Written By Forbes BrandVoice Team
Most people look forward to retirement as a golden age free of frustrating work commutes, early wake ups and other exasperating downsides of the daily grind. Yet even the most gilded retirement isn’t free of income taxes.
This is certainly the case with withdrawals from one of the most popular forms of retirement income — tax-deferred 401(k) plans, which allow investors to grow their contributions tax-free until retirement, at which point distributions are taxed like any other income.
“A 401(k)-defined contribution plan is a great way to squirrel away savings for retirement, as the contributions are deducted from the income you pay taxes on each year, reducing the tax bite,” says Robert Hartwig, a professor of finance at the University of South Carolina Darla Moore School of Business. “The savings also accumulate tax-free until withdrawn at retirement,” a particularly appealing advantage for people who think their overall income will be lower once they retire.
Nevertheless, the IRS will still come to collect its fair share of overall income tax. And when that occurs, not having a tax strategy in place can decrease the payoff. For example, since 401(k) withdrawals are subject to ordinary income tax, a large withdrawal of the savings — added to other streams of income — could kick you into a higher tax bracket.
On the bright side, there are ways to soften the tax impact, including post-tax retirement strategies like Roth IRA accounts. They key is to plan ahead. Hartwig provides four time-tested strategies for getting the biggest bang for your buck from a 401(k) retirement plan:
1. Avoid Penalties For Early Withdrawal
The Internal Revenue Service levies a 10 percent additional tax on withdrawals from a 401(k) or traditional IRA plan prior to the age of 59 ½, in addition to the ordinary income tax that would be levied on the amount withdrawn. Essentially, it’s a slap on the wrist from the IRS, “as the purpose of a 401(k) plan is to provide income post-retirement,” says Hartwig. In addition, withdrawing from these accounts early means squandering the potential future savings growth on your investment, had it been left in the plan. To avoid those losses, “resist accessing income from your 401(k) plan until you’ve passed the age of 59 ½,” advises Hartwig.
What if you hit a rough patch and need the extra income before turning 60? “While [an early withdrawal] may be a better option than borrowing from your credit cards, review other ways of generating capital with your financial adviser,” Hartwig adds. For instance, a short-term loan from a family member or friend — rather than dipping into your deferred-tax investments — may actually be the more advantageous option for you on the long run.
2. But Start Withdrawals Before Age 70 ½
Just because you’ve passed the age of 59 ½ doesn’t automatically mean you need to start accessing regular distributions from your 401(k) plan. In fact, the longer you can enjoy the tax-deferred status of the plan, the better the chance the accumulated investment value will grow. There is a cutoff point, however. “The IRS requires you to make your first withdrawal by April in the year after you turn 70 ½,” Hartwig notes. “Failure to do so results in a whopping 50 percent penalty on the amount that should have been withdrawn.” This obligation, known as required minimum distributions (RMDs), is essentially the IRS’ way of preventing you from deferring taxes indefinitely and affects holders of other plans like IRAs and simplified employee pensions (SEPs) as well. “The best strategy here for many people is to start taking small distributions beginning in your 60s,” to extend the income from the plan through one’s retirement years, Hartwig says.
There is one scenario in which you might not have to pay an RMD at age 70 ½, and that’s if you’re still employed, or newly employed, and enrolled in your current company’s 401(k). It may make sense to roll over qualifying assets into your active 401(k) plan to make use of the “still-working exception” and delay taking an RMD — though if you own more than five percent of your employing company, you’re not eligible to make use of this workaround.
3. Establish A Roth IRA
There is significant value in investing in a pre-tax Roth IRA — or Roth 401(k) if your employer provides the option — to offset the tax impact of withdrawing from a tax-deferred account, particularly for individuals who expect to be in higher tax brackets during retirement. In contrast to a traditional IRA, where the contribution is deductible in the tax year in which it is made, under a Roth account, the tax benefit is reversed. “The contribution to a Roth IRA is not tax deductible, but all the investment earnings are,” Hartwig explains. “Basically, you put money into the Roth IRA after you’ve paid the taxes on it and can withdraw these contributions at any time with minimal tax concerns.” In effect, the retirement options balance out each other’s tax considerations. At retirement, the Roth IRA earnings are tax exempt, while the 401(k) earnings are taxable. “A Roth IRA could greatly reduce your tax burden at a time in your life when every dollar counts,” Hartwig says.
4. Bypass The 20 Percent Withholding Rule
Here’s a 401(k) strategy that people often simply don’t know about: The IRS requires 401(k) plan administrators to withhold 20 percent of distributions until tax time on April 15. For some retirees, that can be a long wait. There is a way to minimize this impact, via a trustee-to-trustee rollover to an IRA, as IRAs are not subject to the same mandatory withholding.
As always, when it comes to something as complicated (and personal) as a retirement savings strategy, due diligence into the varied plan options in relation to their differing tax treatments, often guided by a financial advisor, is needed. Armed with this knowledge, an optimal strategy will add luster to one’s golden years.
