What to Do With Your 401k When You Retire?

A 401(k) plan is a retirement savings vehicle allowing individuals to contribute earnings, often with employer contributions, into a tax-advantaged investment account. As retirement nears, decisions about accumulated 401(k) assets become important. These choices significantly impact immediate financial flexibility and future tax obligations.

Understanding 401(k) Options at Retirement

Upon retirement, individuals with a 401(k) have three primary options for their accumulated funds. One option is to leave funds within the former employer’s 401(k) plan, keeping assets invested in its existing offerings.

Another pathway is rolling over the 401(k) funds. This transfers assets from the former employer’s plan into a new retirement account, such as an Individual Retirement Account (IRA) or a new employer’s 401(k). A rollover maintains the tax-deferred status of savings.

The third option is taking a distribution, which involves directly withdrawing funds as a lump sum or through periodic payments. Each option has distinct implications for fund access, investment flexibility, and tax treatment.

Keeping Funds in Your Former Employer’s Plan

Retirees may leave 401(k) funds within their former employer’s plan, often permitted if the account balance exceeds $5,000. This keeps funds invested in the plan’s existing lineup, which may include institutional-class funds with lower expense ratios than retail-class funds in an IRA.

However, no further contributions can be made to the account. Investment options may also be more limited compared to an IRA. Plan-specific rules dictate fund access, with some plans restricting partial withdrawals or requiring a full lump-sum distribution if funds are needed.

Administrative support continues from the former employer’s plan administrator. While federal law provides creditor protections, retirees should understand the specific terms, conditions, and maintenance fees for the dormant account.

Rolling Over Your 401(k) Funds

Rolling over 401(k) funds involves transferring assets from a former employer’s plan into another qualified retirement account, such as an IRA or a new employer’s 401(k). This allows retirement savings to maintain their tax-deferred status, avoiding immediate taxation and potential penalties. There are two primary methods for executing a rollover: direct and indirect.

Information Gathering/Preparation

A direct rollover involves the plan administrator transferring funds directly from the former 401(k) to the new retirement account custodian. This bypasses the account holder, preventing mandatory tax withholding.

An indirect rollover means the 401(k) plan issues a check directly to the account holder, who then has 60 days to deposit the full amount into a new qualified retirement account to avoid it being a taxable distribution. For an indirect rollover, the plan administrator must withhold 20% for federal income tax. To avoid taxation on the full amount, the retiree must deposit the 80% received plus an additional 20% from other sources within 60 days. If the full amount is not rolled over, the unrolled portion becomes a taxable distribution and may incur a 10% early withdrawal penalty if the account holder is under age 59½.

To initiate a rollover, information and documentation are required. This includes the former 401(k) plan’s account number, the plan administrator’s contact information, and details of the receiving institution, such as the new account number and its tax identification number. Retirees must determine if the receiving account will be a Traditional IRA, Roth IRA, or a new employer’s 401(k), as this choice influences future tax treatment.

The former 401(k) plan administrator provides specific rollover forms, which must be accurately completed. These forms require the retiree’s personal information, old plan details, and instructions for fund disposition, including the chosen rollover type and destination account details.

Procedural Action

After gathering information and completing forms, submit the rollover request. For a direct rollover, the retiree instructs the former 401(k) plan administrator to transfer funds electronically or via check payable to the new custodian. Many financial institutions offer online portals or phone lines to facilitate this.

Expect a processing period, from a few days for electronic transfers to several weeks for check-based rollovers. The former plan administrator sends a confirmation notice once the transfer initiates, and the receiving institution notifies upon receipt.

If an indirect rollover was chosen and a check issued, funds must be deposited into the new qualified account within 60 days of receipt. Failure to meet this deadline results in the entire distribution being treated as a taxable withdrawal, subject to ordinary income tax and potentially the 10% early withdrawal penalty. The new account custodian can assist with the deposit process and confirm proper allocation.

Taking a Distribution from Your 401(k)

Taking a distribution from a 401(k) means directly withdrawing funds from the account. This can be structured as a lump-sum payment or periodic payments. Each distribution method has distinct tax implications.

Information Gathering/Preparation

When taking a distribution, funds from a traditional 401(k) are taxed as ordinary income in the year received. This adds the distribution amount to other taxable income, potentially pushing retirees into a higher tax bracket. If under age 59½, distributions may also be subject to an additional 10% early withdrawal penalty.

Mandatory federal income tax withholding of 20% applies to eligible rollover distributions paid directly to the retiree, even if a rollover is intended. This withholding is an upfront payment towards tax liability, not an additional tax. For non-rollover distributions, a 10% federal withholding may apply, though retirees can sometimes elect out.

Distributions from a Roth 401(k) are tax-free and penalty-free if the account has been open for at least five years and the retiree is age 59½ or older.

Retirees should assess their immediate financial needs, current and projected tax bracket, and the potential impact of a distribution on their overall retirement income strategy. Understanding the specific types of distributions allowed by their plan, whether lump sum or installment payments, is also important, as some plans may limit options.

Procedural Action

To request a distribution, the retiree must contact their 401(k) plan administrator. This involves submitting a formal withdrawal request form, available through the plan’s website or customer service. The form requires details like the desired distribution amount, chosen method (e.g., lump sum, monthly payments), and preferred payment method (e.g., direct deposit, physical check).

The plan administrator processes the request, and funds are disbursed within a few weeks, though processing times vary. For direct deposit, funds transfer electronically to the specified bank account. If a check is issued, it mails to the retiree’s address.

Upon disbursement, the retiree receives a Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” reporting the gross distribution amount and any federal income tax withheld. This form is used for filing income taxes, detailing the taxable portion of the distribution.

Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory annual withdrawals individuals must begin taking from most traditional retirement accounts, including 401(k)s, once they reach a certain age. These distributions ensure tax-deferred savings are eventually taxed by the government. The age for RMDs is 73 for those who reach that age in 2023 or later.

The first RMD must be taken by April 1 of the year following the calendar year the retiree reaches their RMD age. Subsequent RMDs must be taken by December 31 of each year. For example, if a retiree turns 73 in 2024, their first RMD is due by April 1, 2025, and their second by December 31, 2025.

The RMD amount is calculated annually by dividing the account balance as of December 31 of the previous year by a life expectancy factor from the IRS Uniform Lifetime Table. For instance, if an account balance was $100,000 and the life expectancy factor was 26.5, the RMD would be approximately $3,773.58.

Failing to take a timely or sufficient RMD 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 missed RMD is corrected and a corrected tax return submitted within two years. Roth 401(k) accounts are exempt from RMDs during the original owner’s lifetime.