What Do You Do With a 401(k) When You Retire?

Your Main Options for a 401(k)

Upon entering retirement, individuals face several decisions regarding their accumulated 401(k) savings. Each choice presents distinct advantages and considerations. Understanding these options is important for post-employment financial planning.

One option is to leave the funds within the former employer’s 401(k) plan. Many plans allow retirees to keep their assets invested within the plan. This allows the money to continue growing within the existing investment structure.

Another common choice is to roll over the 401(k) funds into an Individual Retirement Account (IRA). This involves transferring the retirement savings from the employer-sponsored plan to a personally managed IRA. This option can provide greater control and a wider array of investment opportunities.

A third approach involves cashing out the 401(k) by taking a lump-sum distribution. This means withdrawing the entire balance directly into a personal bank account. While providing immediate access to funds, this option often carries tax consequences.

For individuals transitioning to another job rather than fully retiring, rolling over the 401(k) to a new employer’s plan might be an available choice. This allows for consolidation of retirement savings into a single active workplace account.

Details of a 401(k) Rollover

Rolling over a 401(k) balance involves moving funds from an employer-sponsored plan to another qualified retirement account, most commonly an Individual Retirement Account (IRA). This process helps maintain the tax-deferred status of the retirement savings.

A direct rollover is the most recommended method, where the funds are transferred directly from the 401(k) plan administrator to the new IRA custodian or another plan administrator. The money never passes through the retiree’s hands, which prevents mandatory tax withholding and avoids the 60-day rule.

Alternatively, an indirect rollover, also known as a 60-day rollover, involves the 401(k) funds being distributed directly to the individual. The retiree then has 60 days from the date of receipt to deposit the full amount into an IRA or another qualified retirement plan. If the funds originate from a pre-tax 401(k), the plan administrator is required to withhold 20% for federal income tax. To avoid income tax and penalties, the retiree must deposit the full original sum into the new account within the 60-day window, including replacing the 20% that was withheld. If the full amount is not redeposited, the un-rolled portion becomes a taxable distribution.

When performing a rollover, a traditional 401(k) can be rolled into a Traditional IRA without immediate tax consequences, allowing continued tax-deferred growth. If rolling a Roth 401(k) to a Roth IRA, this transfer is also tax-free. A traditional 401(k) can also be converted to a Roth IRA, which is known as a Roth conversion; however, this triggers a taxable event on the converted amount in the year of conversion.

The procedural steps for initiating a rollover involve contacting the former employer’s 401(k) plan administrator and the new IRA custodian. The plan administrator will provide the necessary forms and instructions.

Tax Implications of Your Choices

The tax treatment of 401(k) funds varies depending on the chosen distribution method, which can impact a retiree’s financial landscape.

Leaving funds in the former employer’s 401(k) plan allows continued tax-deferred growth. These accounts are subject to Required Minimum Distributions (RMDs) once the account holder reaches age 73, increasing to 75 in 2033. Failure to take the full RMD by the deadline can result in a penalty, which is 25% of the amount not distributed, though it can be reduced to 10% if corrected within a specific timeframe.

Rolling over funds into a Traditional IRA is a tax-free event, preserving the tax-deferred status. Traditional IRAs are also subject to RMD rules, with the same age requirements. Withdrawals from a Traditional IRA in retirement are taxed as ordinary income, like those from a Traditional 401(k).

Converting a traditional 401(k) to a Roth IRA is a taxable event in the year the conversion occurs. The entire pre-tax amount converted is added to the retiree’s gross income and taxed at their ordinary income tax rate. While this results in an immediate tax bill, qualified withdrawals from a Roth IRA in retirement are tax-free, including both contributions and earnings. Roth IRAs do not have RMD requirements for the original owner during their lifetime.

Cashing out a 401(k) by taking a lump-sum distribution results in the entire amount being taxed as ordinary income in the year of receipt. This can lead to a tax liability, potentially pushing the retiree into a higher tax bracket. If the distribution occurs before age 59½, an additional 10% early withdrawal penalty applies.

Key Considerations When Deciding

When making decisions about a 401(k) in retirement, several practical factors warrant consideration. These elements can influence the long-term management and accessibility of retirement savings.

Investment options and fees vary between employer-sponsored 401(k) plans and IRAs. IRAs often provide a broader selection of investment products compared to the more limited choices within a 401(k) plan. Fee structures can differ, with some IRA providers offering lower costs.

Creditor protection is another aspect, as 401(k)s and IRAs may offer different levels of safeguarding from legal judgments. Employer-sponsored plans like 401(k)s receive strong federal protection from creditors under ERISA. While IRAs offer some federal protection in bankruptcy, their protection outside of bankruptcy can vary by state law.

Access to funds can also be a differentiating factor, as plan rules may impose restrictions on withdrawals not present with an IRA. IRAs often provide greater flexibility in terms of when and how funds can be withdrawn. Some 401(k) plans might have specific rules for partial withdrawals or require a full distribution upon leaving employment.

Beneficiary designations ensure that retirement assets are transferred according to one’s wishes. Both 401(k)s and IRAs allow for the naming of beneficiaries, which bypasses the probate process. Review and update these designations regularly.

Estate planning implications should be considered, particularly regarding how retirement accounts will transfer to heirs. Traditional pre-tax retirement accounts are subject to income tax when distributed to beneficiaries. For most non-spouse beneficiaries, the SECURE Act requires the entire inherited account to be distributed within 10 years of the original owner’s death. Roth IRAs, with their tax-free qualified withdrawals for beneficiaries, can be a tool in estate planning.