If you have a traditional 401(k), you will have to pay taxes when you take a 401(k) distribution. That 401(k) money is subject to ordinary income tax. The amount you pay is based on your tax bracket, and if you're younger than 59½ when you take a distribution, add a 10% early withdrawal penalty in most cases. Moreover, a 401(k) distribution could put you in a higher income tax bracket (the highest in 2023 is 37%).
You could look at a Roth 401(k) or a Roth IRA to pay taxes now rather than later, but we wanted to know how financial professionals help clients minimize their tax burden on a standard 401(k) distribution.
We asked, and they gave us some tips on reducing your tax burden and avoiding the 20% mandatory withholding. Read on to find out how you can benefit right now.
- Certain strategies exist to alleviate the tax burden associated with 401(k) distributions.
- Net unrealized appreciation and tax-loss harvesting are two strategies that could reduce taxable income.
- Rolling over regular distributions to an IRA avoids automatic tax withholding by the plan administrator.
- Consider delaying plan distributions (if you are still working) and Social Security benefits.
- Consider taking a loan from your 401(k) instead of actually withdrawing money that would be taxable as ordinary income.
How Are 401(k) Distributions Taxed?
Distributions from your 401(k) are taxed as ordinary income, based on your yearly income. That income includes distributions from retirement accounts and pensions and any other earnings. As a result, when you take a 401(k) distribution, it is important to be aware of your tax bracket and how the distribution might impact that bracket. Any 401(k) distribution you take will increase your yearly earnings and could push you into a higher tax bracket if you're not careful.
There is a mandatory withholding of 20% of a 401(k) withdrawal to cover federal income tax, whether you will ultimately owe 20% of your income or not. Rolling over the portion of your 401(k) that you would like to withdraw into an IRA is a way to access the funds without being subject to that 20% mandatory withdrawal. Tax-loss selling of poorly-performing investments is another way to counter the risk of being pushed into a higher tax bracket.
Deferring Social Security is another way of reducing your tax burden when you take a 401(k) withdrawal. Social Security benefits are not usually taxable unless the recipient's overall annual income exceeds a set amount. Sometimes a large 401(k) withdrawal is enough to push the recipient's income over that limit.
Here's a look at these and other methods of reducing the taxes you need to pay when you withdraw funds from your 401(k)
1. Explore Net Unrealized Appreciation (NUA)
If you have company stock in your 401(k), you may be eligible for net unrealized appreciation (NUA) treatment if the company stock portion of your 401(k) is distributed to a taxable bank or brokerage account. When you do this, you still have to pay income tax on the stock's original purchase price, 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. (You should also think twice before rolling over company stock.) This strategy can be rather complex, so it might be best to enlist the help of a professional.
2. Use the "Still Working" Exception
Most people know they are subject to required minimum distributions (RMDs) at age 73, even on a Roth 401(k). Please note that the RMD age was changed from 70½ to 72 at the end of 2019 through the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, and then to 73 in 2023. But if you're still working when you reach that age, these RMDs don't apply to your 401(k) with your current employer (see item 8, below).
In other words, you can keep the funds in the account, earning away to augment your nest egg, and postpone any tax reckoning on them. Keep in mind that the IRS has not clearly defined what amounts to "still working." Probably, though, you would need to be deemed employed throughout the entire calendar year. Tread carefully if you're cutting back to part-time or considering some other sort of phased retirement scenario.
Also, there are issues with this strategy if you are an owner of a company. If you own more than 5% of the business that sponsors the plan, you're not eligible for this exemption. Also, consider that the 5% ownership rule means over 5%; includes any stake owned by a spouse, children, grandchildren, and parents; it may rise to over 5% after age 73. You can see how complicated this strategy can get.
3. Consider Tax-Loss Harvesting
Another strategy, called tax-loss harvesting, involves selling underperforming securities in your regular investment account. 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, but there are limitations to this strategy and one must be careful to avoid violating the wash-sale rule.
4. Avoid the Mandatory 20% Withholding
When you take 401(k) distributions and have the money sent directly to you, the service provider is required to withhold 20% for federal income tax. If this is too much—if you effectively only owe, say, 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. 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.
If you borrow from your 401(k) and neglect to repay the loan, the amount will be taxed as if it was a cash distribution.
5. Borrow Instead of Withdraw 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. 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.
With these parameters, 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 house in the relatively inexpensive South to rent out. 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 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 (less maintenance)! 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, not to mention the hassles of becoming a landlord. You should always talk to a financial advisor before embarking on such a step.
The CARES Act doubled the amount of 401(k) money available as a loan to $100,000 in 2020, but only if you had been impacted by the COVID-19 pandemic. This benefit expired in 2020.
6. Watch Your Tax Bracket
Since all (or, one hopes, only a portion) of your 401(k) distribution is based on your tax bracket at the time of distribution, you should 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 (after deductions) to a minimum. Say, for example, you are married and filing jointly. For 2023, you can stay in the 12% tax bracket by keeping taxable income under $89,450—up from $83,550 in 2022.
By planning carefully, you can limit your 401(k) withdrawals, so they don't push you into a higher bracket (the next one up is 22%) 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. Keep Your Capital Gains Taxes Low
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%. For 2023, singles with taxable income up to $44,625 and married filing jointly taxpayers with taxable income up to $89,250 will stay within the 0% capital gains threshold. In 2022, singles with taxable incomes up to $41,675 and married filing jointly taxpayers with taxable incomes up to $83,350 stayed within the 0% capital gains threshold. Any amount over this was taxed at the 15% tax rate.
Any amount over the 2023 income levels will be taxed at the 15% rate.
Retirees can subtract their pension from their annual spending amount, then calculate the taxable portion of their Social Security benefits and subtract this from the balance from the previous equation. Then, if they are over 73, subtract their required minimum distribution. The remainder, if any, is what should come from the retirees' 401(k). Any income needed above this amount should be withdrawn from positions with long-term capital gains in a brokerage account or Roth IRA.
8. Roll Over Old 401(k)s
Remember, you don't have to take distributions from your 401(k) funds at your current employer if you're still working. However, if you have 401(k)s with previous employers or traditional IRAs, you would be required to take RMDs from those accounts.
To avoid the requirement, roll your old 401(k)s and traditional IRAs into your current 401(k) before the year you turn 73. There are some exceptions to this rule, 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 Social Security Payments
To keep your taxable income lower (when you've taken a 401(k) withdrawal) and also possibly stay in a lower tax bracket, consider delaying taking your Social Security benefits. One way to do this is to delay or defer Social Security payments as part of a tax-saving strategy that includes converting some funds to a Roth IRA.
If retirees can afford to delay collecting Social Security benefits, they can raise their payment by almost a third. If you were born within the years 1943–1954, for example, your full retirement age—the point at which you will get 100% of your benefits—is 66. But if you delay to age 67, you'll get 108% of your age 66 benefit, and at age 70, you'll get 132% (the Social Security Administration provides this handy calculator to help you determine your benefit). This strategy stops yielding any extra benefit at age 70, however, and no matter what, you should still file for Medicare Part A at age 65.
Don't confuse delaying Social Security benefits with the old "file and suspend" strategy for spouses. The government closed that loophole in 2016.
10. Get Disaster Relief
For people living in areas prone to hurricanes, tornadoes, earthquakes, or other forms of natural disasters, 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 401(k) distribution, see if you can wait for one of these times.
In addition, there are other events that constitute a hardship and therefore yield an exemption from the 10% penalty. They include economic challenges, such as job loss, the need to pay college tuition, or putting a down payment on a house.
What Are the Rules for a 401(k) Distribution?
You can withdraw money from your 401(k) penalty-free once you turn 59½. The withdrawals will be subject to ordinary income tax, based on your tax bracket. For those under 59½ seeking to make an early 401(k) withdrawal, a 10% penalty is normally assessed unless you are facing financial hardship, buying a first home, or needing to cover costs associated with a birth or adoption.
How Can You Withdraw From a 401(k) Without Penalty?
You can withdraw from a 401(k) distribution without penalty if you are at least 59½. If you are under that age, the penalty is 10% of the amount withdrawn. There are exceptions for financial hardship, and for certain qualified reasons such as:
- Essential medical expenses for treatment and care
- Home-buying expenses for a principal residence
- Up to 12 months worth of educational tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods)
How Long Does a 401(k) Distribution Take?
There is no universal period of time in which you must wait to receive a 401(k) distribution. Generally, it takes between three and 10 business days to receive a check, depending on which institution administers your account and whether you are receiving a physical check or having it sent by electronic transfer to a bank account.
Can I Take a Distribution From My 401(k) While Still Working?
Yes, but any distribution will be taxed as ordinary income and will be subject to the 10% penalty if the person making the 401(k) withdrawal is under 59½. The penalty is waived if you qualify for a hardship.
How Much Tax Do I Pay on a 401(k) Withdrawal?
Your withdrawal is taxed as ordinary income and the amount of tax you'll pay depends on what tax bracket you fall into for the year. Bear in mind that, normally, if you take a distribution before age 59½, you'll owe a 10% penalty on the distribution amount as well as income tax.
The Bottom Line
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.
Keep in mind that these are advanced strategies used by the pros to reduce their clients' tax burdens at the time of 401(k) distribution. Don't try to implement them on your own unless you have a high degree of financial and tax knowledge.
Instead, ask a financial planner if any of them are right for you. As with anything with taxes, there are rules and conditions with each, and one wrong move could trigger penalties.