What’s the Best Thing to Do With a 401k When You Retire?

Upon reaching retirement, individuals face a significant decision regarding their 401(k) retirement savings. This account, often accumulated over many years of employment, represents a substantial portion of an individual’s financial security for their post-working life. Navigating the choices for these funds requires careful consideration, as each option carries distinct financial implications and potential tax consequences.

Maintaining Your Account with Your Former Employer

One option for managing 401(k) funds at retirement is to leave them within the former employer’s plan, provided the plan permits this. Another potential advantage in some jurisdictions is that employer-sponsored plans may offer greater protection from creditors compared to individual accounts.

However, keeping funds in a former employer’s 401(k) plan often comes with limitations. Investment choices may be restricted to a specific menu of funds, which could limit diversification or the ability to pursue a desired investment strategy. Fees, while sometimes competitive, might be higher than those available through other retirement account options. Additionally, individuals may experience a lack of direct control over their investments and could face inconvenience if the plan administrator or its offerings change over time.

Accessing funds might also be less flexible, as employer plans typically have specific rules for withdrawals that differ from individual retirement accounts. Consolidating multiple retirement accounts becomes more challenging if funds remain scattered across various former employer plans. Required Minimum Distributions (RMDs) will eventually apply.

Transferring Funds to an Individual Retirement Account

Transferring 401(k) funds to an Individual Retirement Account (IRA) is a widely utilized option that offers expanded control and investment flexibility. An IRA rollover involves moving retirement savings from an employer-sponsored plan into an IRA, allowing the funds to continue growing on a tax-deferred basis. This process can be executed through two primary methods: a direct rollover or an indirect rollover.

A direct rollover, also known as a trustee-to-trustee transfer, is generally the preferred method due to its simplicity and tax efficiency. In this process, the funds are transferred directly from the 401(k) plan administrator to the chosen IRA custodian without the funds ever passing through the individual’s hands. This method ensures that no taxes are withheld and no immediate tax consequences arise from the transfer. It streamlines the process and minimizes the risk of errors or penalties.

Conversely, an indirect rollover involves the individual receiving a check for the 401(k) distribution, which they then must deposit into an IRA within 60 days. This method carries notable risks and complexities. The 401(k) plan administrator is required to withhold 20% of the distribution for federal income taxes, even if the individual intends to roll over the entire amount. To avoid the portion withheld from being considered a taxable distribution and potentially subject to early withdrawal penalties, the individual must deposit the full original amount of the distribution into the IRA, making up the 20% withholding from other personal funds. Failure to deposit the full amount within the 60-day window can result in the entire distribution being treated as taxable income and possibly incurring a 10% early withdrawal penalty if the individual is under age 59½.

The benefits of an IRA rollover are substantial, including a significantly broader range of investment options, which can allow for more tailored portfolio diversification. Individuals may also find lower administrative fees with certain IRA custodians compared to some employer plans. Consolidating multiple retirement accounts into a single IRA simplifies financial management and provides greater control over the account. While RMDs still apply to Traditional IRAs, Roth IRAs do not have RMDs for the original owner during their lifetime, offering an additional layer of flexibility.

Before initiating a rollover, it is important to choose an IRA custodian and understand the tax implications of the different IRA types. A Traditional IRA is typically used for rolling over pre-tax 401(k) funds, maintaining their tax-deferred status. If an individual had a Roth 401(k), the funds would generally roll into a Roth IRA tax-free. Converting pre-tax 401(k) funds to a Roth IRA, however, would trigger immediate taxation on the converted amount, as the funds transition from tax-deferred to tax-free in retirement.

Taking a Direct Cash Distribution

Taking a direct cash distribution from a 401(k) means withdrawing the funds outright, rather than transferring them to another retirement account. This action immediately converts the retirement savings into taxable income. The entire pre-tax portion of the distribution is added to the individual’s gross income for the year, potentially pushing them into a higher tax bracket.

A significant consequence of a direct cash distribution is the mandatory 20% federal tax withholding applied at the time of the payout. Beyond the income tax, distributions taken before age 59½ are generally subject to an additional 10% early withdrawal penalty.

There are limited exceptions to this 10% penalty, such as separation from service at or after age 55 for funds from that specific employer’s plan. However, even with an exception to the penalty, the distribution remains subject to ordinary income tax. Considering the immediate tax burden and potential penalties, cashing out a 401(k) is typically not recommended unless faced with an immediate and dire financial necessity. This action significantly depletes retirement savings, sacrificing future tax-deferred growth and long-term financial security. State income taxes may also apply, further reducing the net amount received.

Understanding Required Minimum Distributions

Required Minimum Distributions (RMDs) are mandatory withdrawals that individuals must begin taking from their traditional retirement accounts, including 401(k)s and Traditional IRAs, once they reach a certain age. These distributions ensure that tax-deferred retirement savings are eventually taxed. For most individuals, RMDs generally commence in the year they turn age 73.

The amount of an RMD is calculated annually based on the account balance at the end of the previous year, specifically December 31st, divided by a life expectancy factor provided by IRS tables. For example, if an individual reaches age 73 in 2024, their first RMD would be due by April 1, 2025, based on their account balance at the end of 2023.

Failing to take the full RMD by the deadline can result in substantial penalties. The Internal Revenue Service (IRS) may impose an excise tax of 25% on the amount that was not distributed as required. This penalty can be reduced to 10% if the oversight is corrected promptly within a specified timeframe.

RMD rules apply whether the retirement funds remain in a former employer’s 401(k) plan or are rolled over into a Traditional IRA. A significant distinction exists for Roth IRAs, which are not subject to RMDs for the original account owner during their lifetime.