Estate Planning Business Succession
No one likes paying taxes on retirement funds. However, unless you have a Roth IRA or SEP, funded with after-tax dollars, you will owe taxes on withdrawals. However, according to a recent article from U.S. News & World Report, “How to Pay Less Tax on Retirement Account Withdrawals,” there are strategies to reduce taxes on your retirement account withdrawals.
Avoid the early withdrawal penalty. If you take money from a traditional IRA before age 59½, the penalty is 10% plus the income tax due on the withdrawal. If you are in a pinch and need the funds, you would be better off taking withdrawals from a 401(k), which is penalty free if you leave the job associated with the 401(k) at age 55 or later. You might be able to avoid the penalty if the money is needed for a large medical bill, college costs or a first home purchase.
Roll over a 401(k) without tax withholding. Changing jobs? If you take money from a 401(k) when you change jobs, 20% is held for income tax. If you do not put the entire distribution directly into a new retirement account, you could end up owing income tax and the early withdrawal penalty. One way to avoid the tax withholding and penalties is to do a direct transfer from your 401(k) to the trustee of another 401(k) or IRA. Trustee-to-trustee transfers are not generally considered a taxable event.
Manage your required minimum distributions. IRA and traditional 401(k) owners are required to take minimum distributions after age 72. Missing an RMD is expensive: the penalty is 50% of the amount you should have withdrawn, plus income taxes. However, if you are still working after age 72 and do not own 5% or more of the company you work for, you can keep delaying those RMDs from a 401(k) account held for you by your employer until you retire. For IRAs, you still have to take those withdrawals.
Be careful about distributions. Plan the distributions for the first year. You do not want to take two distributions and risk getting bumped into a higher tax bracket. The first RMD needs to be taken by April 1 of the year you turn 72 (or 70½ if you were born before July 1, 1949). The second and all subsequent distributions are taken by December 31 each year. If you delay the first distribution until April, you will end up taking two distributions, which could lead to a big tax bill.
Taking withdrawals earlier than age 72. By taking traditional retirement account withdrawals during your 60s, you can spread the tax bill over more years and enjoy the benefits of a lower tax bracket, reducing your overall lifetime tax bill. Try to take 401(k) or IRA withdrawals during a year when your income is low, like after you retire but before you take Social Security benefits.
Consider a qualified charitable distribution made directly from your IRA. Retirees 70½ or older can avoid income taxes on IRA withdrawals of up to $100,000 (or $200,000 per couple), if they make a QCD directly from their IRA to a qualifying charity. You can also donate part of your RMD and withdraw the rest of income.
Keep tax-preferred investments out of retirement accounts. If you have investments generating long-term capital gains in a retirement account, you will pay a typically higher regular income tax rate when you take the funds from the account. By contrast, you can lower the taxes by holding more highly tax investments (like Treasury inflation-protected securities, corporate and government bonds and funds generating short-term capital gains) within retirement accounts.
Balance retirement funds taxes with your overall retirement plan to try to minimize taxes. Do not neglect to discuss tax planning when you sit down with your estate planning attorney to create or revise your estate plan.
Reference: U.S. News & World Report (March 8, 2022) “How to Pay Less Tax on Retirement Account Withdrawals”
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