How to Pay Fewer Taxes on Your 401k Withdrawals in Retirement

Traditional 401k withdrawals require you to pay taxes on what you take out, reducing the amount of funds available for you to live out your golden years. The good news is that there are strategic moves you can make to reduce the tax burden. Here are 5 ways to minimize taxes on your 401k withdrawals in retirement.

Employ Regular Roth Conversions 

If you’re still actively saving for retirement, you could consider converting a portion of your 401k to a Roth 401k or Roth IRA. Unlike a traditional 401k, Roth accounts are funded by after-tax dollars, so you don’t have to worry about taxes on withdrawals later on. You will still owe tax on the amount of your Roth conversion in the year you convert, but you won’t owe additional taxes on withdrawals. This is especially helpful if you anticipate being in a higher tax bracket in retirement since a Roth account will allow you to take advantage of your current lower tax rate. That’s why regular Roth conversions can help you save for retirement in a more tax-efficient way. Beware that the IRS requires any conversion to occur at least five years before you access the money. Withdrawing the money early can result in penalties.

Make Early Withdrawals 

Required minimum distributions (RMDs) dictate how much you must take out of your retirement accounts annually. RMDs make it so that your money can't grow tax-deferred within your retirement account forever. You are required to withdraw money from your traditional 401k account once you reach age 72. If you’re still working after age 72 and don’t own 5% or more of the company you work for, you can continue to delay 401k withdrawals from your current employer’s account until you retire. This does not apply to Roth IRA and HSA withdrawals. To lessen your tax bill, you could withdraw early instead of waiting until age 72. By taking smaller distributions during your 60s, the benefit is two-fold.

1. Your tax bill will be spread out over more years, so you will pay less later on.

2. Taking early distributions could allow you to stay in a lower tax bracket, reducing your lifetime taxes.

If you'll be in a lower tax bracket at the beginning of retirement, it makes more sense for you to begin making withdrawals early rather than later when you have RMDs and may have to pay a higher tax percentage. It’s important to use early withdrawals for saving or investing purposes and avoid frivolous spending. What’s the point in withdrawing money early to save on taxes if it won’t serve you in the long run? 

Don't Forget About Tax Loss Harvesting 

If you have investments that have lost value, you can sell them, replace them with a similar investment that's more lucrative, and offset any investment gains made with your previous losses. This is called tax loss harvesting. With tax loss harvesting, you'll pay fewer taxes on the gains you make with your new investment. Let’s take a look at an example:

• Say you have a stock that appreciated to $25,000 and you sell it. You would be required to pay capital gains. 

• In the same year, you have another stock that lost $20,000. 

• Instead of $25,000 in capital gains, tax loss harvesting would result in only $5,000 in capital gains.

You're saving on taxes and getting rid of a stock that's not serving you. Note: you cannot sell a stock for a loss and then repurchase it in 30 days or less. This is referred to as the wash sale rule. The wash sale rule can make tax loss harvesting more tricky, so we recommend working with a financial professional to avoid any mishaps.

Keep Donating to Charity 

If you need another reason to donate to charity, here it is. If you are 70 ½ years old and you don’t need your 401k distributions to pay for your living expenses, you can convert a portion of your traditional 401k to a traditional IRA and donate the qualified charitable distribution (QCD) to a qualifying charity. There are a few things to note with this strategy:

• Donations cap at $100,000 per year

• Married couples filing jointly can contribute $200,000 per year

• Donations are not subject to income tax

• QCD must be paid directly from your IRA

If charitable giving is already a portion of your financial plan, this is a strong move to consider. 

Do You Have Company Stock in Your 401k? Check Out NUA 

If you have company stock in your 401k and it’s distributed to a taxable bank or brokerage account, you may be eligible for net unrealized appreciation (NUA). NUA is a tax strategy that can help you pay lower capital gains on your tax-deferred assets instead of paying regular income tax. It’s important because when you want to distribute your company stock or its cash value out of your 401k, you will have to make a decision:

1. Roll it into an IRA or another 401k plan 

OR

1. Distribute the stock into a taxable account and roll over the remaining assets into an IRA or 401k  

Typically, the second option is the most tax-efficient, but like tax loss harvesting, NUAs can be complex, so contacting a professional can make the process more efficient.

The Bottom Line: It’s Complicated

There are several ways to reduce your tax bill on 401k withdrawals, but it can be overwhelming to do it on your own. Reach out to our team today to better understand how you can pay fewer taxes on your 401k withdrawal in retirement and live out your golden years in bliss.