5 Ways to Pay Fewer Taxes on Your 401(k) Withdrawal

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Please note the publish date of this blog. Financial information, market conditions, and other data mentioned in this post may no longer be accurate or relevant.

Saving for retirement is a marathon. As you near the finish line, it’s pragmatic to maximize the money you’ve invested in your 401(k) since your personal savings will likely handle most of your retirement bills.

A critical way to maximize your nest egg is to pay as little taxes as possible (and legal) when you make distributions. 

Since you contributed funds to your traditional 401k before tax, the IRS will take their cut when you withdraw that money in retirement. 

Are there ways to minimize the tax impact?

Let’s look at some creative ways to pay as little tax as possible on your 401(k) withdrawal.

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1. Convert Your Traditional Account Into a Roth

Where traditional accounts defer taxes until retirement, Roth accounts have you pay taxes now and take tax-free distributions when your golden years arrive. 

So, one way to minimize taxes on your 401(k) withdrawals is to convert some (or all) of it into a Roth. You may be able to accomplish this in a few ways:

In-plan Roth conversion

Here, you convert funds from a traditional 401(k) to a Roth 401(k) if your plan allows. Keep in mind you’ll have to pay income taxes on the amount converted. This extra tax bill could be a good idea if you want to build up tax-free income in retirement or pass on tax-free assets to your heirs. 

Roll your traditional 401(k) into a Roth IRA. 

Roth IRA’s are one of the most popular accounts for retirement savings, offering several key benefits: tax-free withdrawals, no required RMDs (more on this later), investment flexibility, and they are a tax-free vehicle to pass on to heirs. 

It’s an excellent idea to convert some of your 401(k) into a Roth IRA. Why? Even though you pay taxes up front, any earnings and withdrawals are tax-free in retirement (provided you follow the rules). 

While a Roth is not for everyone, Roth conversions can benefit high earners who anticipate being in a higher tax bracket when they retire. By paying money now, you won’t have to later on. And if you’re in a lower tax bracket than when you withdraw the money, you’ll end up paying less in taxes over the long term. 

Using an employment tax calculator, here’s an example of the difference that a 401(k) to Roth IRA conversion can actually make:

Say you have $120,000 in retirement income and you live in California. Those numbers put you around a 32.1% tax rate. If you withdrew $10,000 monthly solely from your 401(k), you would only receive about $6,790 of spending money. If you converted half of it into a Roth IRA, you could avoid paying such a high tax rate and take home over $1,605 in additional income each month.

Under the right circumstances, paying taxes upfront yields more dividends later on. 

2. Withdraw Before You “Have To”

Your money can’t grow tax-deferred in your 401(k) forever; eventually, Uncle Sam will want his cut. To accomplish this, the IRS issues required minimum distributions (RMDs) that dictate how much you must annually take out of your account.  

RMDs start once you turn 72 and apply to nearly every retirement account except Roth IRAs and health savings accounts (HSAs).

At first, it seems logical to hold off taking distributions from your retirement account until you absolutely have to. However, this isn’t always the best idea.

You will likely be in a lower tax bracket when you first start retirement since you don’t have RMDs, Social Security, and other sources of income. You’ll pay less tax if you’re in a lower tax bracket, so if you start taking money out earlier, you can avoid losing a higher percentage of it later on. 

Meaning, you can let money accrue wealth in your Roth IRA or another investment account (without RMDs) while you prioritize taking money at a lower tax rate from your retirement accounts. 

Also, if you want to do a Roth IRA conversion (discussed earlier), it’s a great idea to start taking RMDs early because it will free up funds for that conversion when the time comes. You’ll also be in a lower tax bracket, which helps mitigate the tax burden of the conversion itself. 

3. Employ Tax-Loss Harvesting

Paying taxes is never enjoyable, and most Americans likely pay more than their fair share because they don’t have a financial advisor to guide them through the complicated tax system. 

One clever way to save taxes on a retirement investment account like a 401(k) is to employ a strategy known as tax-loss harvesting. 

Say you have an investment that has lost value and you would like to switch to a more lucrative investment. With tax-loss harvesting, you can sell an investment that’s down, replace it with a similar investment, and offset any investment gains made with your previous losses. That way, if you make a decent amount of money on your new investment, you will pay fewer taxes on it. 

If you have a monthly retirement distribution that would land you in a higher tax bracket, you could also sell off securities to balance your tax liability for the year. 

Work with your financial advisor to determine how large of a sell-off would save you the most on taxes while still being financially responsible.

Also, ensure you are mindful of the wash-sale rule when repurchasing shares. This rule bars selling an investment and buying a similar one within 30 days before or after the sale.

4. Rollover Your 401(k) to an IRA, Then Donate to Charity

LendingTree found that 56% of US adults donated to charity in 2021, and you’re likely one of those people who decided to make a difference in their community. Whatever cause matters most to you, make the most of your charitable giving by employing tax-smart strategies. 

As a brief reminder, required minimum distributions (RMDs) are mandatory for both 401(k)s and traditional IRAs. Helpfully, there’s a workaround that could meet all RMD requirements while also opening the door to making a positive impact in your community.

A Rollover IRA allows you to move money from your 401(k) into an IRA while still maintaining the tax-deferred status and allowing the money to continue growing. 

This means you can transfer a set amount (like your annual RMD from your 401(k) to an IRA) and then donate a portion (or all) of your RMD to charity via a Qualified Charitable Distribution (QCD), which requires that you make donations to a 501(c)(3) organization.

Employing this strategy lets you satisfy your RMDs while keeping taxes at bay. Like some of the techniques mentioned before, this is especially helpful if it prevents you from being bumped into a higher tax bracket.

Plus, an added bonus: you can roll over old 401(k)s into one IRA, simplifying your life with fewer accounts to keep track of.  

Giving back and creating a legacy of generosity enriches the soul. If you employ tax-smart strategies when donating to charity, it will open the door to more giving in the future.

5. If You Have Company Stock, Consider Net Unrealized Appreciation (NUA)

Our final strategy is an advanced one, so you’ll want to consult your financial advisor before taking any steps. If you have been at the same company for 25+ years, your employer’s stock has likely increased exponentially, and this strategy could be a great choice to protect your assets.

If you have appreciated company stock in your 401(k), you may be able to avoid paying income tax on the unrealized gain or the net unrealized appreciation (NUA). Instead, you could pay tax at the more favorable long-term capital gains rate if you strictly adhere to all the rules, like transferring the stock from your 401(k) into a taxable brokerage account. 

While income tax can be as much as 37% depending on your tax bracket and where you live, this strategy could bring significant savings. Depending on your income, capital gains tax ranges from 0% to 20%.

Pro tip: You can only take advantage of NUA if the money is placed in a tax-deferred account like a 401(k), so a Roth IRA won’t work for this particular strategy. 

Support For Your Retirement Planning

Financial maneuvering in retirement can be intimidating, but your Abacus financial advisor will always help walk you through it. As a financial partner and fee-only fiduciary with your best interests at heart, we love to see clients build a future that is most meaningful to them.

Our advisors are well versed in the best strategies to make the most of your 401(k) (or any other investment account), minimizing your expenses while allowing your money to grow. 

Get started on expanding what’s possible with money today. Schedule a free introductory call with one of our advisors.


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