You work hard all your life to effectively save for retirement. However, a financially secure retirement results from in-depth financial planning, smart investments, and, most of all, minimum taxes and bills. Taxes consume a large share of your hard-earned money. Tax bills affect your income when you work and even after you retire. Typically, an average American pays approximately $10,500 annually in income taxes. This figure is nearly 14% of the average American household budget. If you’re wondering if retirement is income taxable, the answer is yes! Even though you do not have a steady income source during retirement, you still owe tax on retirement withdrawals from accounts like a 401(k), an IRA (Individual Retirement Account), etc. Distributions from such retirement accounts are taxable as ordinary income. Therefore, while retired life might be less stressful and relaxed, there is no freedom from taxes. You may have to pay 401(k) or IRA withdrawal taxes. Hence, your retirement savings account balances are not your absolute retirement savings. You must accommodate tax on retirement withdrawals to arrive at the net retirement corpus figure.
Understanding retirement taxes and how to pay less tax on retirement account withdrawals is important for your retirement financial security. The less you pay in taxes, the more retirement savings you have. It is advisable to consult with a professional financial advisor on how to minimize taxes when making a withdrawal from your 401(k) or IRA to ensure maximum savings for yourself during your retirement years.
Here are some effective tips that can help you minimize tax on retirement withdrawal:
- Opt for qualified withdrawals from your retirement accounts:
By nature, retirement accounts like an IRA or a 401(k) are tax-deferred accounts. This means that you contribute pre-tax dollars in these accounts but pay taxes at the time of withdrawal. The IRA or 401(k) withdrawal tax rate is the same as your applicable income tax slab. However, suppose you withdraw any money from your tax-deferred retirement accounts before the eligible age (also known as non-qualified withdrawals), you will pay the penalty along with income tax on withdrawals. Typically, the Internal Revenue Service (IRS) allows you to take qualified withdrawals from your retirement accounts like a 401(k) or an IRA after the age of 59.5. If you take money from these accounts before the eligible withdrawal age, you will be liable to pay a 10% early-withdrawal penalty, in addition to the applicable taxes. In terms of a 401(k), the IRS also automatically withholds 20% of your early withdrawal amount for taxes. So, if you take $10,000 from your 401(k) account before 59.5 years, you might only get a credit of $8,000. Taking non-qualified withdrawals increases your penalty burden along with taxes, significantly reducing your retirement reserves. Therefore, take only qualified or required minimum distributions (RMDs) from your retirement accounts to minimize tax on retirement withdrawals. However, in some cases, early distributions are not penalized like permanent disability, loss of employment, divorce, childbirth or adoption, first-home purchase, hefty medical bill, college funding, death, etc.
- Consider rolling over your 401(k) into an IRA:
A smart tactic that can help you minimize tax on retirement withdrawal is a rollover strategy. A 401(k) rollover is a strategy where you withdraw money from your existing 401(k) account and redirect it to a new 401(k) plan or most preferably, an IRA. The IRS allows you to roll over your 401(k) account within 60 days of receiving the distributions from this account. You can contact an authorized bank or brokerage firm to open an IRA. However, be mindful of the applicable fees and account charges; also, check the investment options offered by your IRA administrator before opting for the 401(k) rollover. Rolling over your 401(k) into an IRA offers multiple advantages, such as tax-deferred growth of funds for a longer period, wider investment choices compared to a 401(k), flexible rules, and more. Rolling your 401(k) into an IRA also lowers your overall taxes. Typically, in a 401(k), the IRS withholds 20% of your distributions for federal taxes. In an IRA, there is no specific percentage that the IRS withholds. You can even opt for no tax withholdings. However, it is advisable to have at least a small percentage of your withdrawals to be withheld in an IRA to avoid an annual hefty tax bill. You can choose a percentage that reflects the actual amount you might owe to the IRS eventually instead of opting for an automatic 20% withholding. The advantage is that your funds have more time to benefit from the tax-deferred power of compounding.
- Do not forget to withdraw your RMDs:
It is advisable to not withdraw any sum from your retirement accounts unless you are eligible to do so or require the sum urgently. The longer your funds remain invested in these tax-deferred retirement accounts, the better return potential you can get. Moreover, you do not pay any taxes unless you take distributions from your retirement accounts. But you should be aware of withdrawal rules like RMDs, which could increase your penalty and ultimately hamper your retirement reserves, diminishing them sooner than anticipated. The IRS mandates you to take RMDs from your retirement accounts (like 401(k) and IRA) when you turn 72. The RMD amount depends on your account balance and life expectancy. Failure to take RMD or the full RMD amount from your retirement account by the due date will result in a penalty. The IRS levies a penalty of up to 50% on the amount not withdrawn from the RMD sum. This penalty, along with applicable income taxes, will reduce your retirement corpus, hampering your financial security in the long run.
- Avoid taking out two distributions in the same year:
Managing your first RMD can be slightly tricky. Generally, your first RMD is due by April 1 of the year you turn 72. In this case, your second RMD can be due by December 31 of the same year, causing you to take two distributions from the account in the same year. Two sizable distributions from your retirement account in the same tax year can shift you to a higher tax bracket. Hence, it is best to not delay your RMD until April 1 of the year you turn 72. Instead, take it in the year it is mandated. You can consider taking your first and second RMD in two separate tax years. Even after the initial RMD, you should be careful with your RMDs, particularly the size. As your retirement account balances fluctuate, so will your RMDs.
- Spread your withdrawals over a longer number of years:
Ideally, your RMDs do not begin until you reach 72 years of age. However, you can take penalty-free drawings post the age of 59.5. Therefore, you can distribute your drawings over a longer period to spread the tax bill over more years to reduce taxes. This will allow you to stay in a lower tax bracket and reduce your lifetime taxes. You can begin taking a low amount from your retirement account in your 60s to distribute your tax bill over a higher number of years. Moreover, you can also consider taking 401(k) and IRA distributions during the non-income years of your life, typically right after you retire and before you start receiving your Social Security benefits or pensions. For instance, you can structure your retirement account withdrawals in such a way that the sum you withdraw keeps you in the lower tax bracket, of say 12%.
- Consider making Roth conversions:
401(k) and IRA withdrawal taxes can be harsh, but it is possible to avoid paying any taxes on your withdrawals if you convert your existing retirement accounts into their Roth counterparts. So, if you are wondering – How can I get my 401(k) money without paying taxes? The answer is by applying a suitable tax strategy and redirecting your funds from these tax-deferred retirement accounts into a Roth IRA or a Roth 401(k) account. Converting into a Roth IRA or Roth 401(k) will help you save a lot of money. Roth retirement accounts do not levy any taxes on the money you save, earn, or withdraw from these accounts, provided you meet the IRS specifications. Moreover, you will need to hold a Roth account for at least five years and be at least 59.5 years to be eligible for tax-free withdrawals. Converting your traditional retirement account into a Roth account can also help you avoid state taxes. However, when you redirect your traditional retirement account balance to their Roth counterparts, you will have to pay taxes on the contributions and earnings. This is because you make Roth contributions with after-tax dollars to get tax-free withdrawals in the future. Also, before you make the Roth conversion, understand the rollover rules, check your eligibility, and know the conversion procedure beforehand. Note that Roth accounts have a maximum contribution, which varies each year. It is advisable to be sure about all details before opting for the Roth conversion.
- Donate your IRA funds to charity:
The IRS allows you to make tax-free charitable contributions from your IRA if you are 70.5 years of age. If you meet the age criteria, you can transfer up to $100,000 per year directly from an IRA to an authorized charitable firm without paying income tax on the transfer. This means that you can reduce your IRA withdrawal sum, and consequently, the payable tax bill. Further, if you file joint tax returns with your spouse, you can save up to $200,000 from your IRA retirement savings if you donate to an eligible charity. However, if you donate above the applicable limits, your donation will be considered as income and will become subject to income tax. Remember to make all charitable contributions by December 31 of each year to exclude the donated sum from your annual taxable income. You can donate to multiple charities. The sum you donate to charity is considered a qualified IRA distribution and can also satisfy the RMD rule. If you want, you can also donate a part of your IRA distribution to charity and use the rest as income.
- Avoid holding tax-preferential investments:
Investments that generate long-term capital gains receive preferential tax treatment outside the retirement savings account. If you hold such investments in your traditional retirement accounts, you will be liable to pay tax per the 401(k) withdrawal tax rate (typically, your regular income tax rate), which is essentially higher than the long-term capital gain tax. Alternatively, you can minimize your tax on retirement withdrawal by holding more heavily taxed investments in your retirement accounts. In your retirement plan, you can consider investing in inflation-protected securities, government bonds, corporate debt, and other options generating short-term capital gains.
- Relocate to live in a tax-friendly state:
The state where you live directly impacts your retirement income, and consequently, the retirement account withdrawals. Some states in the U.S. are highly tax-friendly; you do not have to pay any tax or have the lowest state and local tax burden, which significantly impacts your income during retirement. Tennessee, Arkansas, South Carolina, Colorado, Nevada, District of Columbia, Hawaii, and Delaware are among the most tax-friendly states in the U.S. Delaware has no estate or inheritance tax, low-income tax rates between 2.2% and 6.6%, and an average combined state and local sales tax rate of 0%. Alternatively, Texas, New York, Iowa, Vermont, Nebraska, Kansas, Illinois, and New Jersey are some of America’s most unfriendly tax states. By relocating to a tax-friendly state, you can minimize your tax bill by nearly $10,000 or more per year during retirement, compared to living in a non tax-friendly state. If you live in a tax-friendly U.S. state, like Alaska, Texas, Washington, Florida, Nevada, South Dakota, and Wyoming, you will be free from any state-level personal income taxes because these states have no income tax.
By using the above-mentioned tips and being careful about your retirement account withdrawals, you can easily minimize your tax burden for retirement. If applied well, these strategies can ensure and preserve your future retirement financial security. However, these are only general strategies and may not apply to your unique financial situation. It is best to consult a professional financial advisor to modify these strategies per your financial situation to lower your retirement taxes and increase your income during the golden years.