Employees who accumulate large balances in their 401(k) plans often feel a sense of security because their retirement savings looks like it will be able to carry them through retirement. But the tax consequences that may come when money is withdrawn from them can be greater than anticipated in some cases, and having the majority of your tax savings in your company’s retirement plan can be a disadvantage for those who are trying to get into a lower tax bracket at retirement.

Required Distribution Issues

Savers who are forced to start taking required minimum distributions (RMDs) at age 70 ½ may find themselves in a higher tax bracket if their RMDs are substantial. This is especially true for those who are also receiving a pension or other guaranteed form of retirement income, such as from an annuity. And this income can also affect the taxation of their Social Security benefits in many cases, because the income threshold for this factor is fairly low. (For more, see: An Overview of Retirement Plan RMDs.)

Single and head of household filers will have to start reporting their Social Security benefits if they receive at least $25,000 of other income, and for joint filers the threshold is $32,000. These limits are easy to exceed for many retirees, and this can cause up to 85% of their Social Security benefits to show up on their tax returns each year. Someone with a 401(k) balance of $1 million who takes out 5% of their account value each year will report $50,000 of taxable income right off the bat. This is in addition to any other sources of income, such as from a job, taxable investment income such as dividends, interest and capital gains and Social Security. These can easily combine to bump the retiree up well into the 25% tax bracket.

Reducing Distributions

There are a couple of things that you can do to reduce the amount of taxable distributions that you must take from your 401(k) plan. If you are a charitably-minded individual, you can direct the money that you take from your plan directly to a qualified 501(c)3 organization and exclude that amount from your income each year. Congress finally made this option permanent this year, so you won’t have to wait until the last minute again to see whether they extend it again. The person in the example above could direct half of their income to a charity and possibly keep themselves under the income threshold for taxation of Social Security benefits. You also don’t have to itemize deductions to do this, as it is considered an exclusion instead of a deduction. However, if you do take the distribution and report it as income, then you could still take a deduction for donating that amount to charity. You may also then be able to add in all of your other itemized expenses and reduce your taxable income by a larger amount.

Roth Conversions

If you have a year after you stop working where your income is exceptionally low, such as the year after the year in which you retire, but haven’t begun receiving Social Security benefits then you may be wise to convert some or all of your 401(k) balance to a Roth IRA. This will benefit you in several ways. First, you can use credits or deductions that you are entitled to that might otherwise go unused to pay the tax on at least a portion of your conversion. Then you will have reduced the balance on which your RMDs will be calculated from then on. You will also have a pool of tax-free income that you can draw on whenever you like for the rest of your life.

The Bottom Line

While having a large 401(k) balance is hardly the worst financial problem you could have, it does make sense to use the strategies that are available to reduce the taxation of your distributions whenever possible. For more information on taking money out of IRAs and qualified retirement plans, download Publications 575 and 590 on the IRS website at www.irs.gov. (For more, see: Avoiding Mistakes in Required Minimum Distributions.)