You’ve done the right thing by contributing to your 401(k) up to what your company would match. You’ve also monitored the account and made changes periodically to match market conditions. Because you’ve done the right thing with your account, you’re amassing a large balance. At some point, you will begin making withdrawals or, in 401(k) speak, you will “take distributions.”
But no good deed goes unpunished, especially when the IRS gets involved. Yes, you will likely pay taxes on at least some of your distributions and, if you’re not careful, the taxes could be quite high.
Taxes on a Regular 401(k)
Here’s how it works: The distributions on a regular 401(k) are taxed as ordinary income at the same income tax rate as your paycheck. Most people fall under this rule. There are a few exceptions, however, such as if you were born before 1936 and you take your distribution as a lump sum. In such a case, you may qualify for special tax treatment.
For the rest of us, 401(k) distributions are fairly simple tax-wise. Since 401(k) contributions are tax-deferred (meaning they were made with pre-tax dollars thereby reducing income tax when contributions are made), once distributions start taxes will be due. Contributions to a traditional IRA work the same way; contributions made with pre-tax dollars will be taxed at distribution. To paraphrase a certain cartoon character, "We'll gladly tax you later to help you save today."
New Tax Rates
Under the new Tax Cuts and Jobs Act of 2017, the Federal income tax has seven rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Each tax rate kicks in in addition to a base tax amount. For example, as of 2018, if you earn $38,701-$82,500 per year as a single filer, you’ll pay a base tax of $4,453.50 and then pay a tax on all income exceeding $38,700 at the rate of 22%. Similarly, if you are a married couple that files jointly and earns $77,400-$165,000, you will pay a base tax of $8,907 and then will be further taxed at the rate of 22% on all income exceeding $77,400. As you would guess, the more you earn, the higher tax bracket you will be in and vice versa.
Assuming you are over the age of 59½ when you take 401(k) distributions, you will pay taxes based on that new system. If you're younger than 59½, however, you will pay a 10% penalty for early withdrawal.
Even with the new tax brackets, the system remains pretty straightforward – that is, until required 401(k) distributions are added to other income, such as Social Security payments or other investment income or salary income. That is when it is especially important to pay close attention to how you withdraw money from your 401(k).
“Taxes on your 401(k) distributions are important," says Curtis Sheldon, CFP®, president of C.L. Sheldon & Company, LLC, in Alexandria, Va. "But what is more important is, ‘What will your 401(k) distributions do to your “other” taxes and fees?’ For example, a 401(k) distribution could make up to 85% of Social Security benefits taxable when prior to the distribution they were tax-free.”
Financial planners view income tax as the worst kind of tax because it is significantly higher than the long-term capital gains tax. For those in higher tax brackets, income tax rates are around twice that of capital gains taxes. As of 2018, the capital gains tax rates are zero, 15% and 20%, depending on your income.
What About a Roth 401(k)?
Just as with the Roth IRA, the money you contribute to a Roth 401(k) is taxed before your contribution. Since you paid taxes already, you don’t have to pay them again once you take distributions. You also don’t have to pay taxes on the earnings. In other words, with a Roth 401(k), you will probably pay zero taxes on the money you contributed if you meet the income requirements.
But there are some things to consider. “While the designated Roth 401(k) grows tax-free, be careful that you meet the five-year aging rule and the plan distribution rules to receive tax-free distribution treatment once you are age 59½,” says Charlotte A. Dougherty, CFP®, founder of Dougherty & Associates, in Cincinnati.
Also, if your employer matches your contributions, that part of the money is considered pre-tax. You will pay taxes on those contributions when you take distributions. But unlike the traditional 401(k), you can take distributions of your contributions at any time without penalty. The earnings, however, still fall under the traditional 401(k) rules.
Talk to a Wealth Manager
Sometimes it’s best to go to the experts. In the case of your retirement funds, an expert could be helpful. For example, Christopher Cannon, M.S., CFP®, of RetireRight Pittsburgh, says, “Employer stock held in the 401(k) can be eligible for net unrealized appreciation treatment. What this means is the growth of the stock above the basis is treated to capital gain rates, not [as] ordinary income. This can amount to huge tax savings. Too many participants and advisers miss this when distributing the money or rolling over the 401(k) to an IRA.”
With the new tax law, its higher standard deduction, and $10,000 cap on local and state tax deductions, now in effect, most filers will no longer itemize. In fact, it is predicted that fewer than 10% will itemize under the new tax rules, down from about 30%. That means that most filers will no longer receive a tax-reducing benefit from their charitable giving.
There are a few options, however. For example, anyone 70½ or older may make a direct transfer of IRA balances up to $100,000 per year to a charitable organization. Such qualified charitable distributions (QCDs) can help reduce a filer's adjusted gross income (AGI) and also count toward a required minimum distribution (RMD). Such charitable donations must come from IRAs, however, not 401(k)s. And they are not a good fit for everyone.
“If you are a high-income earner, consider using charitable-planning strategies to strategically convert taxable retirement accounts to tax-free,” says Carlos Dias Jr., wealth manager of Excel Tax & Wealth Group in Lake Mary, Fla.
There are other little-known strategies that could lower your tax burden that a tax professional or financial planner could help you find. Consider a fee-only adviser to help you make tax-efficient plans.
The Bottom Line
Whether a Roth or traditional 401(k) is your best bet depends on a number of individual factors. Some professionals advise holding both a Roth and a traditional retirement account in order to minimize the risk of paying all taxes now or all taxes later. Despite articles that say one is better than the other, factors such as age, income, tax bracket, and domestic status are variables to consider. Unless you have a high level of knowledge in financial planning, it’s best to get help.