If you have a traditional 401(k), you will have to pay taxes when you take a 401(k) distribution. That 401(k) money is subject to ordinary income tax. The amount you pay is based on your tax bracket, and if you’re younger than 59½, add a 10% early withdrawal penalty in most cases. That could put your tax rate in the top 37% bracket. (Note that there was no early withdrawal penalty in 2020 for coronavirus-related withdrawals, following the passage of the CARES Act.)
You could look at a Roth 401(k) or a Roth IRA to pay taxes now rather than later, but we wanted to know how financial professionals help their clients minimize their tax burden on a standard 401(k) distribution. We asked, and they gave us some good tips on reducing your taxable burden and avoiding the 20% mandatory withholding. Read on to find out how you can benefit right now.
Key Takeaways
- Certain strategies exist to alleviate the tax burden on 401(k) distributions.
- Net unrealized appreciation and tax-loss harvesting are two strategies that could reduce taxable income.
- Rolling over regular distributions to an IRA avoids automatic tax withholding by the plan administrator.
- Consider delaying plan distributions (if you are still working) and Social Security benefits or borrowing from your 401(k) instead of actually withdrawing funds.
- The CARES (Coronavirus Aid, Relief, and Economic Security) Act provided some tax relief in 2020 to those with retirement accounts, including 401(k)s, impacted by the coronavirus outbreak.
Your 401(k) Distribution and Taxes
Distributions from your 401(k) are taxed as ordinary income, based on your yearly income. That income includes distributions from retirement accounts and pensions and any other earnings. As a result, when you take a 401K) distribution, it is important to be aware of your tax bracket and how the distribution might impact that bracket. Any 401(k) distribution you take will increase your yearly earnings and could push you into a higher tax bracket if you’re not careful.
There is a mandatory withholding of 20% of a 401(k) withdrawal to cover federal income tax, whether you will ultimately owe 20% of your income or not. Rolling over the portion of your 401(k) that you would like to withdraw into an IRA is a way to access the funds without being subject to that 20% mandatory withdrawal. Tax-loss selling on poorly-performing investments is another way to counter the risk of being pushed into a higher tax bracket.
Deferring taking Social Security is another way of reducing your tax burden when you take a 401(k) withdrawal. Social Security benefits are not usually taxable unless the recipient’s overall annual income exceeds a set amount. Sometimes a large 401(k) withdrawal is enough to push the recipient’s income over that limit. Here’s a look at these and other methods of reducing the taxes you need to pay when you withdraw funds from your 401(k)
1. Explore Net Unrealized Appreciation (NUA)
If you have company stock in your 401(k), you may be eligible for net unrealized appreciation (NUA) treatment if the company stock portion of your 401(k) is distributed to a taxable bank or brokerage account, says Trace Tisler, CFP®, owner of Epic Financial LLC, a northeastern Ohio financial planning firm. When you do this, you still have to pay income tax on the original purchase price of the stock, but the capital gains tax on the appreciation of the stock will be lower.
So, instead of keeping the money in your 401(k) or moving it to a traditional IRA, consider moving your funds to a taxable account instead. (You should also consider thinking twice about rolling over company stock.) This strategy can be rather complex, so it might be best to enlist the help of a pro.
2. Use the “Still Working” Exception
Most people know that they are subject to required minimum distributions (RMDs) at age 72, even on a Roth 401(k). Please note that the RMD age was changed from 70½ to 72 at the end of 2019 through the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019. But if you’re still working when you reach that age, these RMDs don’t apply to your 401(k) with your current employer (see item 8, below).
In other words, you can keep the funds in the account, earning away to augment your nest egg, and postponing any tax reckoning on them. Keep in mind that the IRS has not clearly defined what amounts to “still working;” probably, though, you would need to be deemed employed throughout the entire calendar year. Tread carefully if you’re cutting back to part-time or considering some other sort of phased retirement scenario.
On March 27, 2020, President Trump signed a $2 trillion coronavirus emergency stimulus package into law, called the CARES Act. It suspended required minimum distributions (RMDs) in 2020. This gives retirement accounts, including 401(k)s, more time to recover from the stock market downturns, and retirees who could afford to leave them alone get the tax break of not being taxed on mandatory withdrawals.
Also, “there are issues with this strategy if you are an owner of a company,” warns Christopher Cannon, CFP®, of RetireRight Pittsburgh. If you own more than 5% of the business that sponsors the plan, you’re not eligible for this exemption. Also, consider that the 5% ownership rule actually means over 5%; includes any stake owned by a spouse, children, grandchildren, and parents; and may rise to over 5% after age 72. You can see how complicated this strategy can get.
3. Consider Tax-Loss Harvesting
Another strategy, called tax-loss harvesting, involves selling underperforming securities in your regular investment account. The losses on the securities offset the taxes on your 401(k) distribution. “Exercised correctly, tax-loss harvesting will offset some, or all, of an investor’s tax burden generated from a 401(k) distribution,” says Kevin Pollack, co-founder, and managing partner at Chamberlain Warden LLC. (There are limitations to this strategy that involve reducing investment losses.)
4. Avoid the Mandatory 20% Withholding
When you take 401(k) distributions and have the money sent directly to you, the service provider is required to withhold 20% for federal income tax. If this is too much—if you effectively only owe, say, 15% at tax time—this means you’ll have to wait until you file your taxes to get that 5% back.
Instead, “roll over the 401(k) balance to an IRA account and take your cash out of the IRA,” suggests Peter Messina, Vice President at Salt Lake City’s ABG Consultants, which specializes in retirement plans. “There is no mandatory 20% federal income tax withholding on the IRA, and you can choose to pay your taxes when you file rather than upon distribution.”
If you borrow from your 401(k) and neglect to repay the loan, the amount will be taxed as if it was a cash distribution.
5. Borrow Instead of Withdraw From Your 401(k)
Some plans let you take out a loan from your 401(k) balance. If so, you may be able to borrow from your account, invest the funds, and create a consistent income stream that persists beyond your repayment of the loan.
“The IRS generally allows you to borrow up to 50% of your vested loan balance—up to $50,000—with a payback period of up to five years,” explains Ravi Ramnarain, a CPA based in Fort Lauderdale, Fla. “In this case, you don’t pay any taxes on this distribution, let alone a 10% penalty. Instead, you simply have to pay back this amount in at least quarterly payments over the life of the loan.”
“Given these parameters,” Ramnarain continues, “consider this scenario: You take out a $50,000 loan over five years. With interest, let’s say your monthly payment over this 60-month period is $900. Now imagine taking that $50,000 principal amount and purchasing a small house, apartment, or duplex in the relatively inexpensive South to rent out. Given that you would be purchasing this property without a mortgage, let’s say that your net rent each month comes out to $1,100, after taxes and management fees.”
“What you have effectively done,” says Ramnarain, “is set up an investment vehicle that puts $200 in your pocket each month ($1,100 – $900 = $200) for five years. And after five years, you will have fully paid back your $50,000 401(k) loan, but you’ll continue to pocket your $1,100 net rent for life! You might also have the opportunity to sell that house/apartment/duplex later on at an appreciated amount, in excess of inflation.”
Fast Fact
The CARES Act doubled the amount of 401(k) money available as a loan to $100,000 in 2020, but only if you had been impacted by the COVID-19 pandemic.
Of course, a strategy like this comes with investment risk, not to mention the hassles of becoming a landlord. You should always talk to your financial advisor before embarking on such a step.
6. Watch Your Tax Bracket
Since all (or, one hopes, only a portion) of your 401(k) distribution is based on your tax bracket at the time of distribution, only take distributions to the upper limit of your tax bracket.
“One of the best ways to keep taxes to a minimum is to do detailed tax planning each year to keep your taxable income [after deductions] to a minimum,” says Neil Dinndorf, CFP®, a wealth advisor at EnRich Financial Partners in Madison, Wis. Say, for example, you are married filing jointly. For 2020, you can stay in the 12% tax bracket by keeping taxable income under $80,250. For 2021, you can stay in the 12% tax bracket by keeping taxable income under $81,050.
By planning carefully, you can limit your 401(k) withdrawals so they don’t push you into a higher bracket (the next one up is 22%) and then take the remainder from after-tax investments, cash savings, or Roth savings, says Dinndorf. The same goes for big-ticket expenses in retirement, such as car purchases or big vacations: Try to limit the amount you take from your 401(k) by perhaps taking a combination of 401(k) and Roth/after-tax withdrawals.
7. Keep Your Capital Gains Taxes Low
Try to only take withdrawals from your 401(k) up to the earned income amount that will allow your long-term capital gains to be taxed at 0%. In 2021, singles with taxable income up to $40,400 and married filing jointly tax filers with taxable income up to $80,800 can stay in the 0% capital gains threshold. Any amount over this is taxed at the 15% tax rate.
Nathan Garcia, CFP®, with Strategic Wealth Partners in Fulton, Md., says retirees can subtract their pension from their annual spending amount, then calculate the taxable portion of their Social Security benefits and subtract this from the balance from the previous equation. Then, if they are over 72, subtract their required minimum distribution. The remainder, if any, is what should come from the retirees’ 401(k), up to the $40,400 or $80,800 limit. Any income needed above this amount should be withdrawn from positions with long-term capital gains in a brokerage account or Roth IRA.
8. Roll Over Old 401(k)s
Remember, you don’t have to take distributions on your 401(k) funds at your current employer if you’re still working. However, “if you have 401(k)s with previous employers or traditional IRAs, you would be required to take RMDs from those accounts,” says Mindy S. Hirt, CFP®, a wealth advisor with Argent Financial Group in Nashville, Tenn.
To avoid the requirement, “roll your old 401(k)s and traditional IRAs into your current 401(k) before the year you turn 70½,” (now 72), she advises. “There are some exceptions to this rule, but if you can take advantage of this technique, you can further defer taxable income until retirement, at which point the distributions might be at a lower tax bracket (if you no longer have earned income).”
As mentioned above, RMDs were waived for 2020.
9. Defer Taking Social Security
To keep your taxable income lower when (you’ve taken a 401(k) withdrawal) and also possibly stay in a lower tax bracket, consider putting off taking your Social Security benefits. Frank St. Onge, a Brighton, Mich.-based CFP® at Total Financial Planning LLC, advises some of his clients to delay Social Security payments as part of a tax-saving strategy that includes converting some funds to a Roth IRA. “I recommend that [some clients] wait until age 70 to start their Social Security benefits,” says Onge.
If retirees can afford to delay collecting Social Security benefits, they can also raise their payment by almost a third. If you were born within the years 1943–1954, for example, your full retirement age—the point at which you will get 100% of your benefits—is 66. But if you delay to age 67, you’ll get 108% of your age 66 benefit, and at age 70 you’ll get 132% (the Social Security Administration provides this handy calculator). This strategy stops yielding any extra benefit at age 70, however, and no matter what, you should still file for Medicare at age 65.
Don’t confuse delaying Social Security benefits with the old “file and suspend” strategy for spouses. The government closed that loophole in 2016.
10. Get Disaster Relief
“For people living in areas prone to hurricanes, tornadoes, earthquakes, or other forms of natural disasters,” Ramnarain says, “the IRS periodically grants relief with regard to 401(k) distributions—in effect, waiving the 10% penalty within a certain window of time. An example might be during certain severe Florida hurricane seasons.”
If you live in one of these areas and need to take an early 401(k) distribution, see if you can wait for one of these times.
In addition, there are other events that constitute a hardship and therefore yield an exemption from the 10% penalty. They include economic challenges, such as job loss, the need to pay college tuition, or putting a down payment on a house.
In addition, the CARES Act allows those affected by the coronavirus outbreak a hardship distribution of up to $100,000 without the 10% penalty those younger than 59½ normally owe.
Account owners also have three years to pay the tax owed on withdrawals, instead of owing it in the current year. Or they can repay the withdrawal to a 401(k) and avoid owing any tax—even if the amount exceeds the annual contribution limit. Those who have been impacted by the COVID-19 pandemic are eligible.
401(k) Distribution FAQs
What Are the Rules for a 401(k) Distribution?
You can withdraw money from your 401(k) penalty-free once you turn 59-1/2. The withdrawals will be subject to ordinary income tax, based on your tax bracket. For those under 59-1/2 seeking to make an early 401(k) withdrawal, a 10% penalty is normally assessed unless you are facing financial hardship, buying a first home, or needing to cover costs associated with a birth or adoption. Under the 2020 CARES Act, a hardship 401(k) distribution of as much as $100,000 is allowed, without the 10% penalty.
Can You Withdraw From a 401(k) Without Penalty?
You can withdraw from a 401(k) distribution without penalty if you are at least 59-1/2. If you are under that age, the penalty is 10% of the total. There are exceptions for financial hardship and there is a special one-time deal for withdrawing up to $100,000 without penalty under the CARES Act.
How Long Does a 401(k) Distribution Take?
There is no universal period of time in which you must wait to receive a 401(k) distribution. Generally, it takes between 3 and ten business days to receive a check, depending on which institution administers your account and whether you are receiving a physical check or having it sent by electronic transfer to a bank account.
Can I Take a Distribution From My 401(k) While Still Working?
Yes, but any distribution will be taxed as ordinary income and will be subject to the 10% penalty if the person making the 401(k) withdrawal is under 59-1/2. The penalty is waived if you qualify as experiencing a hardship.
How Much Tax Do I Pay on a 401(k) Withdrawal?
Your withdrawal is taxed as ordinary income and depends on what tax bracket you fall into for the year. You can withdraw up to $5,000 tax-free to cover costs associated with a birth or adoption. Under the CARES Act, account owners can withdraw up to $100,000 without penalty and also have three years to pay the tax owed, rather than having to pay it in the current year.
The Bottom Line
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal. Keep in mind that these are advanced strategies used by the pros to reduce their clients’ tax burdens at the time of 401(k) distribution. Don’t try to implement them on your own unless you have a high degree of financial and tax knowledge.
Instead, ask your financial planner if any of them are right for you. As with anything having to do with taxes, there are rules and conditions with each, and one wrong move could trigger penalties.
