When you use money from pre tax retirement accounts, you generally owe income tax, but there are several ways to potentially avoid or at least reduce those taxes, so that's what we'll talk about in the next couple of minutes here, but first, it's important to acknowledge that there might not be a perfect solution for you as things get more intricate or you start to pursue these sort of too good to be true strategies, you may be setting yourself up for trouble, so do what you can to manage your taxes, but at some point, it may just be a nice problem to have, one potential solution is if you have an income that's low enough for the year, you might not owe any taxes, that might happen if you only work for part of the year, for example, maybe you are retiring or going to school or something happens like that.
For example, you've got as a single person, let's say 13000 or so, have standard deduction if your income is low enough, and let's say you take out 8000 from a pre tax account, that would all be included in your income, 5000 of earnings from work plus 8000 here gets you up to 13000, but your taxable income would be zero, you will notice though that there's an other tax here of 800, that's because this person is under the age of 59 and half, so they still owe that 10% penalty tax for early distributions. However, if they can qualify for an exception or if you're over the age of 59.5, that would not apply and your total tax might be zero, you can even get strategic about this, so if you know that you're going to have a low income here next year, you might wait to take a distribution, maybe it's November or December when you realize you want some money, and if you can wait until January of the next year, that's great.
Or maybe you split distributions and take some of what you need in December and take the rest in January, and that might help you stay in low tax brackets, or even a 0% tax bracket, Roth distributions are another potential way to get money out tax free, so you already paid income tax on your contributions, those should come out tax free, but you need to be mindful of any earnings in your Roth accounts. It's important to distinguish between Roth IRAS and Roth 401K. So when pulling money out of a Roth IRA, the ordering rules say that you can take out your regular contributions first before you get into any earnings, but that's not the case with Roth 401k. Those Roth distributions come out pro rata, meaning you'll have to include some earnings in every distribution, assuming you have any earnings, and you don't get to pull out the most tax favored dollars first, whenever you're talking about Roth distributions, you want to find out if you're making a qualified distribution and a qualified distribution generally requires that you've had the account open for five years or more, and you're over age 59.5, now, death and disability also qualify.
And if you're moving money over to an IRA, things can look different as well, but this is the type of research you want to do, find out if you can make a qualified distribution, of course, the option for using Roth might not matter if you've spent your whole life putting in pre tax money, and of course, you did have to pay taxes when you make those contributions, so again, nothing is perfect here, like I said, you've either paid it sooner or later, but these are ways to potentially manage your taxes today. Next on the list of not perfect solutions is a 401K loan, so when you borrow from your 401K, you don't owe taxes on that withdrawal as long as you repay the loan on time, but if you don't repay, any unpaid amount may be treated as a distribution and that's subject to taxes and maybe early withdrawal penalties, plus with loans, you really need to be careful about leaving your job or losing your job, so you might be required to repay the outstanding loan balance when you stop working for your employer, but you might not have those funds available to just pay off a loan in a lump sum, that's probably why you borrowed in the first place, in some cases, it is possible to offset the loan amount by contributing the money to an IRA later, but those rules can be complicated, and again, you just need a lump sum of money to pay off the loan, if you're going to do that…
What about that Mandatory tax withholding? When you take a cash distribution from a 401k, the plan typically has to withhold 20% of the gross amount and send that over to the IRS, and that's an advance payment or a deposit on your eventual tax bill for the year, it's not necessarily the exact amount you owe… It's just a deposit. You might owe more, you might owe less… That's problematic if you need the full amount that's in your 401k, if you can't afford to do without that 20%, so as a potential solution, you could move all of that money out of the 401K over to an IRA, an individual retirement account that you control and then from there, you can take distributions using whatever tax withholding level you want, it might be 20%, 10% or zero, again, remember that you may owe taxes on that later, and not withholding enough could end up in there being a big tax bill later in the year and possibly some under payment penalties, so there are a couple of pitfalls with that strategy, and you also need to be able to take a distribution from your 401k that might not be possible unless you have left your job.
So it's important to look at all these details. By the way, I'm Justin Pritchard, and I help people plan for retirement and invest for the future, and I'm going to put some resources in the description below, more on this topic about these taxes on 401 withdrawals, IRA withdrawals, I think you'll find that helpful, there will also be some general retirement planning information, just big picture stuff that I think will be really helpful, so be sure to check that out, and it's also a good time to remember, this is just a short video, we're not covering everything here, it's just kind of some food for thought, so definitely do some more research, triple check everything and talk to a professional before you make any decisions, so what if your main concern is the penalty tax, you're under age 59 and half, and you're taking a distribution, what are some ways to at least avoid that, even if you have to pay income taxes? One solution might be the so called rule of 55, this can allow you to get money out of a retirement account without paying the early withdrawal tax penalty.
So you have to leave your job at age 55 or later, and if you use the money from that Job's, 401K or 403B, Not a different job, but that job that you left at 55 or later, you can use that money without the early withdrawal penalty. You still typically owe income taxes if it's a taxable distribution, that age can go even lower for public safety workers, there's also the 72t or substantially equal periodic payments, for example, that would allow you to take a series of payments from your pre tax accounts, and you can start those before age 59 1/2, getting the money without the early withdrawal penalty, but the strategy can be kind of rigid and complicated, you have to do it for at least five years, or age 59 and a half, whichever is longer, and if you make any kind of little mistake, which is easy to do, then you could derail the whole strategy and you would retroactively owe taxes.
You have to be very careful with that one, but it might be a solution. There are also 457 plans out there that don't have an early withdrawal penalty, so if you have a governmental 457 B, for example, you should be able to take withdrawals at any age without an early distribution penalty. That's important to remember, maybe you leave that job in your 30s or 40s or something like that, you might consider leaving the funds in that 457 because then you have the flexibility to access that money early without the penalty.
Ideally. You save it for later. But sometimes life happens. So that's nice to have. There are quite a few other exceptions as well, so be sure to research those on the IRS website or with your tax professional, and you might get some good ideas, of course, Captain Obvious would say, Wait until age 59 and a half, and that might be possible if you're already in your late 50s, maybe you just have a couple of years to go. Maybe there are some alternative sources of the funds to pick from, and if you can just make it a couple of years, you have saved that 10%, which can really make a nice difference. Next, we have qualified charitable distributions or QCDs, so if you are charitably minded, you can give money directly to a tax qualified charity from your IRA, and note that this is from an IRA, not a 401k, so when this is done properly that donation is not included in your income, even though you pull the money out of a pre tax retirement account, so if you're going to donate money anyway, it's really worth investigating this option, and that's because you'll reduce your tax burden and by skipping the tax payment, that leaves more money for your favorite charity in other words, you don't have to take a distribution, pay the taxes on it and then give the remainder to charity, you can cut out the middle step and just send all of the money directly to a charity, be sure to review this strategy very carefully with your tax expert, because there are some rules and restrictions to be aware of certain age limits and maximum amounts, but if you can meet all of those, it's a great strategy, be sure to check out my other videos on taxes and retirement accounts.
And if you found this helpful, please leave a quick thumbs up. Thank you and take care..
Posted in Retire Wealthy, Retirement Planning, Tips for Retiree's