After years of enjoying the deductions for putting money into retirement accounts, it’s always an unpleasant stunner when people realize they have to pay taxes on their withdrawals. Or do they?
Converting a 401(k) to a Roth IRA or Roth 401(k) will eliminate the need to pay taxes on withdrawals, says Investopedia’s recent article, “How to Minimize Taxes on 401(k) Withdrawals.” However, you have to follow the rules for a qualified distribution. Make no mistake: you’ll also have to pay taxes on any funds that are converted.
The primary issue with converting your traditional 401(k) to a Roth IRA or Roth 401(k) is the income tax on the money you withdraw. If you’re near pulling out the money anyway, it may not be worth the cost of converting it. The more money you convert, the more taxes you’ll owe.
You can divide your assets between a Roth account and tax-deferred account to share the burden. You may pay more taxes today, but this strategy will give you the flexibility to withdraw some funds from a tax-deferred account and some from a Roth IRA account to have more control of your marginal tax rate in retirement. Remember that the five-year rule requires that you have your funds in the Roth for five years, before you start your withdrawals. This may not work for you if you're already 65, about to retire, and concerned about paying taxes on your distributions.
Some of the ways that let you save on taxes, also make you take out more from your 401(k) than you actually need. If you can trust yourself not to spend those funds and save or invest the extra money, it can be a terrific way to spread out the tax obligation. If the individual is under 59½ years of age, the IRS allows use her to use “Regulation T” to take substantially equal distributions from a qualified plan without incurring the 10% early withdrawal penalty. However, the withdrawals need to last a minimum of five years. A person who’s 56 and starts the withdrawals, therefore, must keep taking those withdrawals to at least age 61, despite not needing the money.
If you take out distributions earlier while you’re in a lower tax bracket, you could save on taxes, instead of waiting until you’ll have Social Security and possible income from other retirement vehicles. If you plan ahead and are 59½ or older, you can take out just enough money from a 401(k) (or a traditional IRA) that will keep you in your current tax bracket but still lower the amount that will be subject to required minimum distributions (RMDs) when you're 70½. The objective is to reduce the effect of the RMDs (which are based on a percent of your retirement account balance, along with your age) on your tax rate, when you have to begin taking them.
Once you’ve recovered from paying taxes on the money that you withdraw, another tactic is to use those funds to invest. If you invest in a brokerage account and hold the funds for a year (at least), you’ll pay long-term capital gains tax on the earnings, rather than income tax.
Speak with a qualified Houston estate planning attorney to make sure that any significant shifts of funds among your retirement account aligns with your overall estate plan.
Reference: Investopedia (June 26, 2019) “How to Minimize Taxes on 401(k) Withdrawals”