You don’t get to use all the money in your traditional 401(k) and IRA for retirement because you still have to pay taxes on it. However, there are several ways to minimize taxes as you pull money out of your retirement accounts. Consider these strategies to decrease the tax bill for your retirement account withdrawals.
Avoid the early withdrawal penalty. If you withdraw money from your traditional IRA before age 59 1/2, there’s a 10 percent early withdrawal penalty, and that’s in addition to the income tax due on each withdrawal. However, you can take penalty-free 401(k) withdrawals beginning at age 55, if you leave the job associated with that 401(k) account at age 55 or later.
Roll over your 401(k) without tax withholding. If you withdraw money from your 401(k) when you change jobs, 20 percent will be withheld for income tax. However, you can avoid the tax withholding, and the potential to trigger penalties and fees, if you transfer the money directly from your 401(k) to the trustee of another 401(k) or IRA.
Remember required minimum distributions. You are required to withdraw money from your traditional 401(k) and IRA after age 70 1/2. The penalty for missing a required withdrawal is 50 percent of the amount that should have been withdrawn. “You can take a lump sum or set up monthly or quarterly transfers. Tax-wise it doesn’t matter as long as you meet the requirements,” says Cristina Guglielmetti, a certified financial planner for Future Perfect Planning in Brooklyn, New York. “You will be taxed on how much comes out in the calendar year whenever it comes out.” However, if you are still working after age 70 1/2 and don’t own 5 percent or more of the company you work for, you can continue to delay 401(k), but not IRA, withdrawals until you actually retire.
Avoid two distributions in the same year. Your first required minimum distribution is due by April 1 of the year after you turn 70 1/2. Your second and all subsequent distributions must be taken by December 31 each year. If you delay your first distribution until April you will be required to take two distributions in the same year, which could result in an unusually high tax bill or even bump you into a higher tax bracket. “It’s probably better to do them in individual years so you are not doubling up on the taxes,” Guglielmetti says.
Start withdrawals before you have to. While you don’t have to begin traditional retirement account withdrawals until after age 70 1/2, taking smaller distributions beginning during your 60s spreads the tax bill over more years and could allow you to stay in a lower tax bracket and reduce your lifetime tax bill. “While most people consider deferring retirement account withdrawals to the latest possible time—70 1/2—it may be wise to consider spreading out the tax consequences over many years beginning sooner,” says Carey McNeal, a certified financial planner for Buffington Mohr McNeal in Boise, Idaho.
Donate your distribution to charity. Retirees who are age 70 1/2 or older can avoid paying income tax on IRA withdrawals of up to $100,000 per year that they directly transfer to a qualified charity. An IRA charitable contribution will also satisfy the minimum distribution requirement.
Consider Roth accounts. Putting some of your retirement savings in an after-tax Roth account could set you up for tax-free investment growth and tax-free withdrawals in retirement. If you expect to be in a higher tax bracket in retirement, a Roth account also allows you to lock in today’s low tax rate.
Keep tax-preferred investments outside retirement accounts. Investments that generate long-term capital gains receive preferential tax treatment when held outside of a retirement account. However, if you put them in a retirement account, you will pay your typically higher regular income tax rate when you withdraw the money from the account. In contrast, you can lower your tax bill by holding more highly taxed investments, including Treasury inflation-protected securities, corporate and government bonds and funds that generate short-term capital gains inside retirement accounts. “You normally push the equity portion into a non-qualified account, and then you push any income producing securities like bonds into the IRAs,” says Gabriel Anderson, a certified financial planner for Crafted Wealth Management in Venice, California. “You get a higher after-tax return because of the lower tax rates.”
Source: Emily Brandon, U.S. News & World Report, April 18, 2016