What Should I Do With My 401(k) When I Retire?

Retirement brings important decisions about managing accumulated savings. A 401(k) plan often represents a substantial portion of an individual’s retirement assets. Deciding the future of these funds requires careful consideration, as choices made now can impact financial security and tax obligations throughout retirement. Understanding the available options and their implications is essential for navigating this financial landscape.

Your 401(k) Options at Retirement

Upon leaving employment, individuals face several choices regarding their 401(k) funds. Each option carries distinct tax implications, affects access to funds, and provides varying degrees of investment control. Evaluating these paths carefully helps align financial decisions with personal retirement goals.

Leave Funds in Former Employer’s 401(k)

One option is to leave funds within the former employer’s 401(k) plan. This is permissible if the account balance exceeds a certain threshold. A primary advantage is the strong creditor protection afforded by federal law, specifically ERISA. Individuals who separate from service in the year they turn age 55 or later may access these funds without incurring the 10% early withdrawal penalty, a provision known as the “Rule of 55.”

Rollover to Traditional IRA

Alternatively, individuals can roll over their 401(k) into a Traditional Individual Retirement Account (IRA). This involves a direct transfer of funds, ensuring the money remains tax-deferred without triggering immediate taxes or penalties. An IRA offers a broader selection of investment products and greater flexibility in managing the portfolio compared to employer-sponsored plans. While IRAs receive some creditor protection, it is less extensive than that provided to 401(k)s under ERISA, varying by state law.

Roth Conversion

Another choice involves rolling over a pre-tax 401(k) to a Roth IRA, known as a Roth conversion. This requires paying income taxes on the entire converted amount in the year of conversion, as funds transition from tax-deferred to after-tax status. Qualified withdrawals from the Roth IRA in retirement, including earnings, will then be entirely tax-free, provided conditions are met, such as having the account open for at least five years and being age 59½ or older. This strategy can be beneficial if one anticipates being in a higher tax bracket in retirement than at the time of conversion.

Rollover to New Employer’s 401(k)

For individuals transitioning to a new employer, rolling over the old 401(k) balance into the new employer’s 401(k) plan is an option. This allows for consolidation of retirement accounts, simplifying management and maintaining strong federal creditor protections. However, not all new employer plans accept rollovers, and investment options or fees in the new plan might differ significantly from the old one.

Lump-Sum Cash Distribution

Taking a lump-sum cash distribution involves withdrawing the entire 401(k) balance. This immediately subjects the full amount to ordinary income tax. If the individual is under age 59½, an additional 10% early withdrawal penalty applies, unless an exception is met. Plan administrators are required to withhold 20% of the distribution for federal income tax, which may not cover the full tax liability, potentially leading to a substantial tax bill.

Purchase an Annuity

A portion or all of the 401(k) funds can be used to purchase an annuity, which converts a lump sum into a guaranteed stream of income payments, often for life. Various types exist, such as immediate or deferred annuities. The income received from an annuity purchased with pre-tax 401(k) funds is taxed as ordinary income, similar to other pension payments. This option offers predictability and removes investment management responsibilities, but it sacrifices liquidity and control over the principal.

Understanding Required Minimum Distributions

Regardless of the chosen path for a traditional 401(k) or IRA, individuals eventually face Required Minimum Distributions (RMDs), which are mandatory annual withdrawals from retirement accounts. These distributions ensure that tax-deferred savings are eventually taxed and distributed, rather than being held indefinitely. RMDs apply to traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k)s, 403(b)s, and 457(b) plans.

RMD Age Changes

The age at which RMDs must begin has changed. For individuals who turn age 73 in 2023 or later, RMDs commence in the year they reach age 73. However, the first RMD can be delayed until April 1 of the following year. All subsequent RMDs must then be taken by December 31 of each year, meaning delaying the first RMD will result in two distributions in the same calendar year.

RMD Exemptions and Future Changes

The RMD age is scheduled to increase to 75 for individuals who turn 74 after December 31, 2032. Roth IRAs are exempt from RMDs for the original account owner during their lifetime. Effective for 2024 and later tax years, Roth 401(k) accounts are also exempt from pre-death RMD rules for the original account owner.

RMD Calculation and Penalties

Calculating the RMD amount involves dividing the account balance as of December 31 of the previous year by a life expectancy factor provided by the IRS. Failing to take the full RMD amount by the deadline can result in penalties. The IRS imposes an excise tax of 25% on the amount not withdrawn as required. This penalty can be reduced to 10% if the RMD shortfall is corrected and the necessary amount is withdrawn within a two-year period.

Key Considerations for Your Decision

Choosing a path for a 401(k) at retirement involves assessing financial and personal factors. These considerations help individuals determine which option best supports their retirement lifestyle and long-term financial objectives.

Age and Access Needs

An individual’s age and immediate access needs influence the decision. If retirement occurs before age 59½, accessing funds incurs a 10% early withdrawal penalty, unless specific exceptions apply, such as the “Rule of 55” for withdrawals from the current employer’s 401(k). If funds are not needed immediately, allowing them to continue growing tax-deferred for a longer period can be advantageous. Planning for potential future large expenses, like healthcare costs, also plays a role in determining how accessible funds need to be.

Tax Situation

Current and future tax situations are important considerations, especially when contemplating Roth conversions or lump-sum distributions. Converting a pre-tax 401(k) to a Roth IRA means paying taxes now, which can be strategic if one expects to be in a higher tax bracket in retirement. Conversely, deferring taxes by rolling into a Traditional IRA makes sense if current income is high and a lower tax bracket is anticipated in retirement. Large withdrawals can push an individual into a higher tax bracket, increasing the overall tax burden on retirement income.

Investment Control and Management

The desired level of investment control and comfort with managing a portfolio guides the decision. Rolling over to an IRA offers a wider array of investment choices, providing greater flexibility than employer-sponsored 401(k)s. However, this increased control also demands a higher level of personal involvement and investment knowledge. If an individual prefers a simpler, professionally managed approach, keeping funds in a 401(k) or purchasing an annuity is more suitable.

Legacy Planning

Legacy planning goals, particularly the desire to pass wealth to heirs, can also influence the choice. Different account types have varying rules regarding beneficiary distributions and their tax implications. For instance, Roth accounts offer tax-free withdrawals for beneficiaries, making them attractive for wealth transfer, although beneficiaries are still subject to RMD rules on inherited Roth accounts. Understanding how each option impacts the tax burden on inherited assets is an an important component of comprehensive estate planning.

Fees and Costs

A comparison of fees and costs associated with each option is important. 401(k) plans can have administrative, recordkeeping, and investment management fees that vary widely by plan. IRAs have lower custodial fees, but investment expenses within an IRA can still impact overall returns. Analyzing these costs helps ensure that the chosen retirement vehicle does not erode savings over time.