Retirees often use their Social Security checks and 401(k) distributions as their main sources of income during retirement, without utilizing other accounts they are invested in. But that strategy has a problem — taxes. Since the money you contribute to the 401(k) account is pre-tax and the money then grows tax-deferred, you will need to pay taxes on the back end, when you take distributions. The tax rate depends on your income and several other factors, but paying tax is largely unavoidable. And depending on your income, your Social Security benefit could also be subject to tax.
This could mean adding to your tax burden at a time when you would much rather start getting a break from the IRS. However, there’s an easy way to get that break, and you probably already have the tools to do so
Toggling distributions between retirement accounts is a smart way to lower your taxable base while simultaneously keeping your assets invested to keep growing. “Toggling” simply means taking distributions from different accounts at the same time instead of drawing down one account more than another — taking distributions from your 401(k), for example, but not touching your IRA
How To Do It
The best way to do this is to contribute as much as you can to your 401(k) and, if you qualify, a Roth IRA. The main reason for doing so is that these two accounts have two different tax treatments assigned to them.
Contributions to your 401(k) account go in pre-tax, grow tax-deferred and are taxed on the back end when taken out.
Roth money goes in after you’ve already paid taxes on it, grows tax-deferred and is given to you without any tax bill.
If you consistently contribute to both of these accounts, when it’s time to retire, you will likely have sizable investments to draw on, and the important part — benefit from the differences in the way the distributions are taxed.
According to the IRS, any taxable distribution made to you from a 401(k) is subject to a mandatory 20% tax rate before it is paid to you. The same does not apply for Roth IRAs, though.
Let’s assume you want to withdraw $50,000 from your 401(k). This would mean $10,000 immediately paid out to taxes, and a net benefit of $40,000. If, on the other hand, you take out $25,000 from your 401(k) and take the other $25,000 from your Roth IRA, you would only be taxed $5,000 — 20% of the $25,000 from the 401(k) — for a net benefit of $45,000 and a 50% reduction in your tax bill.
By reducing your tax bill, toggling distributions between different accounts keeps more assets invested in the market. Another benefit to this strategy is diversification of assets. The investment offerings in 401(k)s and IRAs tend to differ. Typically, 401(k)s are designed to be invested in target funds that taper off in terms of volatility and risk the closer you get to your target date of retirement. This usually means larger, more stable funds and a mix of government bonds. While you can do this with IRAs as well, there are also riskier and more aggressive options available to you in IRA accounts that you can (and should) invest in that likely are not available to you through your 401(k) provider. This allows for diversification of assets to hedge risk during downturns — and reap greater upside potential in market upswings — if you’re spread across sectors.
If you also receive Social Security benefits, you can use those payments to reduce your reliance on retirement-account distributions and net an even smaller tax bill. You can also consider waiting to collect Social Security to allow for a larger benefit in the future if you prefer to draw on other retirement accounts with more beneficial tax rates.
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