Although retirement plans, such as 401(k) and IRA accounts are not tax-free, they are described as tax-advantaged.
When you stop working for a paycheck and start relying on your retirement plan, it’s easy to think of your tax burden and seek ways to reduce it. Unfortunately, there are many complexities involved in the tax code, and finding a one-size-fits-all answer isn’t possible because every individual has different needs. This guide takes you through steps you can take to minimize your tax burden on retirement plan withdrawals.
Convert the 401(k) a Roth
The easiest way to lower your tax burden on 401(k) withdrawals is to convert the funds to a Roth 401(k) or a Roth individual retirement account (IRA). Your withdrawals from these accounts will not be taxed as long as they meet the rules for a qualified distribution. You will, however, be required to declare the conversion when filing your taxes.
Another caveat is that you will have to pay income tax on the funds you convert. It may not be worth the extra cost of converting the money if you are close to the retirement age for pulling the funds. The more money you convert, the more taxes you will pay.
How to Get Around the Early Withdrawal Penalty
The IRS imposes a 10% penalty for withdrawing funds early from a 401(k) if you are under the age of 59 ½ years. Moreover, withdrawing your funds from the account limits your potential to grow your savings. The same also applies to IRAs – in addition to the income tax you will owe.
Note that you can make withdrawals from your 401(k) without incurring a penalty once you turn 55 and leave the job associated with that account.
Technically, there are ways to withdraw early from a 401(k) without increasing your tax liability: a rollover and a loan.
401(k) Rollover
A rollover is commonly done when an employee leaves their job and is moving funds from their old 401(k) plan into one sponsored by the new employer. It is also possible to roll over 401(k) funds into an IRA.
You have about 60 days to move the money from one account to another. During these 60 days, you have access to all of the funds (they are not treated as income). Note that you will have to report the transfer on your tax return.
However, your funds will be treated as ordinary income if you fail to complete the transfer within 60 days. A penalty fee will also apply if you are younger than 59.5 years old.
401(k) Loan
You can also borrow funds from your 401(k) by taking out a loan. Not all plans allow loans, but those that do, allow you to borrow as much as 50% of the balance, up to a maximum of $50,000. You will have about five years to pay the loan back, although you may qualify for different terms if you are on active military service.
Money borrowed from a 401(k) is not treated as income, and you won’t have to pay any tax. However, the amount will be considered as income if you fail to pay the loan back on time.
For more tips on saving your tax burden on your retirement withdrawals, visit our experienced certified public accountant in Bay Area. Click here for more information.
