What Should You Do With Your 401k When You Retire?

Deciding what to do with your 401(k) as you approach retirement is a significant financial decision. Your 401(k) often represents a substantial portion of your wealth, requiring careful consideration of available options. Each path offers distinct advantages and considerations that can impact your tax situation, investment flexibility, and access to funds.

Leaving Your 401(k) with Your Former Employer

One option is to leave your 401(k) funds in your former employer’s plan, if permitted. This can offer advantages, such as institutional-class investment options with potentially lower expense ratios. These plans also offer strong creditor protection under federal law.

However, keeping funds in a former employer’s 401(k) plan can have limitations. Investment choices might be narrower compared to other retirement accounts, restricting diversification. Fees for 401(k) plans can vary. If choosing this option, confirm with the plan administrator that the account can remain.

Rolling Over Your 401(k) to an IRA

Rolling over your 401(k) to an Individual Retirement Account (IRA) is a common decision upon retirement, allowing your funds to maintain their tax-advantaged status. This process involves transferring funds from your employer-sponsored plan into an IRA without triggering immediate taxes. A significant benefit of an IRA is the broader range of investment choices available, offering more control and potential for diversification compared to many 401(k) plans. IRAs may also have lower fees.

When considering a rollover, you can choose between a Traditional IRA or a Roth IRA. Rolling pre-tax 401(k) funds into a Traditional IRA keeps them tax-deferred, with taxes paid only upon withdrawal. Converting pre-tax 401(k) funds to a Roth IRA requires paying income taxes on the converted amount in the year of the rollover. The advantage of a Roth IRA is that qualified withdrawals in retirement are tax-free.

To initiate a rollover, gather information from your 401(k) provider and select an IRA custodian and the type of IRA you wish to open. The most common method is a direct rollover, where funds are transferred directly from your 401(k) plan to your new IRA custodian. This avoids the funds ever passing through your hands, minimizing tax withholding and potential penalties.

An alternative is an indirect or 60-day rollover. In this scenario, the funds are distributed directly to you. You then have 60 calendar days from the date of receipt to deposit the full amount into a new IRA. Your 401(k) plan administrator is generally required to withhold 20% of the distribution for federal taxes.

To complete the rollover and avoid the distribution being treated as taxable income, you must deposit the entire original distribution amount, including the 20% that was withheld, within the 60-day window. If you fail to meet this deadline or deposit the full amount, the unrolled portion becomes a taxable distribution, potentially subject to ordinary income tax and a 10% early withdrawal penalty if you are under age 59½. Monitor the transfer with both your former 401(k) administrator and your new IRA custodian to ensure the process is completed accurately.

Taking Distributions from Your 401(k)

Another approach upon retirement is to take direct distributions from your 401(k) plan. This can involve withdrawing a lump sum, or if the plan permits, taking periodic withdrawals. Taking a direct distribution means the funds are paid out to you and are no longer held within a tax-advantaged retirement account.

Distributions from a traditional 401(k) are taxed as ordinary income. If you are under age 59½, these withdrawals may also be subject to an additional 10% early withdrawal penalty, although some exceptions apply, such as the rule of 55. A large lump sum distribution could push you into a higher income tax bracket.

The process for requesting a distribution involves contacting your 401(k) plan administrator. You will need to complete a distribution request form, specifying the amount or frequency of withdrawals. Funds are then disbursed to you. Confirm with your plan administrator what distribution options are available, as some plans may not offer periodic withdrawals, only lump sums.

Understanding Required Distributions

Regardless of how you manage your 401(k) upon retirement, you will eventually need to consider Required Minimum Distributions (RMDs). These are minimum amounts that individuals must begin withdrawing from their traditional retirement accounts annually. For most individuals, RMDs begin in the year they reach age 73. This rule applies to traditional 401(k)s, traditional IRAs, SEP IRAs, and SIMPLE IRAs.

Roth IRAs are an exception, as they do not have RMDs for the original owner during their lifetime. If you fail to take the full RMD amount by the deadline, the Internal Revenue Service (IRS) imposes an excise tax on the amount not withdrawn. This penalty is 25% of the shortfall, which can be reduced to 10% if the missed distribution is corrected within two years.

The amount of your RMD is calculated based on your account balance at the end of the previous calendar year and your life expectancy. Your plan administrator or IRA custodian will typically calculate this amount for you, but it remains your responsibility to ensure the RMD is taken by the annual December 31st deadline, or April 1st of the year following the year you turn 73 for your first RMD. A special provision, known as the “still working” exception, may allow you to delay RMDs from your current employer’s 401(k) plan if you are still actively employed by that company and do not own more than 5% of the business. This exception applies only to the plan of your current employer, meaning RMDs from other retirement accounts, such as IRAs or previous employer 401(k)s, would still be required.