Stay smart about your 401(k)

If you’re like most working Americans, chances are good that you’ve had access to a workplace retirement plan such as a 401(k) for decades.

If you’re in the 50s or 60s, retirement is getting closer by the day, and the way you think about your 401(k) should be evolving. Yes, it’s still the same tax-sheltered, nest-egg-accumulating vehicle it always was.

But it’s also a distribution vehicle. And how you handle your distributions can potentially save you a small fortune in taxes.


Peak Earnings

If you’re in your 50s or 60s, you’re at the absolute peak of your career, and you’re probably an empty-nester by now as well. So, there’s really no excuse for you not to be maxing out your 401(k) plan contributions.

Chances are good that you’re currently in the highest tax bracket you’ll ever be in, so sheltering every dime you can makes all the sense in the world.

Check with your company’s HR department to make sure you’re maxing out your contributions.


Now, let’s talk about the best way to take distributions. And here too, it makes sense to review the basics.

Once you reach age 59 ½, you can take penalty free distributions from a 401(k) plan. But just because you can doesn’t mean you should.

You’re not actually required to start taking distributions until you reach age 70 ½, and even here, there is a little flexibility.

If you’re still employed at age 70 ½ or older and actively contributing, you generally don’t have to start taking required minimum distributions (RMDs) until the year you retire.

Tax Hit

Any dollar you take out of a 401(k) plan is subject to regular income tax. So it makes sense to delay taking distributions for as long as absolutely possible.

But, let’s say you’ve done well and plan to retire young, in your 50s or 60s. Even then, I recommend you push off taking distributions for as long as reasonably possible.

If you’re retiring young, that presumably means you have ample savings outside of your 401(k).

Patience Pays

To the extent possible, it makes sense to spend every taxable nickel you have before taking distributions from your 401(k) plan (or at least taking distributions larger than the minimums required by the IRS).

Every year you postpone taxation is an extra year for your 401(k) plan to compound and grow.

As an example, let’s say you have a liquid net worth of $1 million, half of which is in a 401(k) plan and the other half in a taxable brokerage account invested in stocks and bonds.

Passing It On

It makes sense to spend down that half a million dollars in the taxable brokerage account to nearly zero before touching the 401(k) assets.

And this is equally true if you are thinking of leaving a legacy to your kids or grandkids. RMDs on inherited retirement accounts are based on the life expectancy of the beneficiary, not the original owner.

So, your kids or grandkids could potentially benefit from additional decades of tax-deferred compounding. Taxes indefinitely deferred are effectively taxes avoided altogether.

One word of advice regarding 401(k) funds you intend to leave to your heirs: Not all plans allow your heirs to stretch out their distributions, so if you’re already retired, it probably makes sense to roll the assets into a Rollover IRA.

(This post first appeared in InvestorPlace)

Disclaimer: IB Asset Management does not provide tax advice.  Readers of this article should consult their personal tax advisers regarding the tax consequences of any courses of action discussed herein.