Most of what you hear about a 401(k) plan has to do with
taking advantage of your employer's offer to match and making sure you roll the
account over each time you take a new job. But what happens to all that money
once you're retired? Learning the ins and outs of 401(k) distributions—aka
withdrawals from your 401(k)—will not only prepare you for the day you have to
rely on that money, but it will also reinforce the importance of setting it
aside now.
This is what financial planning experts say you need to know
about how 401(k) distributions work.
When do distributions start?
When it comes to your retirement money, 401(k) plans will
not be immediately available for your use. In other words, you can’t retire
early at age 50 and expect to cash in—at least not without some hefty fines.
As a rule of thumb, 401(k) distributions cannot start until
you are 59 1/2 years old.
“That’s the age when you can start taking the money out of
retirement accounts without paying the additional 10 percent penalty,” says
Shelly-Ann Eweka, director of financial planning strategy at TIAA.
Retirement planning, then, has a lot to do with deciding
which age to retire at and how to stretch your money between the various stages
at which these funds become available: 401(k) distributions start at 59 1/2,
but social security benefits won’t start until age 62. And while age 59 1/2
might be a number you’re familiar with, you’re likely less familiar with age
72. That’s the magic year at which you must begin taking your distributions.
That’s because there’s money to be made off of your cash stockpile—you’ll pay taxes
each time you take a distribution from your 401(k).
“Say someone has been working since age 25 and contributing
during that time,” says Arvind Ven, CEO and founder of Capital V Group, a
California-based wealth management firm. “Until then they haven’t paid any
taxes, so the IRS is saying ‘I want my money.’ At 72, they say you’ve been
sitting on it enough.”
What if I need the money sooner?
As with all things, there are a few exceptions to the rule
when it comes to getting that 401(k) money out early. Some individuals can do
so without paying the hefty penalties.
“You’ll hear a lot about age 59 1/2. However, 401(k) plans
are employer-sponsored plans, so there are some exceptions to being able to
take the money out before and not paying the penalty,” Eweka says. “One of the
exceptions is if you retire in the year when you turn 55 with the company you
have that account with. You can take the money out then without paying the
penalty.”
Sometimes the money can be used in the case of death or
disability, too, she adds.
In some extreme situations, you might also consider taking a
loan out against your 401(k). While the fees for doing so are often lower than
the options for traditional loans, you’ll have to pay yourself back over a
five-year period—with interest—to avoid a penalty. Many advisors recommend
against this because it often sets you back on your overall retirement savings
goals by several years.
How big are the distributions?
Once you’re ready to begin your taking money from your
401(k), there are five main ways you can go about it that will help determine
how much you take out.
Rollovers are the first option. With a rollover, you can
take money from your 401(k) and move it to another kind of account where it can
continue to grow during retirement. This is especially useful if you don’t plan
to take the money out quite yet (and you’re younger than age 72), but want to
continue to watch it grow until you are. 401(k)s and traditional IRAs (individual
retirement accounts) both have required minimum distributions starting at age
72; Roth IRAs have no required withdrawals until after the death of the owner.
(The IRS has required minimum distribution worksheets to help calculate what
yours are; alternately, you can confer with a retirement planning expert.)
“If you have a Roth portion of your 401(k), you need to roll
it over to a Roth IRA to avoid the need to take required minimum distribution
at age 72,” says Jody D’Agostini, CFP, an Equitable Advisor. “Roth IRA
withdrawals are tax-free so long as the individual is at least age 59 1/2 and
you have established the Roth IRA for at least five years.”
Note that 401(k) plans have full creditor protection while
some IRAs might not, depending on where you live, D’Agostini says. Plus,
rolling a traditional 401(k) into a Roth IRA will have some tax consequences in
the tax year that the rollover takes place, but you won’t owe taxes when you
eventually withdraw that money in retirement.
“If you or your spouse are still working, you can continue
to contribute to [an] IRA for as long as you like due to the changes instituted
in the SECURE Act,” she says. “One of you will need to have taxable
compensation such as wages, salary, commissions, bonuses, self-employment
income, or tips. Any distributions from your [traditional] IRA are taxed at
ordinary income tax rates.”
The second way to get the money is through regular
systematic withdrawals. This is probably the method you imagine when you think
about using your retirement money because it operates much like your savings
account at a bank.
“This is where you call the company and say ‘send me $3,000
a month,’” Eweka says. “Or you can just take out withdrawals as you need it.
Call up and say ‘send me $500.’”
Going this route means you’ll be in charge of keeping an eye
on the bottom line as it decreases year after year. If that seems dangerous,
you might like the next option.
The third option is based on required minimum distributions.
You can leave it up to your money managers to tell you how much you have to
take out each year to both spread the money out over the course of your
estimated lifespan and avoid any penalties. Doing so will ensure you use it all
and will help you avoid having to budget on a monthly basis.
“You can do it annually, monthly, or quarterly,” Eweka says.
The fourth option is to purchase an annuity—basically, a
form of retirement insurance that provides a fixed stream of payments to an
individual—and it’s the option many financial advisors like best.
“When you purchase an annuity, you turn it into a lifetime
income stream for you and your partner, if you have a partner,” Eweka says. If
an annuity sounds like something you’re interested in, speak with an expert to
learn more.
The fifth option is a bad one, according to most advisors,
because it involves cashing out your 401(k) in a lump sum. Take all the money
out at once, and you’ll owe taxes on the entire amount when you go to file the
same year.
“If you take all of it out at once, you’re taking yourself
up to one of the top tax brackets, so it’s very rare that’s recommended,” Eweka
says.
Taxes aside, you’ll also suddenly be responsible for making
that fixed amount of money last until your death. The money won’t continue to
grow if you do this, unless you invest it elsewhere (which has its own risks),
and you’ll have to budget it wisely.
How to decide which option is right for you
Steve Bogner, managing director at New York City–based
wealth management firm Treasury Partners, says choosing how to cash out on your
401(k) is a decision you should reevaluate each year.
“It’s very important to do a forensic on your retirement
situation at least yearly and just plug in your numbers and use the models to
figure out what’s really the right solution for you,” he says.
In other words, don’t set your 401(k) on autopilot the day
you leave the workforce and fail to check in. Each scenario for your distributions
can change based on taxes and the state where you live, so be sure to keep a
pulse on your unique situation.
Click here for the
original article.