How do I avoid paying taxes on my 401k withdrawals?

Read on to find out how to avoid taxes on 401k withdrawals when the IRS wants a cut of your distributions. Consider Roth Contributions. ... Stay in a lower tax bracket. ... Borrow Instead of Withdrawing from a 401(k) ... Avoid Early Withdrawal Penalty. ... Defer Taking Social Security. ... Donate to Charity. ... Get Disaster Relief.

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When you take money from a traditional 401(k), the IRS subjects the distributions to ordinary income tax. The amount of tax you pay depends on your tax bracket, and you can expect to pay a higher tax for a higher distribution. You may also be required to pay a 10% penalty on the distribution if you are below 59 ½ years. You can rollover your 401(k) into an IRA or a new employer’s 401(k) without paying income taxes on your 401(k) money. If you have $1000 to $5000 or more when you leave your job, you can rollover over the funds into a new retirement plan without paying taxes. Other options that you can use to avoid paying taxes include taking a 401(k) loan instead of a 401(k) withdrawal, donating to charity, or making Roth contributions. If you want to get your 401(k) without paying taxes, there are certain strategies you can use to avoid or reduce your tax bill. Read on to find out how to avoid taxes on 401k withdrawals when the IRS wants a cut of your distributions.

Consider Roth Contributions

If you expect your earnings in your golden years to fall in a higher tax bracket, you should consider moving your savings to a Roth account. This account is funded by after-tax dollars, which means that future withdrawals will be tax-free. While this option does not avoid paying taxes entirely, it allows you to avoid paying taxes on the future accumulated savings by paying the tax as you put the money into the account. When you take distributions in retirement, you will not incur any taxes. This is in contrast to a traditional 401(k) plan that is funded by pre-tax dollars, and any future distributions will be subject to income tax at the ordinary income tax rate.

Stay in a lower tax bracket

When taking 401(k) withdrawals, you should try to keep the taxable income in a lower tax bracket to reduce the tax bill. You can achieve this by taking distributions up to the upper limit of your tax bracket to avoid falling into the next tax bracket with a higher tax rate. For example, a married couple whose income is below $81,050 falls in the 12% tax bracket. A higher income above $81,051 pushes the saver into the next tax bracket with a 22% tax rate, which results in a higher tax bill. An account holder can limit the amount of 401(k) withdrawals by taking a combination of 401(k) and other sources such as Roth savings and cash savings.

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Borrow Instead of Withdrawing from a 401(k)

Some 401(k) plans allow employees to take a loan from their 401(k) balance before attaining retirement age. The specific terms of the loan depend on the employer and the plan administrator, and an employee may be required to meet certain criteria to qualify for a 401(k) loan. The amount borrowed is not subject to ordinary income tax or early-withdrawal penalty as long as it follows the IRS guidelines. The IRS provides that 401(k) account holders can borrow up to 50% of their vested account balance or a maximum limit of $50,000. This limit applies to the total outstanding loan balances of all loans taken from the 401(k) account. The loan must be paid within five years, and the borrower must make regular and equal loan payments for the term of the loan.

Avoid Early Withdrawal Penalty

Withdrawals made before age 59 ½ are subject to a 10% early withdrawal penalty and income taxes depending on your tax bracket. However, if you leave your current employer at age 55 or later, you may qualify to get a penalty-free 401(k) withdrawal. However, the distribution will still be subject to ordinary income tax at your tax bracket. The IRS requires that an employee must have left their employer to qualify for a penalty-free distribution. This rule is known as the Rule of 55, and it does not apply to earlier plans or Individual Retirement Accounts.

Defer Taking Social Security

If you have taken a 401(k) withdrawal, you should consider deferring your Social Security benefits to keep your taxable income in a lower tax bracket. Taking both distributions at the same time increases your taxable income, hence increasing your income tax bill. If the 401(k) withdrawals are enough to meet your needs, you can delay taking social security benefits until 70 years. Not only does this strategy minimize tax on 401(k) withdrawal, but it also increases your social security payments by up to 28%. This strategy works if you delay taking social security benefits after reaching the full retirement age, which ranges between 65 to 67 years.

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Donate to Charity

If you are 70 ½ years and you do not need the 401(k) distributions to pay for living expenses, you can rollover your funds directly to an IRA and donate the distribution to a qualifying charity to avoid paying income tax. The IRS caps such donations on up to $100,000 per year, and the IRA account holder does not need to pay income tax on the charity donation, as long as it is within the required threshold. For married couples filing jointly, the spouse can make another charitable contribution of up $100,000, and still qualify for the tax exemption. Qualified charitable distributions are limited to IRAs, and not 401(k)s.

Get Disaster Relief

Sometimes, the IRS offers 401(k) distributions relief to people living in areas prone to hurricanes, tornadoes, and other forms of disasters. When such disasters occur, you can qualify for a waiver of the 10% early withdrawal penalty if you are below 59 ½ years. The IRS also considers other events that constitute a hardship such as the need to pay college tuition, job loss, and if you need to put a down payment for your primary residence mortgage. During the COVID-19 pandemic, the CARES act allowed a hardship distribution of up to $100,000 without incurring the 10% penalty for early withdrawals.

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