Reliable income is one of the most important parts of your retirement strategy and working hand-inhand with that is a strategy for limiting your taxes on retirement withdrawals.
A U.S. News and World Report article, How to Pay Less Tax on Retirement Account Withdrawals has some excellent insights.
Avoid Penalties
The first piece of your strategy should be ensuring that you avoid early withdrawal penalties. If you begin taking money out of your traditional 401(k) before you reach age 59 ½, you could be staring at 10% early withdrawal penalties. Essentially, that means you’re just giving a chunk of your money away.
But you may be able to begin penalty-free 401(k) withdrawals when you turn 55 if you leave the job linked directly to that specific account.
Additionally, it may be possible to avoid IRA early withdrawal penalties if you utilize the money you take out for an approved expense like medical bills, college costs, or to buy your first home.
Roll it over
In some cases, you may also be able to roll your 401(k) over without tax withholdings. Here’s an example: you take money out of your 401(k) when you change jobs.
In this scenario, 20% may be withheld to cover income taxes. Then, if you don’t quickly put the entire distribution, including the 20%, in a different retirement account, you could be slapped with income taxes on top of an early withdrawal penalty for what you’ve taken out.
However, you may be able to avoid both the tax withholding and those possible penalties and fees if you directly transfer the money from your 401(k) to the trustee of a different 401(k) or IRA. Income taxes aren’t withheld on trustee-to-trustee transactions.
RMDs
As many of you listening right now likely know, you’re required to withdraw money from traditional 401(k)s and IRAs once you hit your 73rd birthday. The penalty for not taking an RMD is 25% of the total that you should have taken out. And don’t forget that that penalty is in addition to the income tax that’s also required on the withdrawal.
Luckily, if you notice the error and promptly correct it, the penalty may drop to as low as 10%. Furthermore, if you’re still working after you’ve turned 73 and you don’t own five percent or more of the company that employs you, you’re permitted to continue delaying 401(k) withdrawals from your current company until you officially retire. Be aware though that this doesn’t apply to IRA withdrawals.
Also note that the RMD age will rise to 75 on the first day of 2033.
Don't double up
You should next be careful to not inadvertently take two distributions in one year. You must take your first RMD no later than April 1 in the year following the year you reach age 73. From there, your next — and every subsequent — RMD is required before December 31 each year.
If you delay your first distribution until April, you would be required to take two distributions in the same year, which may mean a heftier tax bill or a nudge into a higher tax bracket.
Be sure to sit down with both your financial services professional and tax professional to discuss strategies for taking your first and second RMDs in different years.
Working with your financial services professional, you may be able to build a strategy that identifies how much you can annually withdraw from your retirement accounts while maintaining your status in your current tax bracket.
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