What Happens to My 401(k) When I Retire?

Upon reaching retirement, individuals often consider how to manage their 401(k) savings, which represent years of dedicated contributions and tax-deferred growth. These employer-sponsored retirement plans accumulate funds that become accessible as a new phase of life begins. This overview will detail the various ways to handle 401(k) assets at retirement, along with their tax considerations and specific rules for required withdrawals.

Understanding Your 401(k) Distribution Options

Upon retiring, individuals typically have several choices for managing their 401(k) funds. One common approach is to leave the funds within the former employer’s plan, provided the plan rules allow it. This option permits the funds to continue growing tax-deferred within the existing investment structure.

Another frequent choice is rolling over the 401(k) into an Individual Retirement Account (IRA). A direct rollover is generally preferred as the funds move between financial institutions without the account holder taking physical possession, thereby avoiding potential tax withholdings and penalties. This allows for consolidation of retirement savings and often provides a broader array of investment options than an employer-sponsored plan.

For individuals who begin a new job after retirement, rolling over the 401(k) balance into a new employer’s 401(k) plan is sometimes possible. This option depends on whether the new plan accepts rollovers from previous employers. It can be a convenient way to keep all retirement savings within a workplace plan, though it is less common for individuals fully retiring from the workforce.

Taking a lump-sum distribution means receiving the entire 401(k) balance at once. It can have substantial financial consequences, particularly regarding taxation. Individuals opting for this method should carefully consider the impact on their current income and tax bracket.

Alternatively, a retiree can opt for periodic withdrawals directly from the 401(k) plan. This involves setting up regular payments from the account, similar to receiving a salary. The frequency of these withdrawals, such as monthly, quarterly, or annually, can often be customized to meet income needs. The remaining account balance continues to be invested according to the plan’s allocations, allowing for continued growth.

Tax Considerations for Distributions

Each method of distributing 401(k) funds carries distinct tax implications that retirees must consider. If funds are left in the former employer’s plan, they continue to grow on a tax-deferred basis. When withdrawals are eventually taken from a traditional 401(k), these amounts are taxed as ordinary income in the year they are received.

Rolling over a traditional 401(k) to a traditional IRA is a tax-free transfer. Subsequent distributions from the traditional IRA will then be taxed as ordinary income, similar to withdrawals from the 401(k). If a Roth 401(k) is rolled over to a Roth IRA, this is also a tax-free transfer, and qualified distributions from the Roth IRA will remain tax-free. Converting pre-tax 401(k) funds to a Roth IRA, however, is a taxable event, with the converted amount taxed as ordinary income in the year of conversion.

Taking a lump-sum distribution from a traditional 401(k) means the entire amount is taxed as ordinary income in the year it is received. This can significantly increase taxable income for the year, potentially pushing the retiree into a higher tax bracket.

Periodic withdrawals from a traditional 401(k) are also taxed as ordinary income as each payment is received. This allows for more predictable tax planning, as the income is spread out over time rather than concentrated in a single year.

For those with a Roth 401(k), qualified distributions are tax-free. To be considered qualified, the distribution must occur after the account has been open for at least five years, and the account holder must be at least age 59½, disabled, or deceased. This tax-free status on qualified distributions extends to Roth IRAs when a Roth 401(k) is rolled over.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are mandatory annual withdrawals from most tax-deferred retirement accounts, including traditional 401(k)s and traditional IRAs. The SECURE Act 2.0, enacted in 2022, raised the age at which RMDs must begin to age 73, effective January 1, 2023. This age will further increase to 75 starting in 2033.

The amount of an RMD is calculated based on the account balance as of December 31 of the previous year and the account owner’s life expectancy, using tables published by the IRS. This means the RMD amount will vary each year.

RMD rules apply to various retirement accounts, including traditional IRAs, SEP IRAs, SIMPLE IRAs, and employer-sponsored plans like 401(k)s, 403(b)s, and 457(b)s. However, Roth IRAs are not subject to RMDs for the original account owner during their lifetime. Similarly, Roth 401(k)s are also exempt from RMDs for the original owner if the funds remain in the plan.

Failing to take the full RMD by the deadline can result in a penalty. The penalty for not taking the required amount is 25% of the amount not distributed.

A “still-working exception” may allow individuals who are still employed and participating in their employer’s 401(k) plan to delay RMDs from that specific plan. This exception applies as long as they are not a 5% owner of the business sponsoring the plan. However, this exception does not apply to RMDs from traditional IRAs, which must begin at the designated age regardless of employment status.