How to Pay Less Taxes on 401(k) Withdrawals

Tax Strategies | by Jules Buxbaum | Monday, February 03, 2025

How to Pay Less Taxes on 401(k) Withdrawals can feel like a pressing question for anyone approaching retirement. If you’re a busy professional or business owner looking to keep more of what you’ve saved, there are proven ways to cut down on tax bills.

Many retirees experience unnecessary tax burdens because they rush withdrawals without preparing. For a deeper look at methods that might help you minimize taxes on your retirement income, let’s explore practical strategies that could make a difference in your golden years.

Why 401(k) Taxes Matter

A 401(k) is a tax-advantaged plan that your employer typically sponsors. Traditional versions reduce your taxable income when you contribute, but Uncle Sam eventually collects taxes on withdrawals.

Roth 401(k)s work in reverse: you contribute after-tax dollars. Over time, potential growth can be tax-free, but only if you follow age and holding-period requirements before taking money out.

Because retirement income can stack up with Social Security and other sources, your total tax bill can jump into higher brackets fast. According to Fidelity Investments (2022), 63% of retirees regret not preparing more for the tax implications related to withdrawals.

Shifting the Burden: Key Strategies

Keeping your total taxable income low is a prime goal. One approach is to spread withdrawals across multiple years to avoid spiking into a higher tax bracket.

Another important tactic is to review contribution types in advance. If you have time before retirement, placing funds in both traditional and Roth accounts can boost tax flexibility.

If your plan allows after-tax contributions, you could explore “mega backdoor Roth” techniques, though these can be complex. Thorough research or professional guidance may help you sidestep pitfalls.

Optimize Roth Conversions

Roth conversions involve moving money from a traditional 401(k) to a Roth account. This triggers taxes in the year of conversion, but future qualified withdrawals are tax-free.

Retirees sometimes convert a portion of assets in years when their income is lower. Doing so may help them avoid key mistakes and keep lifetime tax costs more predictable.

Data from T. Rowe Price suggests that well-planned conversions in the first 10 years of retirement can enhance after-tax wealth by around 4% over three decades. That figure might differ by individual, but it indicates the potential power of this strategy.

Leverage Proper Timing and Tax Bracket Management

Tax brackets range from 10% to 37%, so it matters greatly how you spread out your 401(k) distributions. By withdrawing smaller amounts each year, you might stay in a lower bracket overall.

Watch out for how your state treats 401(k) income. Some retirees in high-tax states aim to relocate, while others systematically manage yearly distributions to reduce total state taxes.

In certain states, the tax break on pension-like income is modest or nonexistent. Learn more about local rules by reviewing resources like State-Specific Tax Benefits for Retirees: NY, NC & FL Compared if you’re considering a move or already reside in those areas.

Up to 85% of your Social Security can be taxed if your provisional income crosses a specific threshold. This means large 401(k) withdrawals could push you into a territory where more of your benefits face taxes.

Some retirees delay Social Security while they draw down from their 401(k) so that, by the time they claim benefits, their annual taxable income is in check. There’s no universal rule: each person’s situation differs.

Managing Required Minimum Distributions (RMDs)

RMDs used to start at age 72 for most people, but new legislation is phasing in a later age (73, and eventually 75 in 2033). These mandatory withdrawals apply to Traditional 401(k)s and can boost your total taxable income.

Donating part of your distribution directly to a charity is one way to reduce your taxable portion, as long as you follow IRS guidelines. Another path is to take smaller elective distributions in the years before RMD age, keeping those later balances lower.

If you’re not sure how RMDs work, consider checking out Understanding Required Minimum Distributions (RMDs). Early planning can help you regulate the impact when RMDs finally kick in.

Factoring in State Taxes

A handful of states do not tax 401(k) withdrawals. Others exempt only a portion of retirement income, while some fully tax any distribution.

This variation means $40,000 in withdrawals could be taxed very differently in New York versus Florida. If a long-term relocation is part of your plan, investigate potential tax savings carefully.

Some states also have unique credits or other perks for retirees. Checking local guidelines early can be a game-changer in planning your post-work finances.

When Early Withdrawals Are Unavoidable

Accessing your 401(k) before age 59½ typically means a 10% penalty on top of regular income tax. However, certain rules like the Substantially Equal Periodic Payments (SEPP) exception exist.

If you retire in or after the year you turn 55 (and separate from your employer), you can sometimes tap that specific 401(k) without the penalty. Every approach has rules, so reading up on IRS guidelines or seeking qualified advice is wise.

Planning earlier in your career can help you avoid these fees altogether. Even small steps each year might guard your nest egg’s value over time.

Watch Out for Future Tax Changes

Tax laws shift, and retirement rules are no exception. The Tax Cuts and Jobs Act might sunset after 2025, edging the top income rate back to 39.6%.

Increasing contribution limits—reaching $23,500 in total annual deferrals by 2025—could also shape how you approach your savings timeline. Catch-up contributions for people aged 60 to 63 will jump to $11,250, allowing some to save up to $34,750 just in their 401(k).

These evolving thresholds indicate that ongoing adjustments matter as you set long-term goals. Avoiding surprise taxes often means keeping up with legislative updates.

Consider 2Pi Financial’s Planning Engine

Having a clear look at withdrawal amounts, timing, and future projections can remove guesswork. Our firm, 2Pi Financial, offers a Financial Planning Engine that shows how small tweaks, such as retirement age or savings rate, affect overall success.

This tool provides a probability-based plan adapted to your risk tolerance, projected inflation, and other inputs. It can also illustrate how adjusting your 401(k) distribution amounts interacts with Social Security, RMDs, and more.

Checking all these factors through a single platform could simplify your tax strategies. You might uncover extra ways to optimize each withdrawal so you don’t overshoot your bracket.

The Role of Asset Allocation

Some investors rely on target-date funds that reduce equity exposure with age. At 2Pi Financial, we focus on an approach shaped by your personal wealth relative to your future earnings.

It’s not just about how old you are. Realistically, an older individual with substantial future income prospects could handle higher risk, while a younger person with limited future earnings might want more stability.

A portfolio balanced around these factors could influence how you draw funds. If your equities outperform, you might harvest gains in lower-income years to reduce taxes overall.

How State Residency Influences RMD Strategies

RMD amounts are federally mandated, yet the taxes you pay at the state level can differ significantly. Some states treat all retirement distributions the same, while others allow partial exemptions if you meet certain criteria.

If you move from a high-tax state to a low-tax alternative right before RMDs begin, you might significantly shrink your combined tax burden. Check out property taxes, sales taxes, and other levies before making that leap.

Combining strategic geographic choices with advanced planning can deliver more favorable outcomes. Even a few percentage points in state taxes can add up over a long retirement.

Evaluating Net Unrealized Appreciation (NUA)

If you hold company stock within your 401(k), NUA rules might reduce how much you pay. With NUA, you pay ordinary income tax on the stock’s cost basis and long-term capital gains on the appreciation, if you distribute shares directly from the plan.

This can be a game-changer if your company stock soared while you were employed. Despite that, NUA is complicated, so you’ll want to do the math or work with an experienced professional before you act.

Incorporating Other Retirement Accounts

Moving money between different account types (like 401(k) rollovers to IRAs) can either postpone or accelerate tax obligations. A direct rollover avoids an immediate tax hit, but partial conversions to Roth accounts trigger taxes in that year.

Diversifying among taxable accounts, Roth accounts, and tax-deferred accounts gives you more control over annual withdrawals. This variety might let you choose which “bucket” to pull from each year, shaping your income to help you stay in a lower bracket.

Bottom Line

Reducing your 401(k) tax burden typically hinges on timing, proper knowledge of the rules, and matching your strategy to personal goals. Roth conversions, bracket management, and monitoring RMDs are just a few pillars of success.

For more ways to strengthen your retirement plan, consider exploring diversifying your retirement portfolio. Smart coordination of accounts, risk, and taxes helps preserve more of your savings for life’s next chapter.

References

Fidelity Investments. (2022). “Tax-Savvy Withdrawals in Retirement.” Available at: https://www.fidelity.com/viewpoints/retirement/tax-savvy-withdrawals(https://www.fidelity.com/viewpoints/retirement/tax-savvy-withdrawals)

Employee Benefit Research Institute. (2021). “How Workers Respond to Required Minimum Distributions.” Available at: https://www.ebri.org(https://www.ebri.org)

Rowe Price. (Year). “Maximizing Roth Conversions in Retirement.” Available at: https://www.troweprice.com(https://www.troweprice.com)