When you’re ready to take advantage of your retirement funds, the last thing you want to deal with is a fee or penalty. Retirement accounts come with plenty of benefits, such as tax deductions and a generally high return on investment.
But they can also come with complicated rules that might make it tricky to get your money.
“Retirement accounts such as 401(k)s, 403(b)s and traditional IRAs are great places to save money for the future while also receiving some tax deductions along the way,” Andrew Herron, certified financial planner and founding partner of Stone Pine Financial Partners, says.
You’ll just need to be careful to follow the policies associated with the type of account you have. For instance, if you withdraw money when you’re too young, it can be subject to tax penalties.
Read on to discover the most tax-friendly ways to make withdrawals from your account(s).
[Read: How to Get the Biggest Tax Refund This Year.]
Avoid the Early Withdrawal Penalty
Taxpayers always pay taxes on their traditional 401(k) withdrawals. But there are strategies to reduce them, says Miles Brooks, certified public accountant and director of tax strategy at CoinLedger.
“The IRS imposes levies of 10% additional taxes on 401(k) withdrawals before the age of 59 1/2 , plus the ordinary income tax that would be imposed on the amount to be withdrawn. Early withdrawal of funds limits the opportunity for future savings growth on investments,” Brooks says.
The same goes for traditional IRAs: If you withdraw money from them before you’re 59 1/2, there’s a 10% early withdrawal penalty — and that’s in addition to the income tax you’ll owe.
You can take penalty-free 401(k) withdrawals beginning at age 55, however, if you leave the job associated with that account.
Roll Over Your 401(k) Without Tax Withholding
If you withdraw money directly from your 401(k) when you change jobs before age 59 1/2, you must withhold 20% for taxes. If you don’t put the entire distribution — including the 20% you withheld — into a new retirement account within 60 days, you could owe income tax plus the early withdrawal penalty on the amount you withdrew.
You can avoid the tax withholding and the potential to trigger penalties, however, if you transfer the money directly from your 401(k) to the trustee of another 401(k) or IRA. You don’t need to withhold tax when you conduct a trustee-to-trustee transfer.
Remember Required Minimum Distributions
You are required to withdraw money from your traditional 401(k) and/or IRA after you turn 73.
“Since the money in these accounts has likely never been taxed, the IRS forces retirees to start taking some distributions by the time they turn 73. Essentially, the IRS wants to start collecting taxes on these accounts, and those withdrawals are referred to as required minimum distributions,” Herron says.
The penalty for missing an RMD is 25% of the amount you should have withdrawn. That’s in addition to the income tax due on the withdrawal. If you correct your mistake in a timely manner, the penalty falls to 10%.
If you’re still working after you turn 73 and don’t own 5% or more of the company you work for, you can continue to delay 401(k) withdrawals from your current employer’s account. You can’t delay traditional IRA withdrawals until you actually retire, however. The age to begin taking RMDs will increase to 75 on Jan. 1, 2033.
“Once you reach the age of required distributions, be sure you have a plan in place to take your annual distributions to avoid any penalties,” Herron says.
Avoid Two Distributions in the Same Year
Your first RMD is required by April 1 of the year following the year you turn 73. You must take your second distribution — and all subsequent ones — by Dec. 31 each year.
If you delay your first distribution until April, you’ll have 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.
Make sure you determine whether it would reduce your tax bill to take your first and second RMDs in separate tax years.
Take Withdrawals Before They’re Mandatory
One way to minimize tax payments on 401(k) withdrawals is to not wait until you turn 73 and the mandatory RMD kicks in, says Jerry Slusiewicz, principal and financial advisor at Pacific Financial Planners LLC.
“Once that occurs, one loses some control as to when taxes are due because they will be taxed at that prevailing rate in those years,” he adds.
While you don’t have to begin traditional retirement account withdrawals until age 73, taking smaller distributions during your 60s spreads the tax bill over more years and could enable you to stay in a lower tax bracket as well as reduce your lifetime tax bill.
[Read: What’s My Tax Bracket?]
Donate Your IRA Distribution to Charity
Retirees who are 70 1/2 or older can avoid paying income tax on annual IRA withdrawals of up to $100,000 ($200,000 for couples) that they donate to charity. You must make your qualified charitable donation directly from your IRA.
You don’t need to itemize your taxes to make an IRA charitable distribution, and you can donate to multiple charities. An IRA charitable contribution will satisfy your RMD. You can also donate part of your RMD to charity and withdraw the rest as income.
[Read: New Rules for Charitable Giving.]
Consider a Roth Account
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.
You won’t get a tax deduction for the year you contribute to a Roth IRA or Roth 401(k), but you don’t have to pay income tax on the account’s investment growth and you can make tax-free withdrawals if your account is at least five years old and you’re at least age 59 1/2. There are exceptions to the early withdrawal penalty, such as for a first-time home purchase.
If you expect to be in a higher tax bracket in retirement, a Roth account also allows you to lock in today’s lower tax rate.
“One of the approaches to reduce taxes on 401(k) withdrawals is converting the funds to a Roth 401(k) or individual retirement account. The withdrawals from such accounts are not taxable, as they comply with the rules for a qualified distribution,” Brooks says.
Keep Tax-Preferred Investments Outside of Retirement Accounts
Investments that generate long-term capital gains get preferential tax treatment when they’re outside of a retirement account. If you put them in a retirement account, however, you’ll pay your higher regular income tax rate when you withdraw the money.
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.
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How to Pay Less Tax on Retirement Account Withdrawals originally appeared on usnews.com
Update 08/30/23: This story was published at an earlier date and has been updated with new information.
