How do I determine how much taxes I pay on withdrawals from my 401(k)?


One of the attractive features of a 401(k) plan is that it is tax-deferred, meaning that there is no tax charged on contributions, or on interest and gains earned on the retirement savings until you withdraw it. This allows individuals to contribute a bigger portion of their paycheck to their retirement savings up to the 401(k) contribution limit. However, you will still have to pay taxes when you withdraw money from a 401(k) plan. You may want to ask yourself, “Could taxes be higher later?”.

When you make a withdrawal from a 401(k) account, the amount of tax you pay depends on your tax bracket in the year when the withdrawal is made. For example, if you fall in the 12% tax bracket rate, you can expect to pay up to 22% in taxes, including a 10% early withdrawal penalty if you are below 59 ½. However, if you are above 59 ½, you will only pay income taxes on the amount withdrawn. You must file your annual tax return, reporting all the income earned during the year, including the 401(k) distributions, and taxes you have already paid. 

401(k) Taxes If you Withdraw Money Early

You can make an early 401(k) withdrawal to pay college fees, emergency medical bills, or when you are a victim of a disaster. In this case, you should expect to pay income taxes on the amount withdrawn, since the distribution is considered an income to you. However, if the withdrawal qualifies as a hardship withdrawal, you may get an exception for the 10% penalty tax.

If you have a Roth 401(k) account, you won’t be required to pay any income taxes as long as you’ve held the account for at least five years. A Roth 401(k) is funded with after-tax dollars, and you only pay taxes on contributions. The Roth 401(k) contributions are not tax-deductible, and you won’t pay taxes on withdrawals in retirement. However, if you make a withdrawal before reaching 59 ½, you will pay income taxes on any interests and gains on your retirement savings, and a 10% early withdrawal tax, unless you need the money due to disability or death.

401(k) Taxes If you Withdraw Money in Retirement

When you withdraw money from a 401(k) in retirement, you will owe taxes in the year when you take the distribution. The withdrawals will be taxed as your other sources of income at your tax bracket rate. At the minimum, you will pay federal income taxes on the distribution. If you are a resident of a state that imposes state income taxes on retirement distributions, you will pay extra taxes. However, certain states don’t tax 401(k) distributions, and you won’t pay additional taxes.

For Roth 401(k) withdrawals, you won’t pay income taxes when you withdraw money in retirement, since you had already paid income taxes at the onset. You must have reached 59 ½ and have held the account for five years or more to qualify for tax-free withdrawals from your Roth 401(k).

If you are already 72, you must start taking the required minimum distributions from a traditional 401(k) and Roth 401(k). If you do not take the mandatory distributions, you will incur a 10% penalty on the distribution not taken.

How to Minimize 401(k) Taxes

Here are some of the ways you can use to reduce, delay, or avoid the 401(k) taxes:

401(k) rollover to a traditional IRA

If you are simply withdrawing funds from a 401(k) and transferring them to another retirement account, you can opt for a direct rollover. A direct rollover moves retirement money directly from one retirement account to another, and it does not have a tax implication. You can also choose an indirect rollover, where the plan sponsor sends you a check with your 401(k) balance. You must then deposit the funds to a 401(k) or IRA within 60 days, failure to which the amount will be considered a distribution for tax purposes.

Roth conversion

If you believe you will be in a higher tax bracket in retirement, you can decide to pay taxes now by rolling over your 401(k) into a Roth IRA. A Roth IRA is funded with after-tax dollars, and you will have to pay taxes now on any contributions made to a traditional 401(k) in the year you execute the rollover. Once you’ve completed the rollover, you won’t owe income taxes when you take a distribution in retirement.

401(k) loan

Instead of making a 401(k) withdrawal before reaching 59 ½, you can decide to take a 401(k) loan. You can borrow up to 50% of your account balance, up to a maximum of $50,000 to meet your current financial needs. You won’t pay any taxes on the 401(k) loan, but you will be required to pay back the loan with interest. The funds will be deposited back to your 401(k) account.

LIRP (Life Insurance Retirement Plan)

You could choose to fund a LIRP. Money placed in a LIRP is after tax dollars and can be accessed Tax Free. Growth within the LIRP is also guaranteed. This could mean huge savings on money that would of been paid out in taxes to Uncle Sam. If your tax bracket is 22% and you have $1,000,000 in your retirement account, you will pay $220,000 alone in taxes leaving only $780,000. In your LIRP, $1,000,000 is $1,000,000 plus you would have a tax free death benefit to leave making this one of the best financial vehicles out there.

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