How to Minimize 401(k) Withdrawal Taxes

A woman is signing a contract.
Image Credit: LDProd/iStock/Getty Images

Many employers offer 401(k) plans to help their employees save for retirement and take advantage of the Internal Revenue Code's tax breaks for doing so. When it comes time to tap your nest egg, how you do so and where you're living at the time can have a noticeable impact on how much you get to keep of your distributions after paying Uncle Sam his share.

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).

references