When it comes to retirement, most of us will need every penny we can get. When you take money from a “qualified” workplace retirement plan like a traditional 401(k), you’ll have to pay taxes on it. But you can plan ahead to make sure you keep as much of your money as possible.
Here’s a look at how 401(k) withdrawals (aka distributions) are taxed and how to minimize the hit on your retirement savings.
How are 401(k) withdrawals taxed?
When you withdraw from“traditional” 401(k)sOpen in new tabor similar workplace retirement plans, you have to pay taxes on it, like regular income. That’s because you contributed pretax dollars into the account. Any earnings you made from the investments are also tax-deferred until you withdraw. How much tax will you owe? That depends on how much income you earned during the year, which includes the money you withdrew from your 401(k). The money from your 401(k) distribution could push you into a higher tax bracket. (Distributions from a Roth401(k), however, are tax-free if you meet certain criteria.)
If you take money from your 401(k) before age 59½, your employer generally must withhold 20% of the withdrawal amount for taxes, no matter what tax bracket you’re in. (Your plan might allow withdrawals to cover for“hardship” expensesOpen in new tablike a funeral, medical emergency, or even home purchase, which are usually exempt from mandatory withholding.)
That withholding can happen even if you withdraw with the intention of rolling over the money to a new retirement account. When you file your taxes for the year you withdrew the money, the IRS will refund any of the 20% you don’t owe. (Read on for how to avoid mandatory withholding.)
To minimize taxes, it’s important to withdraw at the right time. Early withdrawals (before 59½) can trigger a 10% penalty on top of regular income taxes. (Many plans require that employer withhold 20% of your withdrawal, plus the penalty if warranted; if your income tax rate is higher than 20%, you would make up the difference when you file your taxes. For example, assuming a 24% federal income tax rate, a 40-year-old who takes $100,000 from a 401(k) would end up with $66,000 in cash after subtracting the $10,000 penalty and paying $24,000 in federal tax on the $100,000. (The early-withdrawal penalty also applies to any taxable portion of a Roth distribution.)
Once you reach age 73, you’ll usually facerequired minimum distributions (RMDs)Open in new tabeach year. If you don’t take your annual RMD, you could owe up to 25% of what you should have withdrawn as a penalty. (Thanks to the SECURE 2.0 Act of 2022, the 25% penalty gets knocked down to 10% if you correct your distribution in a timely manner.)
Plan before you retire
With some planning before retirement, you can reduce your 401(k) taxes later on when you start to take money out of the account. You usually have to pay taxes when you withdraw from a traditional 401(k), so it’s important to have a good strategy to minimize your taxes later.
Convert to a Roth 401(k)
If you expect your taxes to be higher in retirement (and your plan allows it), you can convert some or all of your traditional pretax 401(k)into an after-tax Roth 401(k).
Remember: You fund a Roth account with money you’ve already paid income taxes on. (The payoff comes down the road when you won’t owe tax on “qualified” withdrawals.)
This means that to convert to a Roth, you’ll owe tax on the amount you convert. That can be a lot of money, all at once.
So, decide if it’s worth paying taxes today to avoid a potentially bigger tax bill in retirement. That can make sense if, say, you’re in a low tax bracket now and expect your bracket—or tax rates in general—will rise later, or you simply think you’ll benefit more with tax-free income in retirement. In any case, if you choose to make the move, be sure you’ll have the funds available to pay the tax you’ll owe.
Consider a direct rollover when you change jobs
If you leave your employer, you have some choices about what to do with your 401(k). You can move it (if you want to) without incurring a penalty.
To do this, you can directly roll your 401(k) balance into a new retirement account. Ask your former employer to transfer the balance of your account directly to a new employer’s traditional plan or an IRA. Depending on the plan, you might have (or can ask) to receive a check, usually made out to the new account provider “for your benefit.”You must deposit the check into a new retirement account within 60 days to avoid being classified as a taxable distribution, subject to mandatory 20% withholding. You don’t have to roll over if you don’t want to. If your employer allows it, you can simply leave your money in the account.
Avoid early withdrawals
Need money? Consider borrowing from your 401(k)instead of taking an early distribution. These loans often have a term of five years. And because you’re borrowing from yourself, the interest you pay goes back into your account. If you’re still working for the 401(k) sponsor, your repayments can come directly from your paycheck, the same as your account contributions.
Even so, there are risks to borrowing from a 401(k). First, if you can’t repay the loan on time, the remaining balance becomes a distribution. That makes it subject to regular income tax and a potential 10% early withdrawal penalty if you’re under 59½. This conversion can also happen if you leave your job—by choice or not—before you pay off your loan. In that case, your total balance would be due at the same time you file your federal tax return (including extensions) for the year your employment ended.
Most importantly, a loan will likely mean a smaller account balance when you retire. That’s because the amount you borrow doesn’t earn anything until you return it to your account. Even though you “pay yourself back” with interest, you could still come out behind.
Also, note that many employers only allow one loan at a time. So, you’d need to pay off your debt before you can borrow again from the same account.
Plan a mix of retirement income
Because different types of accounts have different tax consequences, it can pay to plan your retirement income strategy around that. For example, you might consider drawing “qualified” tax-free funds from Roth workplace accounts or IRAs before tapping traditional, taxable accounts. That could make particular sense early in retirement, when people tend to be more active and spend more—and may have enough income to keep them in a higher tax bracket.
Permanent life insurancecan protect your loved ones and be a source of retirement income. That’s because most permanent policies build cash value you can use as you wish, including for extra income in retirement. You can withdraw up the amount you’ve paid into the policy through premiums without owing taxes. If you withdraw more, you’ll need to pay income tax on that.
Annuitiescan generate a predictable, protected, taxable source of lifetime income. If you’re fortunate enough to expect a traditional pension from work, that income will be taxable too. And don’t forget about Social SecurityOpen in new tab. Benefits can be taxable, but your payments can be larger—for life—the later you choose to start taking them.
If creating the right mix of retirement income from different sources can sounds complicated, that’s because it is. So, consider seeking the help of a trusted financial advisor.
When can you tap your account penalty-free?
Even if you’re under 59½, you can withdraw from a 401(k) without facing the 10% penalty in certain situations:
Hardship withdrawals
If your plan allows, you can take distributions to cover costs including medical bills, college expenses (up to $10,000) like tuition, room and board, and fees for you or a family member; money needed to avoid foreclosure and eviction; and funeral costs. To qualify, you must prove an “immediate and heavy financial need” and can only withdraw enough to cover it.
‘Substantially equal periodic payments’
Under this scenario, you can take payments from a 401(k) held at a former employer—you can’t still be working there—before age 59½ without triggering the 10% penalty. (You’ll still be responsible for income tax on the payments.) Note that you must take distributions at least once a year and continue for at least five years or until you reach 59½, whichever is later.
Divorce
If you get divorced, you may be able to cash out and divide a 401(k) without penalty—but only if you need money to fund the divorce or are ordered by a court to split the assets. Consult a financial advisor or attorney to help you navigate the rules.
Disability or terminal illness
This exception applies if you are or become disabled or face a terminal illness.
Childbirth or adoption
If you have or adopt a baby, each parent can take up to $5,000 per child from their respective 401(k)s (or 403(b)s or 457s), for a total of $10,000. You must take the withdrawal within one year of the birth or adoption.
Home purchase
You may be able to borrow up to $50,000 (or 50% of your vested account balance, whichever is less) from your 401(k) to help fund the purchase of a new home. Caveats: Many plans restrict how many loans you can take at a time. You'd typically need to repay the loan within five years, though some plans allow up to 25 years if you use the loan to buy your primary residence. While there's no penalty for borrowing the funds, you'd have to pay loan interest (to yourself) as you deposit the money back into the account. (Keep in mind that the money won't be working for your future while you're repaying the loan.)
Minimize 401(k) taxes after retirement age
If you’ve retired or are about to, try to avoid situations that could increase your tax bill. One way is to avoid tax penalties. You can also be strategic about withdrawals to avoid landing in a higher tax bracket. Some tips:
Take your RMD each year ...
When you reach age 73, you’ll probably have to start taking required minimum distributions (RMDs) every year. If you don’t, you’ll face a penalty of 25% of what you should have taken.
As of 2024, RMDs only apply to traditional 401(k)s. You can potentially convert a traditional or Roth 401(k) to a Roth IRA (or roll over some of the money into a Roth IRA to avoid or lower your RMDs). However, because withdrawals from traditional 401(k)s and IRAs are taxed differently than withdrawals from Roth 401(k)s and IRAs, you could end up with a big tax bill when you convert.
But make sure you only take one RMD per tax year
Once you’re retired, you can time your first RMD to avoid making two taxable withdrawals in the same tax year. TheIRS ruleOpen in new tab: Your first RMD must happen by April 1 of the year after the year you turn 73. Your second RMD must happen by Dec. 31 of that same year.
To keep those two RMDs in separate tax years, you don’t have to wait until the following year—let alone April 1—to take that first distribution. Instead, you can take it anytime during the year you hit 73.
Here’s an example: Let’s say you’ll turn 73 this year, on Aug. 30, 2024. You’ll need to take your first RMD, for the 2024 tax year, by April 1, 2025—but your 2025 RMD will also be due next year, by Dec 31, 2025. To avoid owing taxes on two RMDs for one tax year, you could take the first RMD any time this year (when you’ll turn 73). So, you could push up that first RMD to Dec. 31, 2024—or even sooner—and avoid two tax hits when you file your 2025 return.
(Note that the rules on RMDs have changed: If you were born before July 1, 1949, you had to start taking RMDs after age 70½; if you haven’t done so, you’ve already faced the tax.)
Keep an eye on your tax bracket
You can plan 401(k) distributions carefully to keep yourself in the lowest possible tax bracket to reduce how much income tax you owe.
For example, if you expect to be in a higher tax bracket after age 73, consider starting 401(k) withdrawals before you need them (but after you turn 59½). By taking out just enough money to stay in your current tax bracket, you can lower the amount that will be subject to RMDs later on.
Conversely, if you’re still working after 73, you can usually delay distributions—but only from your current workplace plan, not any from former employers. (One way around that is to roll old 401(k) money into your current 401(k) if the plan allows it.) This could help ensure that distributions on top of your pay don’t push you into a higher tax bracket.
You can also adjust your distributions based on your income for a given year. In general, try to avoid withdrawing more than you must each year. But if you have a particularly low-income year and need extra money, you could take out more than the RMD as long as you can stay in thesame tax bracket.
Work with a pro to minimize your 401(k) taxes
Managing your tax bracket can be complicated. So, it’s a good idea to consult a tax advisor about potential strategies. Depending on your situation, you might want to delay starting Social Security benefits. There’s also no reason to keep tax-advantaged investments, like municipal bonds, in already tax-advantaged retirement accounts.
A Roth IRA offers tax advantages but has income limits. If you earn too much to contribute to a Roth IRA, you could potentially get around the income caps through a “backdoor Roth“ conversion. With this maneuver, you move traditional 401(k) assets to a traditional IRA—then convert them to a Roth IRA.
Two key caveats: You’d owe income tax on the amount you convert (but you could save overall). Also, it’s uncertain how long Congress will keep this loophole available (they’ve talked of eliminating it).
Give to charity—and get a tax break
Even if you don’t need the money, you must take RMDs from your traditional 401(k) account starting after age 73. That income can push you into a higher tax bracket.
However, if you roll overOpen in new taba traditional 401(k) to a traditional IRA, you can use your RMD from the IRA to make a charitable donation from the account. This is known as a qualified charitable distributionOpen in new tab(QCD). It allows you to donate up to $105,000 a year to one or more eligible charities. (Income from a traditional IRA is usually taxable, but a QCD makes it tax-free.) Plus, you can support causes that are meaningful to you.
