How Can I Avoid Paying Taxes on My 401(k) Withdrawal?

Author: Siân Killingsworth / 17 Jun 2020 / 401(k) Resources

From making Roth 401(k) contributions to avoiding penalties by not withdrawing funds early, there are several strategies for reducing your tax burden with a 401(k) retirement savings account.

Avoid paying additional taxes and penalties by not withdrawing your funds early.

First and foremost, you want to avoid withdrawing money from a traditional IRA before age 59.5. There is a 10% early withdrawal penalty on top of the income tax owed. However, if you leave your job at age 55, you may be able to at least take a penalty-free 401(k) withdrawal from that particular job under the “Rule of 55,” though you’ll still be hit with income tax.

You may be eligible to take out a fixed five-year loan worth up to 50 percent of your balance without incurring additional taxes – as long as you pay the money back on-time. Alternatively, you may qualify for a hardship exemption that absolves you from having to pay an IRS penalty at the very least.

Make Roth contributions, rather than traditional 401(k) contributions.

If you expect to be in a higher tax bracket in your retirement years, you may consider setting up an after-tax Roth account, where you pay your taxes sooner rather than later. When you take distributions out in retirement, you will owe no tax, as you have already paid it when you put the money into your account.

While you don’t avoid paying taxes entirely, a Roth 401(k) allows you to avoid paying tax on any earnings and interest you may have accumulated over 20-30 years.

Delay taking social security as long as possible.

Keeping yourself in a lower tax bracket will reduce the amount of your tax liability. If you don’t need that much money right now, you can live off your 401(k) withdrawals starting at age 59.5 and wait until age 70 to begin collecting Social Security benefits. Not only does it reduce the taxes owed now, but waiting until “full retirement age” also increases your payment by almost a third later on.

Rollover your 401(k) into another 401(k) or IRA.

Quitting, getting laid off, or getting fired from a job that provides a 401(k) could trigger a taxable event. If you have a very small amount in the account ($1,000 or less), you may be able to leave the money where it is. If the money is between $1,000-$5,000, you may want to roll the cash over into an IRA or do a custodian-to-custodian transfer to a new employer’s 401(k) or a solo 401(k). You have up to 60 days to roll the money over without being charged tax.

Consider tax loss harvesting.

Tax-loss harvesting helps investors minimize what they pay in capital gains taxes by offsetting the amount they must claim as income. Capital losses occur any time an asset diminishes in value and is sold for a price lower than the initial purchase price. Selling investments at a loss can lower or even eliminate the amount of taxes paid on gains that year.

Tax-loss harvesting only applies to taxable investment accounts – not IRA or 401(k) accounts, which grow tax-deferred and are not subject to capital gains taxes. Married couples can claim up to $1,500 (filing single) or up to $3,000 (filing joint) per year in realized losses to offset federal income tax.

Tax-loss harvesting won’t help you avoid paying tax on a 401(k) withdrawal directly, but it can offset your overall tax obligations.

Contact Ubiquity for details on 401(k) plans, including questions on 401(k) withdrawals.