How Can I Avoid Paying Taxes on My 401(k) Withdrawal?

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, your withdrawals will be taxed at your ordinary income rate in retirement. But if you withdraw money from your 401(k) prior to age 59½, not only will you have to pay taxes, you’ll 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.)  

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. But there are some specific situations where you might be able to access your 401(k) money with minimal tax implications, even if temporarily. 

• 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. However, there are strategies to help you manage your tax liability once you start using the savings in your 401(k). 

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 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) 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 2022 will be married filing jointly. According to 2022 tax brackets, as long as your taxable income stays below $83,550, 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 $83,550 in taxable income, so you stay in the 12 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). 

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.

You might not be able to avoid paying taxes on a 401(k) withdrawal, but 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.