How To Withdraw Over $100k From Your 401(k) Tax-Free During Retirement

January 11, 2019

Do you know how your retirement accounts will be taxed at retirement? If not, you might want to get up to speed with the IRS tax code (or work with an advisor who is) otherwise you may be missing out on some significant tax savings. Let’s start with the basics of how different sources of retirement income are taxed:

Common retirement income sources taxed as ordinary income

Traditional retirement accounts, including deductible IRAs, pre-tax 401(k)s, and inherited traditional retirement accounts are taxed as ordinary income in the year of distribution and pension benefits are taxed as ordinary income in the year received. (which means it will be taxed as if you earned it working during that year.)

Another source of taxable ordinary income during retirement is Social Security, but only a portion depending on the amount of total income from other sources. To estimate the taxable portion of Social Security benefits, check out this helpful calculator.

Common retirement income sources taxed as capital gains

Some sources of income during retirement may be taxed at preferential capital gains tax rates (basically lower rates than you pay on income that you earn working, aka “ordinary income”.) These sources include proceeds from the sale of stocks and mutual funds that are NOT held in a retirement account, which are subject to long-term capital gains tax treatment if held for over one year prior to sale. (Losses may be used to offset gains in the same year. Up to $3,000 in net losses may be deducted from income and losses that exceed $3,000 may be carried forward.)

Qualified dividends are a special type of dividend that also receives capital gains tax treatment (aka most people only pay 15% tax on dividends, even if they are in, say, the 32% tax bracket.)

Real estate is also subject to capital gains tax treatment when sold. There is, however, a special exclusion that applies to the sale of a primary residence. If a taxpayer lives in a primary residence for at least 2 of the previous 5 years before sale, the taxpayer may exclude up to $250,000 ($500,000 if married filing jointly) in capital gains from tax.

Common tax-free sources of retirement income

Not all sources of retirement income are taxable. Roth IRAs and Roth 401(k)s are tax-free when the account has been open for at least five years and the owner is at least age 59½. This is referred to as a qualified distribution. Inherited Roth accounts are also tax free as long as the deceased owned the account for at least five years.

Health Savings Accounts (HSA) are tax-free if funds are used for qualified expenses. Funds used for non-qualified expenses are taxed as ordinary income and subject to a 20% penalty tax if withdrawn before age 65 (after age 65, it’s just taxed as income when not spent on medical expenses.)

Finally, withdrawals from your regular savings account may be spent without incurring additional tax liability, although as you probably know, you pay taxes on any interest as you earn it.

Running a few ‘what if’ scenarios

Once you have a general understanding of how your different income sources will be taxed during retirement, you can run a few different “what if” scenarios. For example, let’s assume Hank and Cindy each are age 61 and recently retired at the beginning of the year. They would like to delay the start of their Social Security benefits until full retirement age or later (66 since they were born in 1954). They both have retirement plans from their former employers and can start making distributions penalty-free now that they are over 59½.

Their goal is to minimize taxes as much as possible and to take out just enough from their 401(k) accounts to stay in the safe zone of not outliving their money during retirement. Here is a quick snapshot of their retirement savings:

  • Hank’s 401(k) = $325,000
  • Cindy’s 403(b) = $275,000
  • Emergency savings/“rainy day” fund (checking, savings, CDs) = $150,000

Now, let’s assume that Hank and Cindy have an annual retirement spending goal of $42,000 per year ($3,500 per month). The mortgage is paid off and they are completely debt-free. Based on a generally accepted but widely debated 4% “safe withdrawal rate” rule, they could actually withdraw up to $24,000 in Year 1 of retirement. In this example we’ll stick with a $20,000 withdrawal from Hank’s 401(k), which is realistic based on this How Long Will it Last Calculator. The remaining $22,000 in annual income would come from their checking and savings accounts.

Looking at how their withdrawals will be taxed

How will Hank and Cindy be taxed using the 2018 income tax tables? The $20,000 retirement plan distributions are included as taxable income. The $22,000 coming from their regular checking and savings is after-tax return of principal and would not be taxed. (Only interest earned would be included as taxable income).

Hank and Cindy choose a married filing jointly tax status and their total income tax for 2018 will be a grand total of $0. Yes, that is zero. Here is how they will be taxed:

A quick review of the current Income Tax Rate Table shows us that a married couple filing jointly is taxed at the 12% marginal tax bracket for income over $19,050 but less than $77,400. But keep in mind that your total deductions and exemptions are subtracted from your income to determine your taxable income. The total deductions amount is either your standard deduction or your itemized deductions, whichever amount is greater.

The standard deduction is a fixed amount based on your age and filing status (e.g., $24,000 for married couples filing jointly in 2018). Hank and Cindy’s taxable income will look something like this:

Total Income: $20,000

–        Total Deductions: $24,000

=       Taxable Income: $0

Note: Hank and Cindy benefited from maintaining an emergency savings account that eventually transitioned into their short-term retirement income bucket. Most financial planners would suggest keeping assets that will be needed within a 3 to 5 year time horizon in safe, conservative investments such as cash equivalents, savings, CDs, or short-term fixed income instruments. This is sometimes referred to as the “safety bucket.

Using a Roth account instead of a savings account

In this example, a similar result could be obtained if the additional $22,000 retirement income was funded through tax-free sources such as a Roth IRA or Roth 401(k).

A similar result with taxable investments

If this couple held taxable investments in a brokerage account, they could also take advantage of historically low long-term capital gains rates (currently 0% for the 10% and 12% marginal tax brackets).

In essence, they could “fill up” the 12% income tax bracket with long-term capital gains up to the marginal tax bracket cap of $77,400 and not have to pay a dime of federal income taxes on that growth. But they would still want to invest that money in tax-efficient investments such as passively managed mutual funds or ETFs with relatively low turnover and low costs.

Remaining tax-free until Social Security starts

In summary, this type of retirement funding strategy could be replicated for the next 5 years until this couple has reached full retirement age for Social Security purposes. By that time, they could realistically take out over $100,000 from their retirement nest egg completely tax-free.

The secret is found within a simple concept known as tax diversification. Having multiple retirement income sources that are each taxed in a different manner can help you legally use the complicated IRS tax code to your advantage.

This is an example of just one of many different ways to minimize taxes during retirement. As you approach retirement, go ahead and run a few different “what-if” scenarios to examine your projected taxes. You can use this simple TaxCaster tool from TurboTax if you want to run a quick estimate using the current tax tables.

Keep taking full advantage of your retirement plan at work, especially up to the max to get the match. But take a second look at Roth IRAs, taxable accounts, HSAs, and good old-fashioned savings as well to help you obtain optimal tax diversification.