11 April 2021

How 401(k) Distributions Work

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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.

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