401(k) withdrawals are considered taxable income and are therefore taxed at your ordinary income tax rate.
Having a diverse mix of assets to work with in retirement can help you make strategic decisions that can help to minimize the impact of taxes.
A financial advisor can help you design a tax-efficient retirement plan.
A traditional 401(k) is a great way to save for retirement. That’s because you don’t pay taxes when you make contributions or when your employer makes matching contributions (if your company offers them). In addition, you don't owe tax on earnings as your money grows, which allows your contributions to compound more quickly. It all adds up to a lower taxable income during your working years — hopefully allowing you to save more money.
Now for the catch: traditional 401(k) withdrawals (technically, they’re called distributions) in retirement are taxed as ordinary income. As a result, you’ll be hit with a tax bill when it comes time to withdraw your savings.
How much tax will I pay on a 401(K) withdrawal?
Because you don’t pay taxes on your contributions (or your employer's contributions if you get a match), your withdrawals will be taxed at your ordinary income rate in retirement. You'll also have to pay taxes on any funds your employer contributed. And if you withdraw money from your 401(k) prior to age 59½, not only will you have to pay taxes, you’ll typically also be hit with a 10 percent penalty. (If you have a Roth 401(k), you won’t pay taxes on your withdrawals in retirement because the money you put in was already taxed — however, you can still be assessed taxes and penalties for taking out your money prior to 59½.)
How to calculate 401(k) withdrawal taxes
Any withdrawals you take from your 401(k) in retirement will be taxed at your ordinary income tax rate. To calculate your taxable income rate, you’d take your gross income (which includes any distributions from your 401(k)) less any deductions. (Most people just take the standard deduction.) That number will determine which tax bracket you’re in. Your tax bracket will determine your effective tax rate and thus, how much tax you’ll pay on your income—including disbursements from your 401(k).
Can you minimize taxes on your 401(k)?
That may lead some people to naturally ask the question: “How can I avoid paying taxes on my 401(k) withdrawal?” The short answer is that there’s no way to get out of paying the taxes you’ll eventually owe. However, there are some specific situations where you might be able to access your 401(k) money with minimal tax implications, even if temporarily. (A Roth IRA has a bit more flexibility in terms of penalty-free early withdrawals.)
Taking out a 401(K) loan. If your company allows it, you may be able to borrow against your 401(k), and you won’t be taxed on the amount you borrow. However, if you don’t pay the loan back on time or default, you will owe taxes and possibly early-withdrawal penalties.
Taking a distribution in retirement during a year where your income (including the distribution) falls below a household’s standard deduction.
Outside of those specific circumstances, if you’re planning to make regular 401(k) withdrawals in retirement, you'll have to pay taxes. That said, there are strategies to help you manage your tax liability once you start using the savings in your 401(k).
How to make tax-efficient 401(k) withdrawals
When it comes to being tax-efficient with your 401(k) in retirement, it’s all about the order in which you withdraw from your accounts. Here's an example.
Let’s say you’re retired (over age 59 ½) and your tax status in 2023 will be married filing jointly. According to 2023 tax brackets, as long as your taxable income stays below $89,450, you'll remain in the 12 percent tax bracket—but even a dollar above that amount will be taxed at 22 percent. That’s a big jump, and the rate gets progressively higher as your taxable income increases.
Planning your 401(k) withdrawals strategically could mean that you withdraw just enough to get you to $89,450 in taxable income, so you stay below the 22 percent tax bracket. If you need more than that to live off in retirement, then you can switch to taking money from accounts where your withdrawals won’t be taxed, like a Roth account or the basis you paid into your whole life insurance (which you can typically withdraw tax-free).
Have diverse retirement income sources
To be truly efficient with your taxes in retirement, it’s best to have a diverse mix of assets to work with — which means saving for retirement using more than just a traditional 401(k). This allows you to make strategic withdrawals in retirement that can help you lower your tax burden overall because different assets like Roth accounts, whole life insurance and even annuities have different attributes, including their tax treatment.
Stay in a lower tax bracket
The lower your taxable income, the lower your tax bracket will be. While you may not want to reduce the amount of total income you receive (though it is a way to pay fewer taxes), there are additional ways to manage your taxable income. Creative strategies such as using tax-advantaged accounts like an HSA or FSA along with carefully balancing Roth distributions with traditional distributions could yield tax savings. If you’re open to working a bit longer, delaying retirement and taking a lower-paying job could also reduce your taxable income (and give your 401(k) savings even more time to grow).
Consider a Roth IRA conversion or IRA rollover
If you’re still saving for retirement, you could also consider converting a portion of your 401(k) to a Roth IRA. You will owe tax on the amount of your Roth conversion in the year that you convert, but you likely won’t owe any additional taxes during your lifetime. This can help set you up to be more tax-efficient during retirement.
Keep required minimum distributions (RMDs) in mind
It's important to keep in mind that required minimum distributions (RMDs) begin at age 73. This amount is determined by dividing your previous end-of-year account balance by a life expectancy factor that’s based on your age. The IRS provides these resources to help you calculate your RMD.
Once you're required to start RMDs, you will be required to withdraw a certain amount and pay taxes on it each year. Taking lower withdrawals in your early years could leave you with higher required minimum distributions in later years. That’s why it’s a good idea to have a well-thought-out plan to generate your income in retirement.
Incorporate charitable giving strategies
A qualified charitable distribution (QCD) is a strategy some people use to distribute an IRA while minimizing taxes. With a QCD, an IRA owner can give up to $100,000 per year (which counts toward your RMD) from an IRA to qualified charities. These funds satisfy RMDs without counting against your taxable income—in fact they could qualify you for a tax break. If your money is in a 401(k), you could roll it over to an IRA to take advantage of this strategy.
How to control what you’ll pay in taxes overall
You might not be able to avoid paying taxes on a 401(k) withdrawal, but this is an area where a financial advisor can make a big difference—helping you to keep more of your money. If you’re saving for retirement, a Northwestern Mutual financial advisor can help you ensure that you’re saving in a way that positions you well to take advantage of the strategies above. If you’re entering retirement, an advisor can build a tax-efficient income plan that also protects your retirement portfolio against other risks to your money, like market downturns or a long lifespan. He or she can help guide the heavy lifting, leaving you with more time to live the life you planned for.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.