How to Minimize 401(k) Withdrawal Taxes

How to Minimize 401(k) Withdrawal Taxes
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Wait to Take Qualified Distributions

If you take out money from your 401(k) plan before you turn 59 1/2, the IRS imposes a 10 percent tax penalty on your withdrawals -- on top of what you already owe in income taxes -- unless you qualify for an exemption. For example, if you take out $5,000 before you turn 59 1/2, that's an extra $500 you pay to Uncle Sam. Exceptions that permit you to escape the additional penalty include doctor's costs above 10 percent of your adjusted gross income, taking distributions from a 401(k) plan you inherited from someone else, or taking distributions after you leave your job at age 55 or older -- age 50 if you're a public safety employee.

Spread Out Distributions

When you take distributions from your 401(k), it increases your taxable income for the year. Because the federal government uses a progressive tax structure, higher rates apply to higher amounts of income, rather than the same rate applying to all your income. So, if you take out $100,000 in one year, and then $0 the following year, you'll pay more overall than if you take out $50,000 in each year. Consider consulting with a financial adviser or tax preparer to help minimize the tax bite.

Pick a Retirement-Friendly State

Not everyone has the ability -- or the desire -- to pick up and move to a different state for retirement. However, if you really want to minimize your taxes on your 401(k) plan distributions, retire to a state that doesn't have a state income tax, like Florida, Texas or Nevada, or a state that exempts 401(k) withdrawals from income tax, like Illinois. Some other states offer exemptions that permit you to exclude a certain amount of your 401(k) withdrawals from state income taxes.

Advance Planning with Roth 401(k)s

If you have some time before retirement and your employer offers a Roth 401(k) option, planning ahead can help lower your taxes later on. A Roth functions differently than a traditional 401(k) because you don't get to exclude your contributions from your income, but you do get to take tax-free withdrawals in retirement. So, if you have years where you fall into a lower income tax bracket while you're still working, consider contributing more to a Roth 401(k) -- or converting some of your traditional 401(k) assets -- during those years. That way, if you find yourself in a higher tax bracket during retirement, you can use your tax-free distributions from your Roth 401(k).