How You Can Avoid High Taxes at Traditional IRA and 401k Withdrawal
Eventually, you’re going to need to make a 401k withdrawal. That’s the entire point of your retirement account, anyway.
However, pulling money from that account could leave you facing a significant tax burden. Uncle Sam wants his share, too. It doesn’t have to be that way, though.
There are a few steps Baby Boomers can take to limit the bite the government takes from your 401k withdrawal.
Know Your Situation Before You Make a 401k Withdrawal
Before you withdraw any money from your 401k without a penalty, you need to be at least 59.5 years old. This is also when you’ll find the IRS waiting for you with their arms wide open.
No, that’s not a loving hug. It’s a grasping reach for your money, and they’ll get it if you’re not careful.
How’s that happen?
It’s simple. Your withdrawal can push your income tax bracket higher, meaning that your tax liability at the end of the year is more than it should be.
Ideally, you’ll go into the situation knowing what your current tax bracket is, and what it will be with a 401k withdrawal.
For some Baby Boomers, it’s too late for anything but damage control. The oldest Boomers are now reaching 70.5 years of age, and finding that their tax deferred status is no longer protecting their retirement nest egg.
It’s time to pay the piper, and if you haven’t had plans laid well before now, there might not be anything you can do to keep Uncle Sam from eating into your savings.
Ideally, you’ll dig into the situation and learn how required minimum distributions work well before you actually have to worry about them. This gives you time to plan, and to find a financial expert with whom to work.
Start as early as possible. While you might not need to worry about mandatory disbursements until 70.5, you can start planning as early as your 30s.
Know Your Required Withdrawal
Once you turn 70.5 years old, you’re required to start making withdrawals from 401k accounts and other tax-deferred accounts annually. There is no way around this unless you are still working and are participating in your employer’s plan.Even then, you might be stuck making withdrawals.
The amount you are required to withdraw is not in your control – the IRS will determine how much you have to take. You cannot take less than the minimum amount. And, if you “forget” about a distribution, the IRS will penalize you by taking half of the amount you would have pulled out.
Those penalties are incredibly steep, so make sure you don’t miss a disbursement.
Know Your Income Streams
Once you retire, you’ll have money coming in from multiple sources. It can be easy to forget about some of these, or to downplay just how much money you’re earning.
Because your income consists of several smaller streams, rather than one large one, it might take you by surprise to realize how much you’re pulling in. Know your income streams and make sure you’re accounting for all that money in your planning.
For instance, you might have Social Security payments, as well as RMDs from your 401k and Traditional IRA, pension payments and more. Know what you have coming in, know how much you’re earning overall, and calculate the income gap correctly (if there is one).
By filling the gap with disbursements from your account, and paying taxes on it, you’re able to safely sock it away in a Roth IRA without worrying about paying taxes on it yet again when it’s time to pull from that account.
Automate the RMD Process
One tip for helping you avoid forgetting about those disbursements and incurring the wrath of the IRS to the tune of 50% of the RMD is to automate the process. Your IRA custodian can calculate the disbursement amounts on your behalf, and then automatically transfer the money for you.
That ensures you’re never caught “with your pants down” so to speak, and makes sure that the government isn’t getting any more of your money than they should.
Consider a Roth IRA
One way to get around the prospect of paying the IRS too much of your hard-earned money is to channel those funds into a Roth IRA.
If you have a regular IRA, start converting chunks of that money into a Roth IRA between the ages of 59.5 and 70.5. Furthermore, when you leave an employer, make a decision to roll over 401k directly to Roth IRA. Pay taxes in your early years and grow your retirement nest egg absolutely tax-free.
This can let you take advantage of any gaps in your income that might lower your tax bracket. And, any money pulled from your traditional IRA will incur a tax burden, and then you can place it into the Roth IRA without worrying about incurring additional wrath from the IRS.
That leaves you with the question of just how much you should convert.The answer will vary depending on your financial situation and other factors.
For instance, how much do you have in taxable accounts to pay for the cost of living, as well as the money you’ll owe the IRS?How close are you to the next bracket up the chart? How much will it take to push you over the edge? How much can you afford to lose in terms of interest earned within the IRA? How much will a transfer cost you now, versus later on when you might be receiving Social Security payments as well?
For instance, if you were able to keep your tax bracket at the 15% mark, and you moved $75,000 from a traditional IRA to a Roth IRA, it would cost you just over $11,000.
However, if you waited, and made the transfer later, once you started pulling in Social Security benefits and your tax bracket moved to the 25% mark, that same transfer would cost you almost $19,000. That’s a huge chunk of change.