It’s crucial that retirees have a retirement withdrawal strategy to avoid taxes and penalties. Fortunately, retirement savers only have to understand a few basic rules to enjoy the tax benefits of qualified retirement accounts.
Here are some important points to keep in mind as you enter the decumulation phase of retirement.
Avoid the Early Withdrawal Penalty
Withdrawing early from your individual retirement account or 401(k) can trigger substantial penalties. For IRAs, if you withdraw funds before you turn 59 1/2, you’ll typically face a 10% early withdrawal penalty in addition to regular income tax.
Similarly, 401(k) withdrawals before the age of 59 1/2 incur the same 10% penalty, plus income tax.
There are exceptions for certain circumstances, such as disability or medical expenses. Before you take an early withdrawal, be sure your situation qualifies as an exception.
In addition to creating penalties, early withdrawals can significantly diminish your retirement savings. Explore other options for raising the cash you need before cashing out early.
[See: 12 Ways to Avoid the IRA Early Withdrawal Penalty.]
Roll Over Your 401(k) Without Tax Withholding
Rolling over your qualified retirement assets, rather than cashing out, is the preferred choice for investors who don’t want a big tax hit.
A rollover allows you to maintain the tax-advantaged status of your retirement savings and gives you more control over your investment choices. “If you are retiring or changing jobs, you can roll over your 401(k) to an IRA or, if allowed by the new employer, to a 401(k) with the new employer, without paying tax,” said Mark Luscombe, a Chicago-based principal federal tax analyst at Wolters Kluwer, in an email.
“The best way to do this is by a direct trustee-to-trustee transfer, which avoids 20% withholding on the transferred funds,” Luscombe said.
Remember Required Minimum Distributions
A required minimum distribution, commonly referred to as an RMD, is the minimum amount a retirement saver must withdraw from their retirement accounts, such as a traditional IRA or 401(k), starting at age 73.
If you fail to take these distributions, the IRS penalty is 25% of the amount not taken by the deadline, although the penalty may be reduced if corrected within a short period. The deadline to take your first RMD is generally April 1 of the year after you turn 73 and Dec. 31 in each subsequent year.
Because money held in traditional retirement plans has not yet been taxed, the IRS wants its piece of the pie once an account owner begins retirement withdrawals, said Regina McCann Hess, a certified financial planner and president of Forge Wealth Management in Malvern, Pennsylvania, in an email.
Once an account owner turns 73, or 75 if born in 1960 or later, they must withdraw money from their retirement plan each year.
[READ: Don’t Overlook These New RMD Rules for 2024]
Get the Timing Right on Your First Distribution
Forgetting to take your first RMD by April 1 in the year after you turn 73 can result in a significant tax penalty. To avoid unnecessary penalties and ensure compliance with tax regulations, you must stick to the Internal Revenue Service’s withdrawal deadlines. Financial advisors and tax accountants are well-versed in those deadlines and can help you avoid penalties.
But even if you wait until April 1 to take that first RMD for tax year 2023, you still have to take the RMD for tax year 2024 by Dec. 31.
If you decide to take the first two RMDs in one year, be aware that you’re doubling the tax expenses rather than spreading them across two calendar years.
Take Withdrawals Before They’re Mandatory
You can generally start taking withdrawals from your qualified retirement accounts penalty-free once you turn 59 1/2.
“Consider taking some distributions before age 73 if your distributions after age 59 1/2 would be taxed in a lower tax bracket than the bracket you expect to be in when the required minimum distributions start at age 73,” Luscombe said.
Taking RMDs before turning 73 could reduce taxable income down the road. Spreading out withdrawals may keep you out of higher tax brackets and minimize your tax liabilities over time.
“Some people will have the dividends come out of the plan and sent to their checking account,” Hess said. “This can supplement their Social Security and help pay monthly bills. You will pay taxes on these distributions, but they can help offset some of your expenses.”
Donate Your IRA Distribution to Charity
Donating your RMD to charity satisfies RMD requirements without creating a taxable event.
“Assuming you don’t need the dinero, gifting some or all your required minimum distribution, or more, to a nonprofit can help decrease your tax bill and help the organization,” Hess said. “The money that you gift to the charity directly from your retirement plan is not taxed.”
However, be careful about double-dipping, Hess added. “Since you are not taxed on the money, you cannot claim it as a deduction on your tax return,” she said.
“You can start using this strategy at age 70 1/2,” she said. “Also, in 2024, you can gift up to $105,000 per person using a qualified charitable distribution.”
Consider a Roth Account
A Roth IRA offers several advantages, including tax-free withdrawals in retirement, as contributions are made with after-tax dollars.
Additionally, as the money has already been taxed, there are no required minimum distributions from a Roth, allowing for more flexibility in retirement planning.
“Make contributions to a Roth account in your early years of working when your income is lower than it will be later. This allows earnings a longer time to grow tax deferred and then be withdrawn with no taxes due,” said Sallie Mullins Thompson, a certified public accountant in the District of Columbia.
“I recommend Roth accounts for all my young clients. For my older ones, I encourage them to help their children in their teens who are working summer jobs to open and fund Roth accounts,” Thompson added.
Another option is an annual Roth conversion, which involves transferring funds from a traditional IRA or 401(k) into a Roth IRA, typically subject to income taxes.
“Yes, you pay taxes on this money when it is converted, but it will continue to grow tax-deferred and then used as tax-free distributions years later, assuming you follow the Roth rules,” Hess said.
Hess advises speaking with an accountant before making a Roth conversion so you’ll know the estimated tax bill for making this move.
[Read: How to Reduce Your Lifetime Tax Bill With a Roth IRA.]
Hold Tax-Preferred Investments Outside of Retirement Accounts
If you have investments that generate long-term capital gains, consider holding them outside a qualified retirement account. That’s because if you hold these in a qualified account, you’ll pay your higher regular income tax rate when you make withdrawals.
“We’ll work with new clients who have previously purchased annuity products in their IRA accounts. Annuity products usually grow tax deferred, which is great, but not great if held in an IRA,” said Dina Leader Powers, a certified financial planner and wealth manager at Fairway Wealth Management in Independence, Ohio, in an email.
Because IRAs are already tax-deferred accounts, it’s unnecessary to hold a tax-deferred investment product inside an IRA, she explained. That’s especially true of annuities, which often come with a hefty price tag.
Powers recommended that clients with annuities hold them in a non-retirement account.
“This can sometimes be counterintuitive, but especially for older clients or clients in higher tax brackets, we often want to own slower-growing, higher-yielding assets in IRAs,” she said in an email. “This keeps the taxable income on your 1099s down.”
Powers added that higher-yielding assets, like bonds, tend not to appreciate as much. This results in less growth in the value of the IRA, meaning less overall value and thus less eventual ordinary income tax paid on distributions.
“Meanwhile, with faster-growing assets like equities, we’ll have clients own more in their non-retirement accounts or, better yet, in Roth IRAs if they have them,” she said. “Equities generally produce less income, and that income is usually taxed at lower capital gain rates.”
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How to Pay Less Tax on Retirement Account Withdrawals originally appeared on usnews.com
Update 03/19/24: This story was published at an earlier date and has been updated with new information.
