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Understanding 401(k) Taxation in Retirement

You’ve been diligently contributing to your employer’s 401(k) plan, enjoying the tax benefits and watching your funds grow tax-deferred. However, as you approach retirement, it’s essential to understand how your 401(k) will be taxed. O1ne Mortgage is here to help you navigate these complexities. For any mortgage-related needs, feel free to call us at 213-732-3074.

How Are 401(k)s Taxed in Retirement?

When you start withdrawing from your traditional 401(k) in retirement, your distributions will be taxed as ordinary income. Here’s a breakdown of how this typically works:

Withholding

Generally, 401(k) distributions are subject to a mandatory 20% withholding. This withheld amount applies toward your tax bill, similar to paycheck withholding during your working years. You’ll reconcile your tax bill when you file your tax return, potentially receiving a refund or owing a balance.

Estimated Taxes

If your withholding doesn’t cover the taxes owed on your retirement distributions, you may need to pay quarterly estimated taxes on the difference.

Reporting

Your plan will report annual distributions to you and the IRS using Form 1099-R. Use this form to report taxable distributions on your Form 1040. These distributions contribute to your adjusted gross income for the year.

Lump Sums and Rollovers

In some cases, you may withdraw your entire 401(k) balance as a lump sum. If you plan to roll your funds into a new retirement account, such as an IRA, follow the rollover rules to avoid paying taxes on your distribution.

Required Minimum Distributions

You must begin making minimum withdrawals from your 401(k) by April 1 of the year following the year you retire or turn 73 if you continue working. Failure to take the required minimum distributions can result in a penalty of up to 25% of the amount you should have withdrawn.

How Much Are 401(k)s Taxed?

The tax rate on 401(k) distributions depends on your marginal tax rate and tax bracket. Below are the 2023 tax brackets based on adjusted gross income:

• 10%: $0 – $11,000 (Single), $0 – $15,700 (Head of Household), $0 – $22,000 (Married Filing Jointly), $0 – $11,000 (Married Filing Separately)
• 12%: $11,001 – $44,725 (Single), $15,701 – $59,850 (Head of Household), $22,001 – $89,450 (Married Filing Jointly), $11,001 – $44,725 (Married Filing Separately)
• 22%: $44,726 – $95,375 (Single), $59,851 – $95,350 (Head of Household), $89,451 – $190,750 (Married Filing Jointly), $44,726 – $95,375 (Married Filing Separately)
• 24%: $95,376 – $182,100 (Single), $95,351 – $182,100 (Head of Household), $190,751 – $364,200 (Married Filing Jointly), $95,376 – $182,100 (Married Filing Separately)
• 32%: $182,101 – $231,250 (Single), $182,101 – $231,250 (Head of Household), $364,201 – $462,500 (Married Filing Jointly), $182,101 – $231,250 (Married Filing Separately)
• 35%: $231,251 – $578,125 (Single), $231,251 – $578,100 (Head of Household), $462,501 – $693,750 (Married Filing Jointly), $231,251 – $346,875 (Married Filing Separately)
• 37%: $578,126 or more (Single), $578,101 or more (Head of Household), $693,751 or more (Married Filing Jointly), $346,876 or more (Married Filing Separately)

How Are Roth 401(k) Distributions Taxed?

Roth 401(k) distributions are not included in your taxable income if you meet the requirements for qualified distributions. Since Roth contributions are made with after-tax dollars, you’ve already paid taxes on these funds. Qualified distributions must meet the following criteria:

• Funds have been held in the Roth 401(k) account for at least five years.
• Funds are distributed on or after you reach 59½, due to disability, or after your death.

How to Minimize Taxes on 401(k) Withdrawals

While avoiding taxes on 401(k) distributions is challenging, tax planning can help manage your tax bill in retirement. Here are some strategies:

Minimize Your Distributions

The more you withdraw, the higher your income and tax bill. Plan your distributions carefully to avoid moving into a higher tax bracket.

Consider Social Security

Adjusting your distributions can affect the taxes on your Social Security benefits. Calculate your “combined” income to estimate the taxes on your benefits.

Treat Company Stock as Capital Gains

Company stock in your 401(k) may be taxed as capital gains instead of ordinary income, potentially offering tax savings. Consult your tax advisor for details.

Live in a Tax-Friendly State

State income taxes vary, so consider state-by-state differences. However, also account for property taxes, sales tax, and other local taxes.

Get Tax Advice

Your tax situation changes in retirement. A qualified tax advisor or financial planner can provide valuable expertise to help you structure your income and minimize taxes.

The Bottom Line

The tax advantages of a 401(k) often outweigh the tax burden in retirement. You may benefit from matching contributions, tax deductions, and tax-deferred growth. However, individual circumstances vary, so it’s crucial to stay informed and plan accordingly. For any mortgage-related needs, contact O1ne Mortgage at 213-732-3074. We’re here to help you achieve your financial goals.

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