Right up front, I want to make it clear that I’m not an accountant. No one except an expert in tax law should have the final say about your tax planning. That said, likely not a week goes by that an advisor at Allworth Financial doesn’t meet with a new client who is at risk of paying significantly more in taxes on the “draw down” of a retirement account than they need to.
With that, do you have a 401(k) or a traditional IRA? If you began saving early in your career, those balances can add up to some big numbers over time.
Yet no matter when you began to save, because the deposits into your 401(k) (or traditional IRA) were likely pre-tax, eventually, a good-sized chunk of that money is going to be claimed by the government.
With that in mind, here are 4 “don’ts” you need to stick to if you want to keep as much of your hard-earned money as possible.
When you turn 70½, you have to begin taking distributions from your 401(k) and/or traditional IRA. What’s the timetable for drawing down the money? Monthly, quarterly, or in a lump sum, it doesn’t matter. Just do not miss your required minimum distributions.
As far as the taxes you’ll owe, you’ll be billed on what you take during the year. Just be warned: If you skip (or forget) to take a distribution? Watch out! The penalty for not taking a mandatory minimum distribution from your 401(k) (or traditional IRA) is a whopping 50% of the amount you were supposed to withdraw.
This is where 401(k)s and traditional IRAs are a bit different. If you take money from your IRA before you reach age 59½, not only do you have to pay tax on the income, but you’ll get hit with a 10% penalty. 401(k)s have a bit more flexibility. Yes, early withdrawals also get hit by a 10% penalty, but if you are over age 55, under certain circumstances, you can begin to draw down your 401(k) without penalty, so long as you’ve left the job associated with that 401(k). (You will, of course, still have to pay taxes.)
If you’re still working and you get let go from your job, or if you quit to take a position with another company, do NOT let them cut you a check (payable to you) for your 401(k) balance.
If you do, not only will they withhold taxes, they might also impose early withdrawal penalties (and who knows what else).
I’ve seen someone get seriously hurt financially by a well-meaning (but ill-informed) HR person who recommended this.
Take note: If you get let go from your job, keep the 401(k) balance where it is until you know what you’re going to do. If you change jobs, have them transfer the money in your 401(k) directly to your new 401(k) trustee.
I devote an entire chapter to the importance of “sequencing the draw down of your retirement savings accounts” in my book: “Personal Decision Points.”
Properly timing and planning the process can save (or cost) you many thousands of dollars over time.
What’s another way to save taxes on your retirement accounts?
If you begin taking smaller withdrawals from your retirement accounts earlier than you have to (age 70½), this could lower your tax burden both in the short term and over the long haul (the taxes you’ll pay over your lifetime).
Most of us understandably want to wait as long as possible to begin using the money in our retirement accounts (because it grows tax deferred). But, depending on your situation, it might be better to begin to use some of that money earlier. (It mostly depends on your tax bracket and other income.)
The rules, tax laws, and even the timing of how you manage your retirement accounts can either save or cost you a lot of money in taxes and fees over time. I’ve seen people with no more than $1 million saved waste as much as $30,000 merely by drawing down the wrong account a year too soon. It is not a simple process. Talk with an advisor today.