How to Avoid Taxes on Your 401(k) Withdrawals

Few retirement surprises sting more than realizing how much taxes can eat into your 401(k) withdrawals. Many retirees assume that once they’ve saved diligently, the hard part is over. But poor planning can lead to higher tax bills and reduced income in your later years. With a little smart timing, strategic account use, and an understanding of tax rules, you can minimize your tax burden.

A financial advisor can help you with your 401(k) tax issues and other retirement planning questions.

401(k) Tax Basics

Though not tax-free, 401(k) plans are “tax-advantaged.” You still pay payroll taxes for FICA and Medicare before you contribute it to a 401(k). The tax advantage only applies to income taxes, and it’s only a deferral, not an escape. The IRS still taxes withdrawals of pretax contributions and earnings from a traditional 401(k) as ordinary income. However, qualified distributions from a Roth 401(k) are tax-free.

You generally can’t take a distribution from your 401(k) without tax penalties until age 59 ½. A few exceptions to this rules exist, and some employers also allow withdrawals at any time through certain plans.

Some plans allow for hardship distributions. Hardships include medical needs, education costs, funeral expenses and the repair of your primary residence. Even if your plan allows for it, you’ll still usually be charged a 10% early distribution penalty. This penalty is on top of the income taxes that will be due at your regular rate.

Early Distribution Penalty

There are some situations in which you may be able to avoid the 10% penalty on an early distribution. These include becoming permanently disabled, losing your job after age 55, or having qualifying medical expenses. These situations don’t let you avoid income taxes, however. ¹

You generally can’t avoid paying income taxes on traditional 401(k) funds by simply never taking distributions, either. RMDs generally begin at age 73. However, participants in an employer-sponsored plan can delay them until retirement if the plan allows it. They also cannot own more than 5% of the employer. Roth 401(k) accounts are simpler. Those plans are not subject to RMDs during the account owner’s lifetime.

You typically must take your first RMD by April 1 of the year after the year in which you reach age 73 or, when the later-retirement exception applies, when you retire. After that, you must take your RMDs by Dec. 31 of each year. Failure to take the full required amount can result in a 25% excise tax on the shortfall, which you can reduce to 10% if you correct the shortfall within the applicable period. Retirees may withdraw more than the RMD without penalty. ²

Ways to Avoid Taxes

Although taxable withdrawals from a traditional 401(k) generally are subject to income tax, there are two ways to move or temporarily access 401(k) money without creating an immediate tax bill. A 401(k) rollover can move eligible funds to another retirement account without current tax when the rollover rules are followed, while a qualifying 401(k) loan lets you borrow from your account without treating the loan as a taxable distribution. Both have significant limitations.

1. 401(k) Rollover

One way to move money from your 401(k) without owing current taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer’s 401(k) plan into one sponsored by your new employer. You may also rollover 401(k) funds into an IRA.

The IRS doesn’t generally treat a properly completed rollover as taxable income, although you must still report them. If you choose a direct rollover, the funds generally move directly to the new plan or IRA and the mandatory 20% federal income tax withholding does not apply. If you receive an eligible rollover distribution instead, the plan generally must withhold 20% of the taxable amount, and you must replace the withheld amount from other funds if you want to roll over the entire distribution.

Generally, you have 60 days after receiving an eligible rollover distribution to complete the rollover. Any taxable amount that is not rolled over generally is included in income, and if you’re younger than age 59 ½, it may also be subject to the 10% additional tax unless an exception applies.

2. 401(k) Loan

A second way to borrow from your 401(k) is with a loan. Some plans don’t allow loans, but many of those that do allow you to borrow up to 50% of your vested account balance, generally up to $50,000.

You usually can take up to five years to pay the loan back, with substantially level payments made at least quarterly. Loan repayments are not plan contributions, so taking a loan does not by itself prevent you from making new 401(k) contributions. You may qualify for a longer repayment period when using the loan to buy your primary residence. Special repayment rules can also apply during qualifying military service or a leave of absence.

As long as a 401(k) loan meets federal and plan requirements, the the IRS won’t treat the borrowed funds as a taxable distribution. This avoids any income taxes or early distribution taxes when you receive the loan. However, a loan that fails to meet repayment requirements may count as a taxable distribution. If you leave your job, your plan may also require repayment of the outstanding balance; special rollover rules may provide additional time to move an eligible plan loan offset amount into an IRA or another eligible retirement plan.

Ways to Reduce Taxes on 401(k) Withdrawals

Although you can’t completely avoid paying taxes on taxable traditional 401(k) withdrawals, you can reduce the taxes you’ll pay. For instance, you can avoid the 10% penalty on an early distribution by taking the distribution as a series of substantially equal period payments. Generally, the series must continue until the later of five years after the first payment or age 59 ½.

Strategies for reducing regular income taxes mostly come down to managing your income in retirement. Mostly you want to avoid moving into a higher tax bracket. For this purpose, it’s helpful to have a variety of retirement income sources, such as IRAs, annuities, and taxable accounts. By delaying or accelerating distributions from their retirement investments, retirees can stay in control of their income and tax bracket.

Try our income tax calculator to understand how reducing taxable income changes your taxes.

Bottom Line

Withdrawals of pretax money from a traditional 401(k) generally are subject to ordinary income tax. If you take a taxable distribution before turning 59 ½, you may owe an additional 10% penalty tax. Qualified Roth 401(k) distributions, however, can be tax-free. And some rules allow you to temporarily access 401(k) funds using rollovers and 401(k) loans without immediate tax bills.

Retirement Tips

• Few areas of personal finance are more complex and potentially impactful than retirement accounts and taxes. That’s where the training and expertise of a financial advisor can be valuable. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• You’re not alone if you think 401(k) rules are complicated. If you’re going at things on your own, try using SmartAsset’s 401(k) calculator for help.

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