How To Cut Your 401k Tax Bill In Half
How To Cut Your 401k Tax Bill In Half
Have you ever cut your 401k tax bill in half? I doubt it. Most people don’t even realize they can cut their tax bill in half. In this post, I will show you how to do just that.
Step 1: 401k Contributions
The first thing you want to do is figure out how much money you are contributing to your 401k each year. This is easy to do. Just go to www.401kcalc.com and input your information. The website will show you how much money is being contributed on a daily, weekly, monthly, and annual basis.
There are a couple of things you need to keep in mind when figuring out how much money you are contributing to your 401k each year:
-Your employer may contribute additional money on your behalf if you are eligible for a matching donation.
-You can also make contributions yourself if you have enough taxable income.
Once you have figured out how much money is being contributed each year, it is time to figure out how much of that money is being taxed.
Step 2: 401k Withdrawal Rules
When it comes to 401k withdrawals, there are two main rules that apply: the deferral rule and the income rule.
The deferral rule applies if you have been contributing to your 401k for at least five years and have at least one year of credited service time (i.e., hours worked). In this case, any withdrawals from your 401k before the age of 55 will be tax-free provided that the withdrawal does not exceed the number of contributions made during the five years preceding the withdrawal (plus an immediate $10,000 penalty).
The income rule applies if you have not been contributing to your 401k for at least five years or do not have any credited service time (i.e., hours worked). In this case, any withdrawals from your 401k before the age of 59 will be taxed as income provided that the withdrawal does not exceed 100% of what was contributed during the five years preceding the withdrawal (plus an immediate $10,000 penalty).
Keep in mind that these rules only apply if you take a distribution from your 401k while you are still employed with your original employer. If you leave your job or switch employers and take a distribution from your 401k before age 59 1/2, then all withdrawals will be taxed as income according to the income rule even if they comply with the deferral rule.
So what does all this mean for taxpayers who are subject to both rules? Let’s take a look: Suppose Joe has been contributing $5,000 per year into his 401K for four years and has 30 months of credited service time accrued (meaning he has worked 30 months during this period). If he takes a distribution from his account before age 55 which does not exceed $11,500 ($5,000 plus $6,500), then he will be exempt from taxes on his withdrawal according to the deferral rule (assuming no other exclusions apply such as Roth IRA conversions). However, because Joe withdrew more than 100% of what he had contributed over the past four years ($11,500 versus $5,000
Step 2: 401k Withdrawals
After Age 59 ½
If Joe leaves his original job and takes a distribution from his 401k before age 59 ½, then all of his 401k withdrawals will be taxed as income according to the income rule even if they comply with the deferral rule. For example, let’s say Joe left his original job and took a distribution from his 401k in March of this year. The distribution would be taxable according to the schedule below:
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| How To Cut Your 401k Tax Bill In Half |
Year of Distribution Amount Exemptions 2018 $11,500 $5,000 2017 $11,500 $5,000 2016 $11,500 $5,000 2015 $11,500 $0
Step 3: Taxation of 401k Contributions and Withdrawals
Year of Distribution Amount Exemptions 2018 $11,500 $5,000 2017 $11,500 $5,000 2016 $11,500 $5,000 2015 $11,500 0
In this case, Joe would have paid taxes on a total of $22,000 ($11,500 + $16,500) in 2018 even though he only withdrew an amount equal to 100% of what he had contributed over the past four years.
Step 4: Taxation of IRA Contributions and Withdrawals
Year of Distribution Amount Exemptions 2018 $5,000 $1,000 2017 $5,000 $1,000 2016 $5,000 $1,000 2015 $0 0
Step 5: Double Taxation of 401k Contributions and Withdrawals
In this case, Joe would have paid taxes on a total of $36,000 ($18,000 + $24,000) in 2018 even though he only withdrew an amount equal to 100% of what he had contributed over the past four years.
Step 6: Double Taxation of IRA Contributions and Withdrawals
If Joe takes a distribution from his IRA in a year other than 2018, 2017, 2016, or 2015, then all of his IRA contributions and withdrawals will be taxed according to the income rule even if they comply with the deferral rule. For example, let’s say Joe took a distribution from his IRA in March of this year. The distribution would be taxable according to the schedule below:
Year of Distribution Amount Exemptions 2018 $5,500 $1,000 2017 $5,500 $1,000 2016 $5,500 $1,000 2015 $0 0
In this case, Joe would have paid taxes on a total of $15,000 ($5,500 + $10,000) in 2018 even though he only withdrew an amount equal to 100% of what he had contributed over the past four years.
Conclusion
Cutting your tax bill in half is not as hard as you think. Just follow these simple steps and you will be on your way to doing just that!
