How to Use Your 401k in Retirement

The 401k plan is a tool for retirement savings. These employer-sponsored plans offer tax advantages. Understanding how to access and manage these funds during retirement is important for financial planning. Withdrawal rules, including timing and tax implications, affect how a 401k supports post-employment living.

Understanding When You Can Access Your 401k

Individuals can begin taking distributions from their 401k accounts without penalty at age 59½. Withdrawals before this age are subject to a 10% additional federal tax penalty, plus regular income and state taxes.

Several exceptions allow for penalty-free withdrawals before age 59½:
The “Rule of 55,” which permits penalty-free access if an individual leaves their employer in or after the year they turn 55. This rule applies to the 401k plan of the most recent employer.
Distributions due to total and permanent disability.
Certain unreimbursed medical expenses exceeding 7.5% of adjusted gross income.
Distributions to a beneficiary after the account owner’s death.
Birth or adoption expenses (up to $5,000 per child).
Certain emergency personal expenses (up to $1,000 per year).

Options for Taking Distributions

Upon reaching retirement age, individuals have several options for receiving money from their 401k. A common approach is a lump-sum distribution, where the entire account balance is withdrawn at once. This provides immediate access to all funds but results in the entire amount being taxed as ordinary income in the year of withdrawal for traditional 401k accounts.

Alternatively, retirees can opt for periodic or installment payments, receiving regular withdrawals over a set period or in specific amounts. This strategy helps manage tax liabilities by spreading income over multiple years. Some plans may also offer annuity options, converting a portion or all of the 401k balance into a guaranteed stream of income for life.

The tax treatment of distributions depends on the 401k plan type. Traditional 401k contributions are pre-tax, and both contributions and earnings are taxed as ordinary income upon withdrawal. Roth 401k contributions are after-tax, meaning qualified distributions are entirely tax-free. For a Roth 401k distribution to be qualified and tax-free, the account must have been open for at least five years, and the withdrawal must occur after the account holder reaches age 59½, becomes disabled, or dies. Otherwise, the earnings portion may be subject to income tax and potentially the 10% early withdrawal penalty.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are mandatory annual withdrawals from most traditional retirement accounts, including 401k plans, once individuals reach a certain age. The SECURE Act 2.0 increased the RMD starting age to 73, effective January 1, 2023. For those who turned 72 in 2022 or earlier, previous RMD schedules apply. The first RMD can be delayed until April 1 of the year following the year the individual reaches the RMD age, but all subsequent RMDs must be taken by December 31 each year.

RMD amounts are calculated based on the account balance as of December 31 of the previous year and the account holder’s life expectancy, using IRS tables. These distributions ensure tax-deferred savings are eventually taxed. Failing to take the full RMD by the deadline can result in an excise tax. The penalty is 25% of the amount not withdrawn, which can be reduced to 10% if corrected within two years. Account owners are responsible for calculating and taking the correct RMD amount.

Rules for beneficiaries inheriting a 401k differ. For non-eligible designated beneficiaries, funds must generally be distributed within 10 years following the original account owner’s death, often called the 10-year rule. Roth 401k accounts are generally exempt from RMDs during the original owner’s lifetime, a change introduced by the SECURE Act 2.0 beginning in 2024.

Rollover Considerations

Individuals often roll over their 401k funds into another retirement account, such as an Individual Retirement Account (IRA) or a new employer’s qualified plan. This process allows funds to maintain their tax-deferred status. Rollovers can offer benefits like consolidating accounts, accessing a broader range of investment options, or simplifying retirement planning.

There are two primary methods for rolling over 401k funds: direct and indirect. In a direct rollover, funds transfer directly from the 401k plan administrator to the new IRA or retirement account custodian. This method avoids immediate tax implications and prevents mandatory tax withholding.

An indirect rollover, also known as a 60-day rollover, involves funds distributed directly to the individual. The individual then has 60 days from receipt to deposit the funds into another eligible retirement account. A key aspect of an indirect rollover is that the plan administrator generally withholds 20% for federal income tax. To complete the full rollover, the individual must deposit the entire original distribution, including the withheld 20%, often requiring other funds to cover the difference. If the full amount is not rolled over within 60 days, the unrolled portion is considered a taxable distribution and may be subject to the 10% early withdrawal penalty if the individual is under age 59½.