401(k)s and other workplace retirement plans are an excellent way to save for retirement while also saving money on taxes. But that doesn’t mean there aren’t any taxes associated with these accounts. You’ll usually pay taxes when you withdraw money from your accounts, and you can be subject to additional taxes depending on the age at which you withdraw money.
The good news is there are ways to reduce your tax burden even more with your 401(k) plan. Some strategies allow you to avoid taxes altogether, while others simply reduce the amount you’ll pay.
Taxes on 401(k) Withdrawals
The tax consequences of withdrawing money from your 401(k) depend on the type of withdrawals you made. Assuming you have a traditional 401(k) and make pretax contributions, you’ll pay income taxes on your distributions, regardless of when you take the money out.
When you pay taxes on your 401(k) withdrawals, you’ll do so at your normal tax rate. So if you’re in the 12% tax bracket, then your withdrawal is likely to be taxed at that rate. Likewise, someone in the 37% tax bracket is likely to pay that rate on their 401(k) distributions.
In addition to normal income taxes, you may also pay an additional tax of 10% if you withdraw money from your 401(k) before age 59 ½ and don’t meet one of the other exceptions that allow you to withdraw money early.
Suppose you take $10,000 from your 401(k) and you pay an income tax rate of 12%. First, you would pay $1,200 in ordinary income taxes. If you owe an early withdrawal penalty, you would pay an additional $1,000 tax for a total tax liability of $2,200.
How To Avoid 401(k) Taxes
It’s difficult to avoid taxes on 401(k) withdrawals altogether, but there are a couple of ways to do it.
401(k) Rollover
You can avoid paying taxes on your 401(k) by using a rollover, transferring the balance either into an individual retirement account or into another workplace retirement plan. Many people use a rollover when they leave a job, as it allows them to keep all of their retirement savings in one place rather than with multiple past employers.
There are a couple of different ways to do a 401(k) rollover. First, you can either have your current 401(k) plan administrator send the funds directly to your new IRA or 401(k) administrator, which will then place the funds in your account.
The other way to do a 401(k) rollover is through an indirect or 60-day rollover. In this case, the plan administrator sends you a check for the balance, which you must then deposit in your new account within 60 days to avoid taxes. The plan administrator must withhold taxes from the distribution, but if you deposit the money within 60 days, you’ll get the money back with your tax refund.
401(k) Loan
Another way to avoid taxes on your 401(k) is to take a loan instead of a distribution. You can borrow up to 50% or $50,000 from your account, whichever is lower. You’ll have to repay the loan with interest within five years.
401(k) loans have some serious downsides. First, until you repay the funds, it won’t be able to grow and compound for your retirement. Second, if you leave your job before repaying the loan — whether you quit or are fired — you may have to repay the full loan amount immediately or have it count as an early withdrawal.
How To Reduce 401(k) Taxes
There aren’t many ways to fully avoid taxes on 401(k) withdrawals since the IRS expects to get its money. However, there are ways to reduce the amount you’ll owe.
Make Roth Contributions
You can save your future self money on taxes by making Roth contributions to your retirement account instead of traditional contributions. Roth contributions are made after you’ve paid taxes on the money, meaning you won’t pay taxes on your withdrawals during retirement.
Skip the Early Withdrawal Penalty
The early withdrawal penalty adds an additional 10% tax to your 401(k) withdrawal taxes. You can save a bit of money by avoiding that penalty. The simplest way to avoid the 10% additional tax is to avoid taking distributions until you reach age 59 ½. However, you also won’t pay the penalty in the following situations:
- You become disabled.
- You take a series of substantially equal payments for life.
- You separate from service in or after the year you reach age 55.
- You owe another party under a qualified domestic relations order (often after a divorce).
- You pay for medical care up to the deductible amount.
Stay in a Lower Tax Bracket
Another way to reduce your 401(k) taxes is to stay in a lower tax bracket, which lowers the percentage you’ll pay in income taxes. We’re not necessarily suggesting that you reduce your income (though that’s one way to do it). But there are other ways to get in a lower tax bracket, such as selling investments for a loss, contributing to another tax-advantaged account (such as a health savings account or flexible spending account), and taking advantage of tax deductions.
Do a Roth Conversion
A Roth conversion isn’t a good solution if you want to save money on taxes right now, but it will save your future self money on taxes. A Roth conversion allows you to convert the money in your traditional retirement account into a Roth account. You’ll have to pay taxes on the amount you convert, but you won’t have to pay taxes on your withdrawals down the road.
The Bottom Line
401(k) taxes are (mostly) inevitable. For all the tax advantages these accounts offer, the IRS will expect you to pay taxes, either before you contribute or when you take distributions. But using the strategies above can help you reduce the amount you’ll owe.
And it’s worth noting that if you’re considering an early withdrawal, there may be alternatives that can help you avoid taxes altogether. For example, an emergency fund or personal loan can help you weather a financial storm and avoid pulling money from your 401(k).
