Taxes on 401(k) Withdrawals

Saving for retirement is one of the best financial moves you can make, and workplace retirement plans like 401(k)s offer a huge advantage by allowing you to save on taxes now. But while 401(k)s and other tax-advantaged accounts help you put money away without immediately paying taxes, you won’t avoid taxes forever. Eventually, you’ll owe income taxes on withdrawals, and sometimes even additional penalties, depending on your age when you withdraw. Fortunately, with some smart planning, there are ways to minimize or even avoid taxes on those withdrawals. This post will walk you through the strategies to help you keep more of what you’ve saved.

Taxes on 401(k) Withdrawals


When you withdraw from a traditional 401(k), you’ll face taxes on the amount you take out, taxed at your ordinary income tax rate. For example, if you’re in the 12% bracket, your withdrawal will generally be taxed at 12%. However, if you take money out before age 59 ½, the IRS typically slaps on a 10% penalty on top of regular taxes unless you qualify for an exception, such as using the funds for medical expenses or because you’ve separated from your employer at age 55 or older.

Example: Let’s say you’re 50 and you take out $10,000 from your 401(k) without qualifying for an exemption. If you’re in the 12% bracket, you’d owe $1,200 in regular income taxes. Plus, with the 10% penalty, you’d have another $1,000 added to your tax bill. Altogether, that $10,000 withdrawal would cost you $2,200 in taxes and penalties.

How to Avoid 401(k) Taxes?


401(k) Rollover: When you leave a job, you can roll over your 401(k) balance into an IRA or your new employer’s plan to avoid triggering a taxable event. You can have the plan administrator send your balance directly to the new account, which avoids withholding taxes and keeps your savings intact.

Alternatively, an indirect rollover gives you a check, but you must deposit it into your new account within 60 days to avoid taxes. However, keep in mind that the administrator will withhold 20% for taxes, which you can reclaim when you file your taxes if you successfully complete the rollover.

401(k) Loan: In certain situations, you can take a loan from your 401(k) instead of a withdrawal, which avoids triggering income tax and early withdrawal penalties. The downside? You’re borrowing from your future, meaning that loan balance won’t grow. Plus, if you leave your job before repaying, the balance could be treated as a taxable distribution.

How to Reduce 401(k) Taxes?


While it’s difficult to avoid taxes entirely, here are smart ways to minimize what you owe on 401(k) withdrawals.

1) Make Roth Contributions: 
Unlike traditional contributions, Roth contributions are made with after-tax dollars. This means your withdrawals in retirement are tax-free. If you’re concerned about future tax rates or plan to be in a higher bracket when you retire, Roth contributions can be a savvy option.

2) Take Withdrawals After 59½ (and Plan Your Timing)
If you withdraw funds before the age of 59½, you’ll likely face a 10% early withdrawal penalty on top of regular income taxes, with certain exceptions. By waiting until age 59½, you skip the penalty, reducing the immediate tax burden. If you can plan to take withdrawals in years when your income is lower, you can also minimize income tax exposure.
If possible, wait until age 59 ½ to avoid the 10% penalty on early distributions. But there are exceptions, including:
  • Taking equal, periodic payments over your lifetime
  • Separating from your employer in or after the year you turn 55
  • Paying for medical expenses that exceed a certain threshold
  • Following a court order to distribute funds after a divorce

3) Stay in a Lower Tax Bracket: 
Timing your withdrawals and carefully planning your overall taxable income can help keep you in a lower tax bracket. Strategies like tax-loss harvesting (selling losing investments to offset gains), contributing to a Health Savings Account (HSA), or taking advantage of other deductions can help.

4) Consider a Roth Conversion: 
This strategy involves converting some of your traditional 401(k) funds to a Roth IRA, where future withdrawals are tax-free. You’ll owe taxes on the converted amount in the year of conversion, but this can be worthwhile if you expect to be in a higher bracket during retirement. Converting smaller amounts over several years may help you avoid a big tax hit.

5) Leverage the Rule of 55:
The IRS allows penalty-free withdrawals from a 401(k) if you leave your job in the calendar year you turn 55 or older, called the "Rule of 55." This rule can help avoid the 10% penalty if you need to access funds before 59½. Note that you’ll still pay regular income tax on withdrawals, but avoiding the penalty can be a big win if you're retiring early or changing careers.

6) Use Substantially Equal Periodic Payments (SEPP):
SEPP allows for penalty-free withdrawals before age 59½, as long as you agree to take at least five equal withdrawals over time. The payments are based on your life expectancy, and you’ll need to stick with the withdrawals for five years or until you turn 59½, whichever is longer. However, this method avoids the early withdrawal penalty, although it still incurs income tax.

7) Rollover to an IRA for Qualified Charitable Distributions (QCDs):
If you’re 70½ or older, you can make charitable donations directly from an IRA (not a 401(k)), called Qualified Charitable Distributions. These donations can count toward your Required Minimum Distribution (RMD) and are tax-free. This option can be great if you already plan to donate to charity. Rolling your 401(k) to an IRA and making QCDs can reduce your taxable income by fulfilling your RMD without incurring taxes.

8) Plan with Required Minimum Distributions (RMDs):
Once you turn 73 (or 75 in certain cases), you must start taking Required Minimum Distributions (RMDs) from your 401(k). The IRS bases the amount on your life expectancy and account balance. Failure to take RMDs can lead to hefty penalties, but you can minimize taxes by spreading out withdrawals over time or converting some funds to a Roth. If possible, reduce the 401(k) balance by gradually converting to a Roth IRA before you hit RMD age, so you don’t need to take large taxable distributions.

9) Move to a Lower-Tax State:
Some states do not tax 401(k) distributions, and relocating could save you a significant amount if you live in a high-tax state. Not all retirees want to move, but if you're open to it, this can be an excellent way to reduce tax burdens on your withdrawals. States like Florida, Nevada, and Texas have no state income tax, making them tax-friendly for retirees.

10) Keep Taxable Income Low in Retirement:
Social Security benefits and other income thresholds are linked to your taxable income. Reducing withdrawals when possible can help keep your taxable income within lower tax brackets, potentially lowering the overall taxes on your 401(k) withdrawals. Use withdrawals from Roth accounts or other tax-free sources in higher-income years to minimize your taxable income. Being mindful of your tax bracket can prevent your 401(k) withdrawals from pushing you into a higher tax category.

11) Tax-Efficient Withdrawal Strategies (Bucket Approach):
This approach involves dividing assets into taxable, tax-deferred, and tax-free "buckets" and withdrawing strategically to manage your tax situation. Using taxable accounts first and saving 401(k) or IRA withdrawals for later allows investments in tax-deferred accounts to continue growing. For example, you could live off taxable accounts before tapping into the 401(k) and IRA, allowing more of your funds to grow tax-free. Working with a tax professional can help you optimize this approach.

The Bottom Line: Take Control of Your 401(k) Tax Strategy

Avoiding taxes on 401(k) withdrawals entirely may not always be possible, but with smart strategies, you can reduce what you owe. From Roth rollovers to timing withdrawals with tax efficiency in mind, these strategies can help you hold onto more of your hard-earned savings. Planning ahead and consulting with a financial or tax advisor will make it easier to navigate the best options for your situation and enjoy a more tax-efficient retirement.