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10 Ways to Reduce Your 401(k) Taxes

How the pros help clients minimize their tax burden

If you have a traditional 401(k), you will have to pay taxes when you take distributions. Unfortunately, that 401(k) money is subject to the worst kind of taxes—ordinary income taxes. The amount you pay is based on your tax bracket, and if you’re younger than 59½, add 10% (for early withdrawal) in most cases. That could put your tax rate at the top 37% bracket—ouch!

You could look at a Roth 401(k) or a Roth IRA to pay taxes now rather than later, but we wanted to know how the professionals help their clients minimize their tax burden on their regular 401(k)s. We asked, and here’s what they said.


  • Certain strategies exist to alleviate the tax bite on 401(k) distributions.
  • Net unrealized appreciation and tax-loss harvesting are two strategies that could reduce taxable income.
  • Rolling over regular distributions to an IRA avoids automatic tax withholding by the plan administrator.
  • Consider delaying plan distributions (if you are still working) and Social Security benefits, or borrowing from your 401(k) instead of actually withdrawing funds.

1. Explore Net Unrealized Appreciation (NUA)

If you have company stock in your 401(k), you may be eligible for net unrealized appreciation (NUA) treatment if the company stock portion of your 401(k) is distributed to a taxable bank or brokerage account, says Trace Tisler, CFP®, owner of Epic Financial, LLC, a northeastern Ohio financial planning firm. When you do this, you still have to pay income tax on the original purchase price of the stock, but the capital gains tax on the appreciation of the stock will be lower.

So, instead of keeping the money in your 401(k) or moving it to a traditional IRA, consider moving your funds to a taxable account instead. (You should also consider thinking twice about rolling over company stock.) This strategy can be rather complex, so it might be best to enlist the help of a pro.

2. Use the ‘Still Working’ Exception

Most people know that they are subject to required minimum distributions (RMDs) at age 70½, even on a Roth 401(k). But if you’re still working when you reach that age, these RMDs don’t apply to your 401(k) with your current employer (see item 8, below). In other words, you can keep the funds in the account, earning away to augment your nest egg, and postponing any tax reckoning on them. Keep in mind that the IRS has not clearly defined what amounts to “still working”; probably, though, you would need to be deemed employed throughout the entire calendar year. Tread carefully if you’re cutting back to part-time or considering some other sort of phased retirement scenario.

Also, “there are issues with this strategy if you are an owner of a company,” warns Christopher Cannon, CFP®, of RetireRight Pittsburgh. If you own more than 5% of the business that sponsors the plan, you’re not eligible for this exemption. Also, consider that the 5% ownership rule actually means over 5%; includes any stake owned by a spouse, children and grandchildren, and parents; and may rise to over 5% after age 70½. You can see how complicated this strategy can get.

3. Consider Tax-Loss Harvesting

Another strategy, called tax-loss harvesting, involves selling underperforming securities in your regular investment account. The losses on the securities offset the taxes on your 401(k) distribution. “Exercised correctly, tax-loss harvesting will offset some, or all, of an investor’s tax burden generated from a 401(k) distribution,” says Kevin Pollack, co-founder and managing partner at Chamberlain Warden, LLC. (There are limitations to this strategy that involve reducing investment losses.)

4. Avoid the Mandatory 20% Withholding

When you take 401(k) distributions and have the money sent directly to you, the service provider is required to withhold 20% for federal income tax. If this is too much—if you effectively only owe, say, 15% at tax time—this means you’ll have to wait until you file your taxes to get that 5% back.

Instead, “roll over the 401(k) balance to an IRA account and take your cash out of the IRA,” suggests Peter Messina, investment advisor representative at Salt Lake City’s ABG Consultants, which specializes in retirement plans. “There is no mandatory 20% federal income tax withholding on the IRA, and you can choose to pay your taxes when you file rather than upon distribution.”

5. Borrow Instead of Withdraw from Your 401(k)

Some plans let you take out a loan from your 401(k) balance. If so, you may be able to borrow from your account, invest the funds, and create a consistent income stream that persists beyond your repayment of the loan.

“The IRS generally allows you to borrow up to 50% of your vested loan balance—up to $50,000—with a payback period of up to five years,” explains Ravi Ramnarain, a CPA based in Fort Lauderdale, Fla. “In this case, you don’t pay any taxes on this distribution, let alone a 10% penalty. Instead, you simply have to pay back this amount in at least quarterly payments over the life of the loan.

“Given these parameters,” Ramnarain continues, “consider this scenario: You take out a $50,000 loan over five years. With interest, let’s say your monthly payment over this 60-month period is $900. Now imagine taking that $50,000 principal amount and purchasing a small house, apartment, or duplex in the relatively inexpensive South to rent out. Given that you would be purchasing this property without a mortgage, let’s say that your net rent each month comes out to $1,100, after taxes and management fees.

“What you have effectively done,” says Ramnarain, “is to set up an investment vehicle that puts $200 in your pocket each month ($1,100 – $900 = $200) for five years. And after five years, you will have fully paid back your $50,000 401(k) loan, but you’ll continue to pocket your $1,100 net rent for life! You might also have the opportunity to sell that house/apartment/duplex later on at an appreciated amount, in excess of inflation.”

Of course, a strategy like this comes with investment risk, not to mention the hassles of becoming a landlord. You should always talk to your financial advisor before embarking on such a step.

6. Watch Your Tax Bracket

Since all (or, one hopes, only a portion) of your 401(k) distribution is based on your tax bracket at the time of distribution, only take distributions to the upper limit of your tax bracket.

“One of the best ways to keep taxes to a minimum is to do detailed tax planning each year to keep your taxable income [after deductions] to a minimum,” says Neil Dinndorf, CFP®, a wealth advisor at EnRich Financial Partners in Madison, Wis. Say, for example, you are married filing jointly. For 2019, you can stay in the 12% tax bracket by keeping taxable income under $78,950 (as per the Tax Cuts and Jobs Act passed in late 2017). In 2020, the limit for the 12% bracket rises $1,300 to $80,250.

By planning carefully, you can limit your 401(k) withdrawals so they don’t push you into a higher bracket (the next one up is 22%) and then take the remainder from after-tax investments, cash savings, or Roth savings, says Dinndorf. The same goes for big-ticket expenses in retirement, such as car purchases or big vacations: Try to limit the amount you take from your 401(k) by perhaps taking a combination of 401(k) and Roth/after-tax withdrawals.

7. Keep Your Capital Gains Taxes Low

Try to only take withdrawals from your 401(k) up to the earned income amount that will allow your long-term capital gains to be taxed at 0%. In 2019, singles with taxable income up to $39,375 and married filing jointly tax filers with taxable income up to $78,750 can stay in the 0% capital gains threshold. Nathan Garcia, CFP®, with Strategic Wealth Partners in Fulton, Md., says retirees can subtract their pension from their annual spending amount, then calculate the taxable portion of their Social Security benefits and subtract this from the balance from the previous equation. Then, if they are over 70, subtract their required minimum distribution. The remainder, if any, is what should come from the retirees’ 401(k), up to the $39,375 or $78,750 limit. Any income needed above this amount should be withdrawn from positions with long-term capital gains in a brokerage account or Roth IRA.

8. Roll Over Old 401(k)s

Remember, you don’t have to take distributions on your 401(k) funds at your current employer if you’re still working. However, “if you have 401(k)s with previous employers or traditional IRAs, you would be required to take RMDs from those accounts,” says Mindy S. Hirt, CFP®, a wealth advisor with Argent Financial Group in Nashville, Tenn.

To avoid the requirement, “roll your old 401(k)s and traditional IRAs into your current 401(k) before the year you turn 70½,” she advises. “There are some exceptions to this rule, but if you can take advantage of this technique, you can further defer taxable income until retirement, at which point the distributions might be at a lower tax bracket (if you no longer have earned income).”

9. Defer Taking Social Security

To keep your taxable income lower and also possibly stay in a lower tax bracket, consider putting off your Social Security benefits until later. Frank St. Onge, a Brighton, Mich.-based CFP® at Total Financial Planning, LLC, advises some of his clients to delay Social Security payments as part of a tax-saving strategy that includes converting some funds to a Roth IRA. “I recommend that [some clients] wait until age 70 to start their Social Security benefits,” says Onge.

If retirees can afford to delay collecting Social Security benefits, they also can raise their payment by almost a third. If you were born within the years 1943-1954, for example, your full retirement age—the point at which you will get 100% of your benefits—is 66. But if you delay to age 67 you’ll get 108% of your age 66 benefit, and at age 70 you’ll get 132% (the IRS provides this handy calculator). This strategy stops yielding any extra benefit at age 70, however, and no matter what, you should still file for Medicare at age 65.

10. Get Disaster Relief

“For people living in areas prone to hurricanes, tornadoes, earthquakes, or other forms of natural disasters,” Ramnarain says, “the IRS periodically grants relief with regard to 401(k) distributions—in effect, waiving the 10% penalty within a certain window of time. An example might be during certain severe Florida hurricane seasons.”

If you live in one of these areas and need to take an early distribution, see if you can wait for one of these times.

The Bottom Line

Keep in mind that these are advanced strategies used by the pros to reduce their clients’ tax burdens at the time of distribution. Don’t try to implement them on your own unless you have a high degree of financial and tax knowledge. Instead, ask your financial planner if any of them are right for you. As with anything having to do with taxes, there are rules and conditions with each, and one wrong move could trigger penalties.

It’s always a good idea to get advice from a financial planner before making big investment decisions.  Hear Gregory Ricks help a caller who wants to know if he can contribute earned income to his 401k to avoid fees associated with benefit taxes.