), so this strategy can save you money compared to a withdrawal.
One of the downsides is that you lose the chance to earn money on the funds while they’re not invested, but the interest you pay on the borrowed amount is meant to make up for that.
6. Use the “still working” exception
Most people have to start withdrawing from their retirement accounts at age 73. But if you’re still working at that age, you don’t have to take RMDs from the plan your current employer sponsors.
You can choose to keep the funds in the account so they continue growing and you avoid paying taxes on a withdrawal.
What are the rules for 401(k) plans?
Unlike other retirement savings options, 401(k) plans must be provided by your employer. The company may — but is not required to — match employee retirement contributions in full or in part, within limits, depending on the type of 401(k) plan. A common plan is for the employer to match employee contributions up to 3% of the employee’s salary.
You can contribute up to $23,000 in 2024, plus an additional $7,500 for those over age 50. You can choose how you want to invest the funds from the investment choices provided within the 401(k).
Your employer must also follow specific rules to ensure employees of all levels have equal access to the plan.
When do I have to start withdrawing from my 401(k)?
According to the IRS, you generally have to start taking withdrawals from your 401(k) by age 73. You can avoid this requirement if you’re still working.
What is a required minimum distribution?
RMD is the amount you must withdraw from your retirement account each year once you reach age 73. The amount you have to withdraw is determined by your age, life expectancy and the fair market value of your retirement account at the end of the previous year.
Frequently asked questions (FAQs)
Yes — if you’re at least 59½ and your Roth 401(k) has been open for at least five years, the money you withdraw is not taxed. However, traditional 401(k) distributions are generally taxed as ordinary income.
The withdrawals are never tax-free if you have a traditional 401(k). Your distributions are taxed as ordinary income, and you pay a 10% penalty if you withdraw before age 59½.
However, Roth 401(k) distributions are tax-free after age 59½, assuming the account has been open for at least five years.
If you want to minimize taxes on a traditional 401(k) distribution, then only withdraw up to your required minimum distribution. The money will be taxed at your normal tax bracket and having a lower income will keep you in a lower tax bracket, therefore you would pay less in taxes.
Yes, it is possible. Curley offers an example: Say you withdraw money from your traditional 401(k) and the distribution is taxed as ordinary income. If you then move the funds into an interest-earning savings account or brokerage account, you’ll be taxed (again) on the earnings.
