We have $2 million and plan to retire soon, but we aren’t sure how our 401(k) plans are taxed

Here’s my question: Our 401(k) accounts include 1) contributions, 2) company matches, and 3) earnings. These are spread over several different funds within our accounts. When we start withdrawing from these, are there tax implications? For example, are withdrawals from the “contribution bucket” taxed differently from the “company match bucket” or the “earned amount bucket”? If so, what is the best order of “buckets” to withdraw from? 

See: I’m 54 and the primary earner but ‘professionally, I am exhausted’ — we have $2.18 million but what about healthcare?

Dear reader, 

The answer is a bit complicated. If you have a traditional 401(k) with all pretax dollars, then it’s pretty straightforward and your withdrawals are taxed entirely as ordinary income. That changes if your 401(k) plan has any after-tax dollars in it, and the problem is: not everyone knows when they do. 

Every plan has its own rules around spending down a portfolio, such as the order in which buckets of pretax and after-tax money are distributed and taxed, said Brian Schmehil, a certified financial planner and managing director or wealth management for The Mather Group. You may find after-tax dollars in your 401(k) plan for a variety of reasons, such as you’ve maxed out your contributions and your employer switches you to an after-tax contribution. Older plans, prior to 1987, often have after-tax money in there, Schmehil said. 

To clarify, all of the withdrawals would still be taxed as ordinary income, but if there is a spending order to be followed, the distributions would be subject to pro rata breakdown, where the after-tax dollars are nontaxable and the pretax money is taxed. 

You can find out if your portfolio has an after-tax bucket by checking your annual statements. Those statements won’t tell you how after-tax dollars are divided, such as between contributions and earnings, though, so be careful if you plan to switch any of that to a Roth IRA. Rolling over those assets in IRAs, such as pretax dollars into a traditional account and after-tax dollars into a Roth account, could make sense for you, as it will help you visualize how your investments may be taxed, and save some money down the road. 

If this sounds overwhelming, reach out to the firm housing your 401(k) and ask one of the representatives to help you make sense of it. A qualified financial planner or accountant could also help. 

That’s it for that. But there are other buckets to keep in mind, such as Roth IRAs, which could be broken up into contributions, conversions and earnings, or the bucket method investing strategy, which pertains to investments’ time horizons and risk, such as a conservative short-term bucket, a risky long-term bucket and something in between. 

And this may not apply to your situation, since you said you both intend to work for a few more years, but be aware that 401(k) withdrawals prior to age 59½ years old are subject to a penalty.

All of that being said, since you asked about 401(k) withdrawals, I thought I would throw a few more considerations your way.

Social Security is a big one, but there’s no right answer for when to claim it. 

For instance, you may want to extend the time you withdraw solely from your 401(k) to allow your Social Security benefits to increase. The longer a person waits until age 70, the bigger the benefit check. This strategy doesn’t always make sense — recipients need to consider their life expectancy and current financial needs, of course, but if both of those factors are in your favor, and you’re willing to hold off, it could be an advantage. Social Security benefits may be taxed up to 85%, and 100% of 401(k) withdrawals are taxed, Schmehil said. 

The flip side is maintaining your cost of living and not dwindling your retirement assets too much. You don’t want to get to a point where you have reached age 70 (or close to it) and you’re claiming the maximum of your Social Security benefits, but you have little else to rely on from your savings. It is a delicate balance, and will depend on your spending needs, inflation, investment returns and so on. The rates of return on both assets also matters. Taking Social Security earlier “will minimize the drawdown of tax-preferred assets which are likely growing faster than the rate of return on Social Security benefits which is essentially the annual cost of living adjustment,” said Michael McDaid, a certified financial planner and retirement planning specialist at Retirement DNA. 

Dipping into your 401(k) early will also help lower your required minimum distributions, which is the minimum amount you’re mandated to withdraw from your 401(k) plan. Currently, retirees must begin taking RMDs at 73 years old, though that age will increase to 75 in 2033. 

Also see: Assisted living would cost $100,000 a year where we live. We’re almost in our 60s, should we get long-term-care insurance? 

You might want to have a savings account or other liquid investments in addition to your 401(k) plans before you retire, which can act as an emergency account should something unexpected arise, as well as another place to turn if market volatility takes your portfolios on a wild ride. Taking too much from an investment account when your investments are on the decline can hurt future returns, so if you have money you can tap in to from a savings account, you can avoid realizing some of those losses. The amount of money you have in either account can vary, but perhaps a year or two’s worth of living expenses could work for you.

Another potential strategy: Roth conversions, which will allow you to take some retirement savings distributions later in life without paying taxes. The amount you convert may push you into a higher tax bracket, but you can work with a qualified financial planner or accountant who can determine what would keep you in the same tax bracket. “Tax-efficiency doesn’t always mean lower taxes now, it could mean making decisions that increase taxes now but help lower their lifetime tax bill,” said Wes Battle, a certified financial planner.  

Above all, have a plan. Consult with a financial planner who will work in your best interests (that’s known as a fiduciary) if you’re able to, but if you’re not interested in doing that, make a date of it and talk through what you expect to save until retirement, and how you anticipate you’ll spend those assets when you get there. Be as specific as you can, and consider the tax implications of more than your 401(k) withdrawals, such as where you’ll live, healthcare before and after you’re eligible for Medicare at age 65. Good luck. 

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