The 401k has grown in popularity over the last couple of decades because pensions have all but vanished; as a result, strategies around taking withdrawals and how to limit taxes and penalties are extremely prevalent.
In this article, we’re going to discuss the common penalties and taxes, and some of the strategies you can deploy to reduce them.
When a penalty typically applies
In almost all cases, a penalty applies if you withdraw from your account before the age of 59 ½. This is a 10% tax penalty. (Be advised: All withdrawals are subject to ordinary income taxes)
There is also a tax penalty if you fail to withdraw your Required Minimum Distribution (RMD). This applies to individuals over the age of 70 ½. This penalty, however, is 50% of the amount you should’ve withdrawn.
There are several exceptions, however.
Additionally, with the new Secure Act, there have changes to required minimum distributions, contributions, and others. For more information, click here.
When you are exempt from penalty
- Withdrawal after 59 ½
- Left employer after 55
- Left employment in public safety after 50
- Death distributions: your beneficiary is able to take distributions without penalty, regardless of their age
- Totally and permanently disabled as defined by the IRS
- 72t rule – Agree to withdraw the same amount for a fixed period of five years or until you turn 59 ½, whichever is greater.
- Unreimbursed medical expenses: You’re allotted to withdraw the unreimbursed medical expenses minus 10% of your adjusted gross income
- If you over contribute to your retirement plan for the year, you’re allowed to withdraw the excess without incurring a penalty.
- IRS Tax Levies
- Divorce: Depending on your state and how you settle the divorce with your former spouse, he/she can withdraw their respective portion without penalty
- Roth conversion: you pay taxes on the conversion, but there is no 10% tax penalty
*All exceptions may have certain requirements that need to be met to qualify for the exemption. Please check with your 401k Plan Administrator and Financial Advisor regarding your personal situation.
With regard to tax-saving strategies on 401k withdrawals, there are no short-cuts or exceptions like there was for the penalty section.
The best way to save money on taxes when taking distributions is to be strategic.
If the expense you are withdrawing for is something that can be planned ahead of time, determine your current tax bracket, figure out how much you’ll need at that future date, and withdraw slowly over time (how much you withdraw depends on how soon you’ll need it).
For example, if you are in the 22% tax bracket, are $10,000 from going into the next bracket, and need $40,000 for a down payment in 4 years, then withdraw just under $10k each year.
This assumes that your income and tax bracket will stay the same.
Another way to go about it is to utilize Roth conversions. If the intention is to minimize or eliminate your tax liability for retirement, do a Roth conversion every year. Just be mindful of where you are in your current bracket, so you aren’t bumped into the next one.
In this example, however, it can be counter-intuitive because in most cases, your tax bracket in retirement is lower than it was while you are working. This is commonsense, though. You’re making less, so logically you would be in a lower bracket.
With regard to taxes, it comes down to math. If you need to withdraw from your 401k, crunch the numbers and figure out how you can do that while limiting your tax exposure.
*Be advised – Securities offered through Securities America, Inc., Member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. Securities America and its representatives do not provide tax or legal advice; therefore, it is important to coordinate with your tax or legal advisor regarding your specific situation. Please see the website for full disclosures: www.crgfinancialservices.com