How to minimize taxes on 401(k) withdrawals

You’ve invested in a 401(k), made contributions for decades and finally are ready to withdraw – or taking distributions, in retirement plan-speak. But now you’re having to pay taxes on what you’re taking out, effectively reducing your nest egg. What to do? Here are several ways to minimize taxes on withdrawals. (For some background first, see "How Yearly Taxes on 401(k) Accounts Work").

Convert to a Roth

One of the easiest ways to lower the amount of taxes you’ll have to pay on 401(k) withdrawals is to convert to a Roth IRA or Roth 401(k). Withdrawals from those accounts are not taxed as long as they meet the rules for a qualified distribution. Be aware that you’ll have to declare the conversion when you file your taxes. (For more, see: "An Introduction to the Roth 401(k).")

The big issue with converting your traditional 401(k) to a Roth IRA or Roth 401(k) is the income tax you’ll have to pay on the money you withdraw. If you’re close to pulling out the money anyway, it may not be worth the cost of converting it. The more money you convert, the more taxes you’ll have to pay. “The longer the money can stay in the Roth before withdrawals begin, the better,” says certified financial planner (CFP) Daniel Sheehan of Sheehan Life Planning.

CFP Ben Wacek of Wacek Financial Planning recommends splitting your assets between a Roth account and tax-deferred account, to share the burden. “Although you will likely pay more taxes today, this strategy will give you the flexibility to withdraw some funds from a tax-deferred account and some from a Roth IRA account in order to have increased control of your marginal tax rate in retirement,” he said.

This format requires several years of planning ahead. For example, the five-year rule requires that you have your funds in the Roth for five years before you begin withdrawals. This might or might not work for you if you're already 65. about to retire, and suddenly worried about paying taxes on your distributions.

Withdraw Before You Need It

Some of the methods that allow you to save on taxes also require you to take out more from your 401(k) than you actually need. If you can trust yourself not to spend those funds– in other words, save or invest the extra – this can be an easy way to spread out the tax obligation. “If the person is under 59½ years of age, the IRS allows under Regulation T to take substantially equal distributions over one's life from a qualified plan without incurring the 10% early withdrawal penalty,” Sheehan said. “However, the withdrawals need to last a minimum of five years. Therefore, someone who is 56 and starts the withdrawals must continue those withdrawals to at least age 61 even though they may not need the money.”

CFP and certified public accountant (CPA) Jamie F. Block of Wealth Design Retirement Services says that if you take out distributions earlier while you’re in a lower tax bracket, you could save on taxes, versus waiting until you’ll have Social Security and possible income from other retirement vehicles. It could all add up to a sudden increase in how much you're bringing home, and if your spouse is receiving Social Security and has other retirement income too, your joint income might be even higher. “This is when taking money out of a 401(k) before age 70½ at a lower tax bracket has its advantages,” she says.

Get Control Over Your Future Tax Bracket

If you plan ahead and you're 59½ or older, you can take out just enough money from a 401(k) (or a  traditional IRA) that will keep you in your current tax bracket, but still lower the amount that will be subject to required minimum distributions (RMDs) when you're 70½. The goal is to lessen the impact of the RMDs (which are based on a percent of your retirement account balance, along with your age) on your tax rate when you have to start getting them.

While you'll have to pay taxes on the money you withdraw, you can save further by then investing those funds in another vehicle, such as a brokerage account, Sheehan says. “Calculate how much can be taken out (if applicable over the required minimum distribution amount) in a particular year before you are subject to a higher tax bracket and take out the extra and invest it in a taxable account."

Hold it there for at least a year and you will only have to pay long-term capital gains tax on what it earns. Paying at the capital gains tax rate isn't the same as getting free money from a Roth IRA, but it's less than paying regular income tax.

The Bottom Line

There are several (complicated!) options for reducing taxes on 401(k) withdrawals or cushioning their impact on future taxes. Whichever method you choose, it always helps to talk to an advisor to figure out which works best for your individual circumstances. (For more, see "Is It Ever Wise to Make Early Withdrawals from Your 401(k)?")