Navigating 401(k) Withdrawals: Tax Implications and Strategies

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How Are 401(k)s Taxed in Retirement?

When you start withdrawing from your traditional 401(k) in retirement, your distributions will be taxed as ordinary income. Here’s a breakdown of how this typically works:

Withholding

Generally, 401(k) distributions are subject to a mandatory 20% withholding. This withheld amount goes towards your tax bill, similar to paycheck withholding during employment. When you file your tax return, you’ll calculate your final tax bill and either receive a refund or pay any remaining balance.

Estimated Taxes

If your withholding doesn’t cover the taxes owed on your retirement distributions, you may need to pay quarterly estimated taxes on the difference.

Reporting

Your plan will report annual distributions to you and the IRS using Form 1099-R. Use this form to report taxable distributions on line 5b of your Form 1040. These distributions contribute to your adjusted gross income for the year.

Lump Sums and Rollovers

In some cases, you can withdraw your entire 401(k) balance as a lump sum. If you plan to roll your funds into a new retirement account, such as an IRA, follow the rollover rules to avoid paying taxes on your distribution.

Required Minimum Distributions

You must begin making minimum withdrawals from your 401(k) by April 1 of the year following the year you retire or turn 73 if you continue working. Failure to take the required minimum distributions can result in a penalty of up to 25% of the amount you should have withdrawn.

How Much Are 401(k)s Taxed?

The tax rate on 401(k) distributions depends on your marginal tax rate and tax bracket. Here are the 2023 tax brackets based on adjusted gross income:

2023 Marginal Tax Rates and Tax Brackets

• 10%: $0 – $11,000 (Single), $0 – $15,700 (Head of Household), $0 – $22,000 (Married Filing Jointly), $0 – $11,000 (Married Filing Separately)
• 12%: $11,001 – $44,725 (Single), $15,701 – $59,850 (Head of Household), $22,001 – $89,450 (Married Filing Jointly), $11,001 – $44,725 (Married Filing Separately)
• 22%: $44,726 – $95,375 (Single), $59,851 – $95,350 (Head of Household), $89,451 – $190,750 (Married Filing Jointly), $44,726 – $95,375 (Married Filing Separately)
• 24%: $95,376 – $182,100 (Single), $95,351 – $182,100 (Head of Household), $190,751 – $364,200 (Married Filing Jointly), $95,376 – $182,100 (Married Filing Separately)
• 32%: $182,101 – $231,250 (Single), $182,101 – $231,250 (Head of Household), $364,201 – $462,500 (Married Filing Jointly), $182,101 – $231,250 (Married Filing Separately)
• 35%: $231,251 – $578,125 (Single), $231,251 – $578,100 (Head of Household), $462,501 – $693,750 (Married Filing Jointly), $231,251 – $346,875 (Married Filing Separately)
• 37%: $578,126 or more (Single), $578,101 or more (Head of Household), $693,751 or more (Married Filing Jointly), $346,876 or more (Married Filing Separately)

How Are Roth 401(k) Distributions Taxed?

Roth 401(k) distributions are not included in your taxable income if you meet the requirements for qualified distributions. Since Roth contributions are made with after-tax dollars, you’ve already paid taxes on these funds.

Qualified Roth 401(k) Distributions

To qualify, the funds must have been held in the Roth 401(k) account for at least five years, and the distribution must occur after you reach 59½, on account of disability, or after your death.

How to Minimize Taxes on 401(k) Withdrawals

While avoiding taxes on 401(k) distributions is challenging, tax planning can help manage your tax bill in retirement. Here are some strategies:

Minimize Your Distributions

The more you withdraw, the higher your income and tax bill. More income can also push you into a higher tax bracket, so plan your distributions carefully.

Consider Social Security

Adjusting your distributions can affect the taxes on your Social Security benefits. Calculate your “combined” income by adding your adjusted gross income to any nontaxable interest and half of your Social Security benefits. Use the following table to estimate the taxes on your Social Security benefits:

Taxes on Social Security Benefits

• 0%: Up to $25,000 (Individuals), Up to $32,000 (Joint Filers)
• Up to 50%: $25,000 to $34,000 (Individuals), $32,000 to $44,000 (Joint Filers)
• Up to 85%: More than $34,000 (Individuals), More than $44,000 (Joint Filers)

Treat Company Stock as Capital Gains

Company stock in your 401(k) may be taxed differently. The IRS allows the net unrealized appreciation (NUA) to be taxed as capital gains instead of ordinary income when distributed from a qualifying employee retirement plan. This can result in significant tax savings. Consult your tax advisor for more details.

Live in a Tax-Friendly State

In addition to federal income taxes, you may have to pay state income taxes on your 401(k) distributions. Consider state-by-state differences, but also look at property taxes, sales tax, and other state and local taxes.

Get Tax Advice

Your tax situation changes when you retire. Structuring your income to minimize taxes is complex. A qualified tax advisor or financial planner can provide valuable expertise.

The Bottom Line

The tax advantages of a 401(k) plan often outweigh the tax burden in retirement. You may receive matching contributions, deduct your contributions from taxable income, and avoid taxes on capital gains, dividends, or interest. Your tax rate may also be lower in retirement, resulting in a lower tax bill overall.

However, individual circumstances vary. Whether retirement is near or far, it’s a good time to review your finances. Ensure you’re saving enough for retirement and keeping track of your credit report and score to be prepared for taxes and other retirement challenges.

For any mortgage service needs, call O1ne Mortgage at 213-732-3074. We’re here to help you navigate your financial future with confidence.

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