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4 Ways To Minimize Taxes On 401(k) Withdrawals

When it comes to wealth-building, what you keep is more important than what you make.

That timeless bit of wisdom also applies to retirement. The size of your nest egg can matter less than how you manage its inevitable shrinkage over the years and decades. Downsizing your home or moving to a country where the living is cheap are two life-changing ways to stretch your retirement dollars. On the addition side, you can also take on a part-time job, acquire a rental property, or create other streams of income to take the pressure off your savings.

But the cornerstone of nest egg management is the mundane yet vital work of minimizing the tax bite on your 401K and IRA retirement accounts. Remember, the taxes on those hard-earned savings are put on hold only while you are working and contributing to those accounts. Once you retire, the Devil, I mean Uncle Sam, will come for his due.

Withdrawals, or “distributions” from a 401K or IRA are taxed as ordinary income. So, it pays to think strategically about such distributions. If, for example, you make a large withdrawal, that income — combined with any other income — could bump you into a higher tax bracket.

Here are four best practices for minimizing the government’s slice of your retirement pie – and a bonus tip for those who plan to retire early.

Don’t Make Early Withdrawals

Because tax-deferred retirement savings accounts are designed to encourage, you know, retirement saving, the government takes a dim view of tapping those funds before your career is over.

The Internal Revenue Service levies a 10 percent penalty on withdrawals from a 401(k) or traditional IRA plan before age 59 ½. That’s on top of the ordinary income tax due on the amount withdrawn.

Early withdrawals also ding your nest egg by reducing your portfolio’s future growth potential.

If you get into a really, truly serious financial bind before age 59 ½, borrowing from your 401k might be a better option than running up credit card debt. But look long and hard at other options before busting your retirement piggy bank.

And here’s that bonus tip: A little known IRS rule allows you to access your employer-sponsored 401K at age 55 IF you no longer work for that company.

Start Making Withdrawals Before Age 70 ½

The longer you can let your nest egg grow, the better. If you can live on other income sources in their early years of retirement, do it! But make sure to break the seal on your 401K or IRA or SEP before you turn 70 ½. Failure to make the first distribution by April in the year after you turn 70 ½ will prompt a 50% IRS penalty on the “required minimum distribution” (RMD) that should have been withdrawn.

I am not a big fan of this policy because I don’t think the government should be dictating how we manage our money. The RMD is simply a blunt instrument to make sure the IRS gets those deferred taxes by a certain date.

There is one exception to the 70 ½ rule that you can use to your advantage. If you are still working, or newly employed, and enrolled in your current company’s 401(k) at age 70 ½, you can delay your RMD. If you find yourself in that situation, it might make sense, if the plan allows, to roll your qualifying assets into your active 401(k) plan to make use of this “still-working exception.”

Set Up a Roth IRA

A Roth IRA or Roth 401K allows you to settle your tax obligation up front. Your contributions to a Roth vehicle are taxed in the year they are made. Roth withdrawals are tax-free. As a bonus, you can make penalty-free withdrawals from the contribution portion of your Roth IRA before age 59 ½.

The Roth can be a good option to two seemingly different groups – those who expect to endure a higher tax rate in retirement than they currently pay; and people who need every dollar to count in their golden years.

Dodge the Withholding Rule

Did you know the IRS requires 401(k) plan administrators to withhold 20 percent of distributions until April 15? You can avoid this annoying rule by making a trustee-to-trustee rollover to an IRA. IRA’s are not subject to the same mandatory withholding.

Following these four guidelines could make a significant difference in your retirement finances.

I strongly encourage you to address these issues in your retirement planning and post-career financial decision-making. Tax management is a place where the right financial planner could add tremendous value by analyzing the specifics of your situation and crafting a strategy to minimize the government’s taste of your honey.

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