How to Withdraw Money From A 401k and Minimize Tax?
It is important to take a considered and strategic approach when withdrawing money from your 401k, in order to avoid paying too much tax.
Our team of chartered US tax advisers and enrolled agents have shared our answers to all of the most common questions we receive regarding withdrawing money from a 401k and minimizing tax. If you have any further questions contact us.
Minimizing tax on your 401(k) accounts
Depending on your situation and current needs there are many ways to minimize tax liabilities when withdrawing money from 401(k) accounts. Some great places to start include:
Exploring 401(k) penalty exceptions
Using multiple types of retirement plans
There are many other methods to minimize the tax you pay on your 401K- we will delve into several in this article.
We offer US 401(k) and other pension tax planning consultations to identify the best method for you.
Book a consultation to discuss your US pension tax matters with us.
Exploring 401(K) Penalty Exceptions
In the case that you need to withdraw money early from your 401(K), always check to see if you qualify for an exception. You will still need to pay the income tax on the withdrawal, but it could be possible to avoid the 10% early withdrawal penalty fee.
The main exceptions for withdrawing early from your 401(k) include:
Major life changing events like death or disability
Child or spousal support
Hardship withdrawals for situations including disaster relief or major medical expenses. See IRS Hardship Distribute FAQs for more information.
Up to one year of college tuition
Up to $10,000 dollars for first time homebuyers
Go to the IRS “Exceptions to Tax on Early distributions for more information”
IRS Rule 72(t)
If you are retiring early and do not qualify for the above exemptions starting at 54 years old, you can use IRS Rule 72(t) and withdraw early without the 10% penalty fee.
Rule 72(t) also known as the Substantially Equal Periodic Payment (SEPP) Exception, allows individuals to take equal distributions based on life expectancy for at minimum five years or until they turn fifty-nine ½ years old whichever comes later. For example, if you start the SEPP plan at age 58 you would need to continue at least until you are sixty-three. There are three conditions to consider before selecting for this path.
1. Any retirement accounts from your present job are not eligible for the SEPP exemption.
2. You must schedule your deductions, at least annually if not more often. If you miss even one of those annual deductions, then all of the earlier withdrawals are subject to the penalty fee.
3. All funds withdrawn are subject to taxation. Avoid using this exception with Roth IRA accounts, as even these funds are subject to being taxed again.
This exception can really help those who are in need of funds urgently or are planing on investing or saving the funds distributed and it allows them to spread out their future tax obligations. If these funds are used for investments, individuals are highly encouraged to hold those investments for at least a year so that the gains can be taxed as long-term capital gains instead of at the ordinary income tax rate. Depending on your tax bracket that could be a significant decrease in taxes, as the lowest bracket for long-term capital gains tax is 0%, and the lowest bracket for ordinary income tax is 12%.
The Still Working Exception
Alternatively, if you are still working when you are 72 years old and are planning to continue you could qualify for the “Still Working” exception. The federal government has yet to clearly define “Still Working” so it is safest to assume that to qualify you must have worked the entire calendar year. This exemption allows individuals to postpone their required minimum distributions (RMD’s) which begin at age 72.
This can benefit them in the short-term since it is deferring the taxes to later when they finally begin receiving their required minimum deductions. This exemption only applies to your 401(k) account with your current employer, any other retirement accounts will still distribute their minimum required payments. However, you will not qualify for this if you or an immediate family member are the owner of 5% or more of the company who is supplying your 401(k) plan.
Watching your tax bracket
Watching your tax bracket is also a keyway to minimize your tax liabilities when withdrawing from your 401(k) account.
Maintaining a desired tax bracket takes careful and detailed financial planning and can be done in several different ways. However, to be most effective it would be better to use a combination of these methods.
Limit your deductions
The first method is to limit your deductions to the limit of the desired tax bracket, this will keep taxable income to a minimum and therefore sustain a lower tax bracket.
If retirees aren’t careful with their deductions, it can be easy to jump to a new bracket and incur more taxes than predicted.
Furthermore, keeping your income within a lower tax bracket can also keep them within the 0% Capital Gains tax bracket. This will help in the case that you are keeping taxable investment accounts to supplement your income.
With detailed financial planning you can take advantage of diversifying your investment accounts while still preserving your lower tax bracket status to minimize your tax liabilities.
Below are the ordinary and capital gains tax brackets for individual and married tax filers for 2022, they are updated annually so it should be taken under consideration when planning for the following year.
Additionally, it would be best to time your deductions, and try to keep them to a minimum when you can.
When your required minimum deductions begin, you must take the first one by April 1st the year after you turn 72 years old, and then another and all following deductions by December 31st. If you do not plan the first two deductions properly, they can artificially inflate your income for the first year.
For example, if you turn 72 in July, you have until the following April 1st to take your first RMD, and then would need to take another by December 31st that same year. Delaying your first RMD can temporarily boost you into another tax bracket, so it would be advisable to not delay taking your first deduction. Taking the first deduction before December 31st the year you turn seventy-two will reduce your taxes the following year and provide a strong start to sustaining your desired tax bracket.
Delaying your Social Security Retirements Benefits
Traditionally you can begin receiving Social Security retirement benefits at age 62 at a reduced amount, and you will only receive the full benefits unless you wait until your full retirement age. However, you are able to delay taking them until you turn seventy.
Delaying these benefits can increase the benefit payments for the years between your full retirement age and when you turn seventy. Depending on your age you could receive between a 6-8% credit each year on your primary account balance.
For example, if you were born in 1962 your full retirement age would be sixty-seven. If you collected early benefits starting at sixty-two you would only receive 70% of your total benefits, but if you delayed the benefits, you would receive an 8% credit for each year.
So, if you did postpone your benefits then when you turn seventy in 2032, you would be able to collect 124% of your primary insurance amount. Social Security benefits aren’t usually taxable but if your joint income from benefits and 401(k) deductions exceeds the annual limit you could wind up paying taxes on them. Depending on your filing situation the tax could be on 50-85% of your total social security benefits collected that year. Deferring your benefits is extremely beneficial to those who are planning to make larger withdrawals from their 401(k) in the early years.
Maintaining Different Retirement Account Types
As with all choices made when investing - it is best to not rely on just one asset class. Diversifying your account types will allow you to make the most of your money. Common combinations of retirement accounts include Traditional and Roth IRA, personal savings, and taxable investing accounts. Maintaining multiple retirement accounts will allow you to move and manage your funds to best suit your needs while avoiding taxation every time you withdraw from your 401(k). Please note that whilst we offer investment advice, you must consult an experienced financial advisor when managing your investments to ensure you understand the risks involved.
Rolling over your 401K
Whenever you withdraw from your 401(k) there will be a mandatory 20% holding fee which is used for federal taxes. The only way to get the remaining after-tax percentage is to claim it on your tax return at the end of the year. While this holding fee could be considered in your final taxation calculations, this is often too complex for most individuals. Instead many opt to roll over the withdrawal amount to your IRA. This is because there is no holding fee for IRA accounts. Please bare in mind that you would still be required to pay the taxes on the transferred funds.
Partial Rollovers to Roth IRA
You could also choose to roll over just a part of your 401(k) to a Roth IRA, this is one of the easiest ways to reduce tax liability at a later date. You would still be required to pay the taxes upon the creation of (or when adding to) the Roth IRA, but all appreciation in the account will be safe from future taxation. If this course of action is chosen it is recommended that a minimum of 5 years elapses before you gain access to this investment. This is because Roth IRA accounts must be open for a minimum of five tax years (January 1st – December 31st) before you are allowed to withdraw without penalty.
Rolling over your old 401(k) account to your current job’s account is also an effective way to reduce your tax liability. You can defer your required minimum deductions while working at your current job. When rolling over the old 401(k) accounts it is important to ensure that any withdrawn funds are redeposited within 60 days. If they are not, the action will be recorded as a deduction rather than a transfer. This will leave you liable to taxation and potential early withdrawal penalties.
Alternative Options
There are various alternative methods that can help minimize your tax liability when withdrawing from your 401K. Below is a summary of the most commonly used options.
Taking a loan from your 401K
If you are considering investing to create a passive income for yourself during retirement you may be eligible to take a loan from your 401(k). This option has many benefits to the retiree, the first being that as long as it is repaid by the loan maturity date, the funds will not be taxed. Of course, with any investment, there will still be risks so please consult a tax professional to ensure you have a full understanding of said risks.
The last options are Tax Loss Harvesting and Net Unrealized Appreciation. These options are complex and require careful consideration. It is highly recommended that you consult with a qualified tax professional before opting to use these methods.
Net Unrealized Appreciation to reduce tax on 401k
Net Unrealized Appreciation is only practical if you own company stock that you have been employed at. Net Unrealized Appreciation is the process of claiming the difference between the original cost of a stock and the current market value of the shares. This difference will be taxed as a capital gain which can drastically lower your tax liability. However, the original cost of the shares will be taxed at your ordinary tax rate and must be paid at once instead of when the shares are sold in the future. This makes it best to only distribute the lowest cost basis shares, allowing you to still take advantage of the capital gain tax but minimize the ordinary tax liability. There are a couple of requirements to consider if you wish to follow this plan.
You must be or have been an employee at the company whose stock is being claimed
The stock has to be in a tax-deferred account. (Traditional 401(k), 403(b), or IRA)
The owner of the stock must have either left the company, met the minimum retirement age, or suffered an injury resulting in total disability.
You must be planning to distribute the remaining balance held in that employer’s plan, as well as all of the assets attached within one year.
You should not pursue Net Unrealized Appreciation without consulting with a tax professional due to the complexity surrounding the method. Any mistakes can lead to financial and potentially legal ramifications.
Tax loss harvesting to reduce tax on 401k
Tax loss harvesting is the process of selling poorly performing securities in your taxable investing accounts at a loss, this loss can then be claimed on your taxes. You can claim up to $3000 on your taxes. If the loss is greater than $3000 the remainder can be rolled over into the following year. However, those that employ this method should be careful not to violate the Wash Sale Rule. Wash Sales occur when a security is traded and sold at a loss, then the seller proceeds to repurchase the same or a “substantially similar” stock or security within thirty days before or after the sale. A wash sale can also be made when a spouse or the company the individual controls buys a similar stock, or when the individual repurchases the security with their 401(k).
See our calculator below for tax loss harvesting
Tax Loss Harvesting
Work out how much you could earn from tax loss harvesting
Please select the amount of hours you work from home each month?
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The tax rate you would fall under if you sold your investment now?
How much will your investment gain between now and the final sale of the investment?
What is the estimated tax rate on your investment likely to be at the final sale?
Important! This is only a reference point. Your total capital gain owed variable depending on the actual price of your investments upon final sale. Seek guidance from a tax professional if you are still unsure about how to utilize tax loss harvesting to maximize on your investments.
For more information on the wash sale rule, Forbes have a very detailed article on the subject - “ Understand The Wash Sale Rule And Keep Your Trading Clean”
Need More Help
Reducing your tax liability when withdrawing from a 401K is a complex topic. Please remember that any mistake on your behalf can lead to financial and legal repercussions. If you want to know more about withdrawing from a 401K, or any other area of U.S. taxation do not hesitate to contact us.