If you have a traditional 401(k), you will have to pay taxes when you take distributions. Unfortunately, that 401(k) is subject to the worst kind of taxes – ordinary income taxes. The amount you pay is based on your tax bracket, and if you’re younger than 59-1/2, add 10% (for early distribution) in most cases. That could put your tax rate at 43% or higher – ouch!

You could look at a Roth 401(k) or a Roth IRA in order to pay taxes now rather than later (see What Are The Main Differences Between a Roth 401(k) and a Roth IRA?), but we wanted to know how the pros help their clients minimize their tax burden. We asked, and here’s what they said.

1. Take Advantage of Net Unrealized Appreciation (NUA)

If you have company stock in your 401(k), you may be eligible for net unrealized appreciation treatment, says Trace Tisler, CFP®, owner of Epic Financial, LLC, if the company stock portion of your 401(k) is distributed to a taxable account – for example, a taxable brokerage account. When you do this, you still have to pay income tax on the original purchase price of the stock, but the capital gains tax on the appreciation of the stock will be lower.

So, instead of keeping the money in your 401(k) or moving it to a traditional IRA, consider moving your funds to a taxable account instead. (For more on net unrealized appreciation, see Rolling Over Company Stock: A Decision to Think Twice About.)

2. Use the 'Still Working' Exception

Most people know that they are subject to required minimum distributions at age 70-1/2, even on a Roth 401(k). But if you’re still working when you reach that age, these RMDs don’t apply to your 401(k) with your current employer. However, “there are issues with this strategy if you are an owner of a company,” warns Christopher Cannon, CFP® of RetireRight Pittsburgh. If you own more than 5% of the company, you’re not eligible for this exemption

3. Consider Tax-Loss Harvesting

Another strategy, called tax-loss harvesting, involves selling underperforming securities. The losses on the securities offset the taxes on your 401(k) distribution. “Exercised correctly, tax-loss harvesting will offset some, or all, of an investor’s tax burden generated from a 401(k) distribution,” says Kevin Pollack, co-founder and managing partner at Chamberlain Warden, LLC. (Note that there are limitations on this strategy; see Tax-Loss Harvesting: Reduce Investment Losses.)

4. Avoid the Mandatory 20% Withholding

When you take 401(k) distributions, the service provider is required to withhold 20% for federal income tax. If you will only owe 15% at tax time, this means you'll have to wait until you file your taxes to get that 5% back. Instead, “roll over the 401(k) balance to an IRA account and take your cash out of the IRA,” suggests Peter Messina, investment advisor representative at ABG Consultants. “There is no mandatory 20% federal income tax withholding on the IRA, and you can choose to pay your taxes when you file rather than upon distribution.” 

5. Borrow From Your 401(k)

Some plans let you take out a loan from your 401(k) balance. If so, you may be able to borrow from your account, invest the funds and create a consistent income stream that persists beyond your repayment of the loan.

“The IRS generally allows you to borrow up to 50% of your vested loan balance (up to $50,000) with a payback period of up to five years,” explains Ravi Ramnarain, CPA. “In this case, you don’t pay any taxes on this distribution, let alone a 10% penalty. Instead, you simply have to pay back this amount in at least quarterly payments over the life of the loan.

“Given these parameters,” Ramnarain continues, “consider this scenario: You take out a $50,000 loan over five years. With interest, let’s say your monthly payment over this 60-month period is $900. Now imagine taking that $50,000 principal amount and purchasing a small rental house, apartment or duplex in the relatively inexpensive South. Given that you would be purchasing this property without a mortgage, let's say that your net rent each month comes out to $1,100 (after taxes and management fees).

“What you have effectively done, is to set up an investment vehicle that puts $200 in your pocket each month ($1,100 - $900 = $200) for five years. And after five years, you will have fully paid back your $50,000 401(k) loan, but you'll continue to pocket your $1,100 net rent for life! You might also have the opportunity to sell that house/apartment/duplex later on at an appreciated amount, in excess of inflation.”

Of course, a strategy like this comes with investment risk. You should always talk to your financial adviser before taking on this kind of risk.

6. Keep an Eye on Your Tax Bracket...

Since all (or, one hopes, only a portion) of your 401(k) distributions are based on your tax bracket at the time of a distribution, only take distributions to the upper limit of your tax bracket. 

“One of the best ways to keep taxes to a minimum is to do detailed tax planning each year to keep your taxable income [income after deductions] to a minimum,” says Neil Dinndorf, CFP, wealth adviser at EnRich Financial Partners. “For example, say you file ‘married filing jointly.’ For 2015, you can stay in the 15% tax bracket by keeping taxable income under $74,900. The other benefit of keeping your income in the 15% tax bracket is that you can realize capital gains from your after-tax investment account and pay 0% in capital gains taxes.

"By planning carefully, you can limit your 401(k) withdrawals so they don't push you into the 25% bracket and then take the remainder from after-tax investments, cash savings or Roth savings. The same goes for big-ticket expenses in retirement, such as car purchases or big vacations: Try to limit the amount you take from your 401(k) by perhaps taking a combination of 401(k) and Roth/after-tax withdrawals.” 

7. ...And on Your Capital Gains Taxes

Try to only take withdrawals from your 401(k) up to the earned income amount that will allow your long term capital gains to be taxed at 0%, recommends Nathan Garcia, CFP, managing director at Westbourne Investments. “When you add in your standard deduction and personal exemptions – assuming you and your spouse are both 65 and don’t itemize deductions – you can earn up to $96,750 per year and still be in the 0% long term capital gains rate,” says Garcia. 

“If your annual spending is under $96,750, you can use this equation: first subtract your pension from the annual spending amount. Next, calculate the taxable portion of your Social Security benefits and subtract this from the balance from the previous equation. Then, if you're over 70, subtract your required minimum distribution. The remainder, if any, is what should come from your 401(k), up to the $96,750 limit. Any income needed above this amount should be withdrawn from positions with long term capital gains in your brokerage account or Roth IRA.”

8. Roll Over Old 401(k)s into Your Current Employer's Plan

Remember, you don’t have to take distributions on your 401(k) funds if you’re still working. However, “if you have 401(k)s with previous employers or IRAs, you would be required to take RMDs from those accounts,” says Mindy S. Hirt, CFP®, vice president and wealth advisor at Argent Trust Company. 

To avoid the requirement, “roll your old 401(k)s and IRAs into your current 401(k) before the year you turn 70-1/2. There are some exceptions to this rule and not every 401(k) allows for IRA rollovers, but if you can take advantage of this technique, you can further defer taxable income until retirement, at which point the distributions might be at a lower tax bracket (if you no longer have earned income)."

9. Defer Taking Social Security

To keep your taxable income lower, consider putting off your Social Security benefits until later. Frank St. Onge, CFP® at Total Financial Planning, LLC advises some of his clients to delay Social Security payments as part of a tax-saving strategy that includes converting some funds to a Roth IRA. “I recommend that [some clients] wait until age 70 to start their Social Security benefits,” says Onge, “With one spouse using the opportunity to start the benefit, the other one can have their spouse's record at age 67 and then take their own benefit at age 70, when its almost double what the age 62 benefits are. Plus, they won't be limited by any earned income they may want to have from age 62 to the full-retirement age of [66 or] 67.”

10. Take Advantage of Hurricane Season

“For people living in areas prone to hurricanes, tornadoes, earthquakes or other forms of natural disasters,” Ramnarain says, “the IRS periodically grants relief with regard to 401(k) distributions – in effect, waiving the 10% penalty within a certain window of time. An example might be during certain severe Florida hurricane seasons.” If you live in one of these areas and need to take an early distribution, see if you can wait for one of these times.

The Bottom Line

Keep in mind that these are advanced strategies used by the pros to reduce their clients’ tax burden at the time of distribution. Don’t try to implement them on your own unless you have a high degree of financial and tax knowledge. Instead, ask your financial planner if any of them are right for you. As with anything having to do with taxes, there are rules and conditions with each, and one wrong move could trigger penalties.

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