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 it 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: 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.
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 — and we’re sure that’s not what you meant anyway. However, there are strategies to help you manage your tax liability once you start using the savings in your 401(k).
HAVING DIVERSE RETIREMENT INCOME SOURCES IS KEY
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 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.
TAX-EFFICIENT 401(K) DISTRIBUTIONS
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 2021 will be married filing jointly. According to 2021 tax brackets, as long as your taxable income stays below $81,050, your tax rate will be 12 percent — 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 $81,049 in taxable income, so you stay in the 12 percent tax bracket. If you need more than that to live off of in retirement, then you can switch to taking money from accounts where your withdrawals won’t be taxed, like from a Roth account or the basis you paid into your whole life insurance (which you can typically withdraw tax free).
With this strategy, you’re minimizing the amount of tax you will owe as you draw down from your diverse retirement portfolio. Just keep in mind that required minimum distributions (RMDs) begin at age 72. 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 turn 72, you will be required to withdraw a certain amount and pay taxes on it. 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. One possible way to manage your RMDs and taxes is to incorporate charitable giving strategies.
CONSIDER A ROTH IRA CONVERSION
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.
While you can’t avoid paying taxes on a 401(k) withdrawal, it’s a good idea to work with a financial advisor on your retirement plan. He or she can help you build a tax-efficient plan that also protects your retirement portfolio against other risks to your money, like market downturns or a long lifespan.