Whether you are close to retirement or still have some years to go, it’s a good idea to think about what to do with your 401k once that day comes. Fortunately, there are several options available to you, as well as rules and tax implications to consider. Here is some helpful information about how a 401k works during retirement and some of the different choices you have to make.
How Does A 401k Work When You Retire?
Ideally, you’ve been making significant contributions to your 401k and had some goals to follow over the years to prepare for a comfortable and secure retirement. Once you’re ready to leave your job, there are a few general rules for how a 401k works in retirement.
- Distribution Age: You can begin withdrawing money from your 401k without penalty at age 59½. Before that age, you’ll typically pay a 10% early withdrawal penalty on top of regular income taxes, with some exceptions.
- Required Minimum Distributions (RMDs): Once you reach age 72 (or 70½ if you turned 70½ before January 1, 2020), the IRS requires you to start taking withdrawals, known as Required Minimum Distributions (RMDs), from your 401k. The amount you’re required to withdraw is based on life expectancy tables provided by the IRS. If you don’t take the RMD, there’s a hefty penalty.
- Taxes on Withdrawals: Money withdrawn from a traditional 401k is treated as ordinary income and will be taxed at your current income tax rate at the time of withdrawal. If you contributed to a Roth 401k, withdrawals are tax-free, provided you meet certain conditions.
- Loans: If you take out a loan against your 401k and retire, the loan typically becomes due fairly quickly. If you don’t repay the loan, it’s treated as a taxable distribution.
- Beneficiaries: It’s essential to keep the beneficiary designations on your 401k up-to-date. In the event of your death, the account balance will be passed to your named beneficiaries. Depending on the plan’s rules and the beneficiary type (spouse vs. non-spouse), there might be different distribution options and tax implications.
How Much Money Should You Have In Your 401k When You Retire?
While we often get questions such as “How much money do I need to retire?” or “Can I retire on $2 million?” no specific amount can guarantee someone their ideal retirement. Each retiree needs to weigh several factors to decide how much is enough for retirement, including:
- Financial Inventory. Take stock of your assets, debts, and sources of retirement income, including Social Security, investments, pensions, and annuities.
- Set a Retirement Budget. Make an estimate of your yearly retirement budget. Think about things such as daily living expenses, travel and hobbies, and healthcare. Take into account other considerations like your location and expected lifespan.
- Consider Inflation and Taxes. Retirement plans should factor in inevitabilities like inflation, market fluctuations, and taxes that can affect your income down the line.
- Prepare an Emergency Fund. Make sure you have a contingency fund for emergencies or long-term health care.
- Plan for Regular Review. Hire a fee-only financial planner for professional guidance, and plan on regularly reviewing and adjusting your retirement plan as needed.
What Should I Do With My 401k After I Retire?
When you retire, you have several options regarding what you can do with your 401k. Here are the primary choices:
- Leave the Money in Your Current 401k Plan:
- Some employers allow you to keep your 401k with them after you retire or leave the company. This option might be suitable if you’re happy with the investment options and fees associated with your current plan.
- Be aware of any plan-specific rules or fees for retirees or former employees.
- Roll Over Your 401k into an IRA:
- You can move your funds into a Traditional IRA. This is a tax-free rollover, meaning you won’t pay taxes when you make the transfer. However, you’ll pay taxes on withdrawals.
- If you have a Roth 401k, you can roll it over into a Roth IRA, where withdrawals are typically tax-free, given certain conditions.
- IRAs often provide more investment options than employer-sponsored 401k plans.
- Make sure the rollover is a “direct rollover” (or “trustee-to-trustee transfer”) to avoid taxes and penalties.
- “Cash Out” or Take a Lump Sum Distribution:
- You can cash out your 401k, but doing so can come with hefty tax implications.
- Money withdrawn will be considered ordinary income and will be taxed as such. If you withdraw before age 59½, there’s typically a 10% early withdrawal penalty in addition to regular income taxes, unless certain exceptions apply.
- Cashing out might bump you into a higher tax bracket for the year.
- Purchase an Annuity:
- With this option, you’d use the money in your 401k to buy an annuity, which would provide a guaranteed monthly income for life or a set period.
- Make sure to review potential fees and terms associated with any annuity.
- Read more: Collecting the Lump-Sum or the Annuity Payments: Which is Better?
- Take the RMDs:
- Remember, once you reach age 72 (or 70½ if you turned 70½ before January 1, 2020), you’re required by the IRS to start taking minimum distributions from your 401k unless it’s a Roth.
- The amount you need to withdraw is based on IRS life expectancy tables.
- Take Systematic Withdrawals:
- Instead of taking a lump sum or RMDs, you might choose to set up regular withdrawals, either monthly, quarterly, or annually. This can provide a steady income stream in retirement.
It’s essential to have a clear retirement strategy to maximize the benefits of your 401k and minimize potential tax hits. It’s a good idea to talk to a financial advisor to weigh your options and figure out the best plan for your situation as you approach retirement.