You worked hard to put money away for retirement, so it is important that you understand the various strategies available to you to make sure you maximize that savings by minimizing taxes and avoiding penalties. Here are several tips to maximize your retirement savings:
Avoid early withdrawal penalties. Over and above the income tax due on your withdrawals, you must wait until age 59 ½ before tapping your retirement savings to avoid the 10% early withdrawal penalty. However, you can take penalty-free 401(k) withdrawals beginning at age 55 if you leave the job associated with that 401(k) account at age 55 or later.
Roll over your 401(k) when changing jobs. If you withdraw money from your 401(k) when you change jobs, 20 percent will be withheld for income tax, as well as paying a penalty for early withdrawals. The mechanism to avoid these costs is to roll over your 401(k) into either a new 401(k) or an IRA.
Mixing your types of retirement accounts. If you qualify for a Roth IRA, these accounts have a variety of benefits a traditional IRA does not, including more flexibility on penalty-free withdrawals and no required minimum distributions. However the biggest difference between the two types of accounts is how they are taxed. IRAs are tax-deferred, so they provide you with an immediate tax benefit, but you must pay taxes when you withdraw the money during retirement. Roth IRA accounts require paying taxes when you deposit the savings, but that means you don’t pay taxes on them during retirement. Diversifying your money in a traditional IRA as well as a Roth IRA will allow you to moderate your tax burden during retirement. Also, if you expect to be in a higher tax bracket during retirement, maximizing your retirement funds in a Roth account will allow you to lock in today’s low tax rate.
Understanding minimum distribution. You are required to withdraw money from your traditional 401(k) and IRA after age 70 1/2. If you miss a required withdrawal, you must pay a 50 percent penalty on the amount that should have been withdrawn. Make sure you mark your calendar for that cutoff date and make arrangements with your financial institution to remind you automatically about your required distribution.
Understanding the rules on your first distribution. Your first required minimum distribution is due by April 1 of the year after you turn 70 ½. All subsequent distributions must be taken by Dec. 31 each year. If you delay your first distribution until the same tax year as your second distribution, you will be required to take both distributions in the same tax year, which could result in an unusually high tax bill.
Start withdrawals in your 60s. While you must begin traditional retirement account withdrawals at age 70 ½, you can lower your tax burden by take smaller distributions starting at age 59 ½, which can spread the tax bill over more years, potentially allowing you to stay in a lower tax bracket and reducing your lifetime tax bill. Check with your financial advisor to find out if this option would make sense for you.
Calculate your tax burden with added Social Security or Pension Benefits. If you’re going to be receiving Social Security benefits or regular payouts from a pension, it’s important to incorporate them when planning your withdrawal strategy. Even if you’re receiving a relatively small amount each month from these sources, the extra income may increase your tax burden.
Keep tax-preferred investments outside retirement accounts. Investments that generate long-term capital gains receive preferential tax treatment when held outside of a retirement account. However, if you put them in a retirement account, you will pay your typically higher regular income tax rate when you withdraw the money from the account. In contrast, you can lower your tax bill by holding more highly taxed investments, including Treasury inflation-protected securities, corporate and government bonds and funds that generate short-term capital gains, inside retirement accounts.
Caren Parnes for the Senior’s Choice