You’ve been contributing to a 401k plan for years. And, your employer was good enough to add some matching funds. But now that you’re getting ready to retire it’s time to start thinking about the distribution of that 401k plan. So what should you do with your 401k once you retire?
There are two sets of rules governing your 401k plan. Both the IRS and your plan administrator have a say in what you can do with the account. The IRS controls how your choices affect your taxes. The plan administrator has a say in how you invest and how you can withdraw assets.
If you’re 59 1/2 or older you can withdraw funds from your 401k without tax penalty. Under some circumstances you can withdraw a lump sum penalty free if you’re over 55. Note, you’re avoiding penalties, not ordinary income taxes. The penalty for early withdrawal is 10% of the amount withdrawn.
Some retirees want to delay taking withdrawals as long as possible. Mainly to help their savings compound without the negative effect of taxes. Generally it makes sense to delay taxes.
Beginning the year you turn 70 1/2 you must begin taking minimum distributions. The amount is related to your life expectancy. Your plan administrator can provide you with the IRS table. To get a rough estimate of your required distribution divide 1 by the number of years of your life expectancy. Then multiply that by the value of the assets in the 401k plan.
Once you retire, most financial advisors will recommend that you take your money out of the 401k plan. Either as a one time distribution or as a rollover into an IRA account. The reason is to avoid plan fees and to give you greater flexibility in investing your funds.
If you decide to keep your funds within the 401k plan you’ll need to adhere to their rules. Those rules will affect both your options for distribution and your investment choices. Check with your plan administrator to find out how to withdraw funds. Most will allow you to make periodic or regularly scheduled withdrawals. There may also be rules regarding when and how often you can change your distribution options. Some also have rules regarding minimum distributions.
As mentioned, withdrawals will be added to your taxable income unless they’re rolled over into a qualifying IRA.
For many retirees, rolling into an IRA is their best choice. You’ll have lower fees, more investment choices, similar distribution rules and still be compounding tax-free.
If you plan on taking your distribution in cash, you’ll need to do some tax planning. Taking a regular distribution will allow you to spread the taxes and keep you in the lower tax brackets. Taking a lump sum distribution could throw you into a tax bracket designed for the wealthy. Your distribution will also be reduced by a 20% withholding which you can apply to your next year’s tax bill.
A popular option is to take part or all of your funds in a distribution and purchase an annuity. There are various types of annuities. Retirees prefer ones that provide a guaranteed lifetime income. Proponents point out that with an annuity you can’t outlive your money. But you should recognize that not all annuities are indexed for inflation. Your monthly guarantee might look good today, but buy much less in 20 years if prices rise (and it’s likely they will).
No one choice is best for everyone. This might be the time to get some professional advice. The decision you make is the culmination of years of saving and will affect your finances for the rest of your life.
There are many variables to consider. How much you’ve saved. Your investment philosophy. Your income needs. Your expected longevity. Your tax situation. Even your children’s financial situation can affect your decision.