Withdrawing From a 401(k) Know Your Options

401k distributionYou contributed to a 401(k) retirement plan for years and your employer added some matching funds. Now that you’re ready to retire it’s time to think about how to withdraw your money.

 

Two sets of rules govern your 401(k). Both the Internal Revenue Service and your plan administrator (probably your employer) oversee what you can do with the account. The IRS controls how your choices affect your taxes, the administrator how you invest and can withdraw assets.

 

If you’re 59½ or older, you can withdraw funds from your 401(k) without paying a tax penalty (generally 10% of what you take out). Under some circumstances involved in leaving a job, you can also withdraw a lump sum penalty-free if you’re older than 55.

 

Note: You avoid penalties, not ordinary income taxes. Some retirees delay taking withdrawals as long as possible, often to help savings compound safe from taxes.

 

Beginning the year you turn 70½, you must begin taking annual required minimum distribution (RMD) withdrawals. The amount is related to your life expectancy. To estimate your RMD, divide one by the number of years of your life expectancy, according to the IRS, and multiply that by the value of the assets in your 401(k).

 

Most financial advisors recommend that you take your money out of the 401(k) once you retire, either as a one-time distribution or as a rollover (a penalty-free transfer) into an individual retirement account. You avoid plan fees and gain greater flexibility in investing your funds.

 

If you decide to keep your money in the 401(k), you must adhere to the rules affecting both your options for distribution and your investment choices. Check with your plan administrator to find out how to take out your money; most will allow you to make periodic or regularly scheduled withdrawals. Other rules may also cover your RMDs or when and how often you can change your distribution options.

 

Again, withdrawals will be added to your taxable income unless you roll them over into a qualifying IRA. (Check the IRS chart to see how to safely transfer money from one kind of retirement account to another.)

 

Rolling into an IRA may well be your best choice: You have lower fees, more investment choices and similar distribution rules but can still let your money compound tax-free.

 

If you plan to take your distribution in cash, 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 might throw you into a higher bracket designed for the wealthy; your distribution will also incur a 20% withholding that you can apply to your next year’s tax bill.

 

A popular option is to take part or all of your distributed funds and buy an annuity to provide steady retirement income. Annuities come in various types. Retirees tend to prefer ones that provide guaranteed lifetime payouts.

 

Proponents point out that with an annuity you can’t outlive your money. You need to realize, though, that not all annuities are indexed for inflation (currently less than 1%). Your monthly guarantee might look good today yet buy much less in 20 years if prices rise.

 

You face the culmination of years of saving, and your moves will affect your finances for the rest of your life. You must think about many variables: how much you saved; your investment philosophy; your income needs, expected longevity and tax situation. Even your children’s financial situation can sway your decision.

 

No one choice suits everyone.

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How To Handle 401k Distributions

401k distributionYou’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.