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.
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.
Age 70 1/2
As you approach age 65 with money in your 401(k) plan, you need to start thinking ahead to age 70 1/2. 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you fail to take your required minimum distribution, you face a tax penalty equal to half of the amount you should have withdrawn from the plan.
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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.
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. 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.