How To Minimize Your Taxes in Retirement
401K plans are unique platforms for retirement. Not only can you add dollars to them before they are taxed during your career, but by doing so you are actually reducing the amount of income that does get taxed which allows for you to save more for retirement. You are, in effect, delaying taxation. You will need to pay them once you start withdrawing from your 401k account.
401ks and Taxation
401ks is taxable because it is a retirement account funded through your work. This type of account is known as tax-advantaged or tax-deferred. You will not need to pay any taxes on a 401K account or a specific type of IRA until your retirement. This leaves your money time to grow free from taxes. This change takes place once you retire and begin to draw on the money in the account, also known as distributions. For every withdrawal you do, you will owe taxes on it. Some plans are designed to withhold up to 20% of your funds to pay these taxes. More information about the type of plan and how it gets distributed can be found if you contact the holder of your plan.
Once you reach the age of 59 ½ you can start drawing from the 401K. You can also wait until you are 70 ½, but it is required that you do once you do meet 70 ½. The IRS has very specific rules as to when you can access these accounts and how and many have a required minimum distribution clauses that go into effect at age 70 ½.
401k Tax rate
Everything you withdraw from a 401K account is taxable income. The amount you will be charged depends on the amount of income you receive that year. You are expected to pay Federal income tax on any funds you do withdraw and state income taxes can be applied as well such as if you live in California or Minnesota.
You can plan ahead by calculating the amount you will owe for income taxes by using the amounts you paid the last year of your salary; doing this will give you a projection as to what you will owe this year. If you plan on living on a lower fixed income or limiting the amount of money you will be withdrawing every month than you can owe less on the taxes you will be paying and put yourself in a lower tax bracket.
Early withdrawal
There are always situations you might find yourself in that will require you to access this money earlier than age 59 ½, but there are penalties for doing so because this an account designed for retirement. While there are penalties for early access it is understood that things happen in life that is unexpected that can require the use of retirement funds for things it was never designed for such as emergency medical bills.
10% is usually the amount added to access your retirement funds early. You will also still be expected to pay taxes on the amount you withdraw no matter what the reason for you needing to access the funds early. Make sure you have no other option such as selling stock or personal possessions before touching this fund. You will be denying your retirement a lot of money and the state of the stock market can mean withdrawing fund early will result in a loss of potential growth or taking an even greater loss if the market is down.
There are exceptions to prevent you from taking a 10% penalty on your 401lk such as losing your job before age 55 or starting a series of equal payment plans. The IRS has a list of exceptions available on their website. You will still be required to pay the taxes on the funds you withdraw though.
It is not advisable to touch your retirement early. If you do, you will be losing a lot more money than you will realize. It is better to borrow money from you 401K first if the need is that great.
Reducing 401k taxes
No matter what you do, you will end up paying some kind of taxes on your 401K account, but there are ways to access the funds and keep those taxes down. A tax expert can help you customize your tax withdrawals to fit your situation.
If your 401K contains stock in the company you work for you can make it capital gain rather than appreciation. You can do this if you have held the stock for over a year which would make it long-term capital gain which, depending on your tax bracket, is a tax rate of 0%to 20%. This is a lower rate than a lot of income tax rates and to get it requires you moving the stock into a brokerage account that is taxable.
If you 401K is not as sizable you can end up in a lower tax bracket meaning you can spread your distributions out more, dropping the rate of taxes you will potentially pay. All of this is possible as long as you do not touch your 401K account until you are at least the age of 59 ½.
Final Thoughts
Death and taxes is the old saying. You may get to stop working and retire, but you will always have taxes. By being proactive about your retirement accounts and making sure to leave them alone to mature means you will have more funds when that big day comes. It also means you can retire with the knowledge that you will be secure during your retirement as well as will be able to pay less on the funds you do access.
Tips:
Saving and planning for retirement is not easy especially when there are so many more life requirements to get there. If you are wise, you will be setting aside a bit of money each month for your retirement. You are also wise if you work to invest your money in multiple places to gains and anticipate losses. If you do both of those things, you will not be surprised when there are downturns in life.
