Putting money aside in a 401(k) during your working years is one of the most effective ways to accumulate wealth for your retirement years. But accumulating that money is only half of the battle. The other half is devising a strategy that allows you to meet your daily living expenses while minimizing your taxes. Understanding how 401(k) withdrawals impact your taxes makes devising such a strategy a lot easier.
401(k) Withdrawal Age 65
When you start pulling money from your 401(k), the money you take out is taxed as ordinary income. When you do your tax return, the money you pulled from your 401(k) during the previous year is simply added to your other income. Your tax liability is based on the total of all your income, including your 401(k) plan withdrawals, interest and dividends and any wages you may have.
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The amount of tax you pay depends on your tax bracket. So, if you take a higher distribution, you may end up falling into the next tax bracket with a higher tax rate.
The good news is, at age 65, you don't have to worry about paying penalties on the distribution. You may be required to pay a 10 percent early withdrawal penalty if you are below 59 ½ years.
Think Ahead to Age 72
As you approach age 65 with money in your 401(k) plan, you need to start thinking ahead to age 72. When you reach that age, you are required to start taking minimum distributions from your retirement plans, including your traditional IRA and your 401(k) plan. If you fail to take your required minimum distribution, you face a tax penalty equal to half of the amount you should have withdrawn from the plan.
When you take a distribution from your 401(k), your plan will send you a Form 1099-R showing how much you withdrew in the tax year.
Consider also: About the Different Types of 1099 Tax Forms: What You Should Know
Plan for Tax Savings
If you have never taken money from your 401(k), it is a good idea to do some tax planning before you request that first check from the plan administrator. When you start taking money from your plan, you increase your taxable income, and that can boost your tax bill. Taking the time to review the tax implications of your 401(k) withdrawal strategy gives you a chance to tweak the amount you take and keep your tax bill as low as possible.
Developing a Withdrawal Strategy
Tax planning should play a role in your 401(k) withdrawal strategy, but it should not dictate the entire strategy. You also need to make sure your money lasts as long as you live, so taking a conservative approach is a smart move.
Generally when taking 401(k) withdrawals, it is sensible to try to keep your taxable income in a lower tax bracket. You can achieve this by planning your distributions up to the upper limit of your tax bracket. Withdrawing no more than 4 percent to 5 percent of your 401(k) portfolio the first year can help preserve your capital, while lowering your tax bill at the same time.