When You Retire, How Does Your 401(k) Work?

A 401(k) plan is a tax-advantaged retirement savings vehicle offered by many employers. Contributions to a traditional 401(k) are made with pre-tax dollars, and the money grows without being taxed until withdrawn in retirement. This tax-deferred growth allows savings to compound over time.

Options for Your 401(k) at Retirement

Upon retirement, individuals with a 401(k) plan from a former employer face several choices regarding their accumulated savings. One option is to leave the funds within the former employer’s plan, if the plan rules permit it. This can offer continuity with familiar investment options and potentially lower institutional fees, but it might also come with limited investment choices and less direct control over the account. Some plans may even require balances below a certain threshold, such as $5,000, to be moved out of the plan.

Another common choice is to roll over the 401(k) funds into an Individual Retirement Account (IRA). This can be done as a direct rollover, where the funds are transferred directly from the 401(k) administrator to the IRA custodian, or an indirect rollover, where a check is issued to the individual, who then has 60 days to deposit the funds into a new IRA. Rolling over to an IRA provides a wider array of investment choices, more flexibility in managing distributions, and the ability to consolidate multiple retirement accounts into one. However, IRAs do not offer the same level of creditor protection as employer-sponsored plans in some states.

For those transitioning to a new employer who offers a 401(k), rolling over the funds into the new plan is a third possibility. This option allows for consolidation of retirement savings in one place, which can simplify management. However, the new employer’s plan might have different investment options, fee structures, or eligibility requirements that need to be considered. A direct rollover, where funds are sent directly between plan administrators, is recommended to avoid potential tax withholdings and penalties.

A lump-sum distribution of the 401(k) balance is another option. While it provides immediate access to the funds, the entire amount is subject to income tax in the year received, which can increase one’s tax liability. If the individual is under age 59½ and no exception applies, a 10% early withdrawal penalty may also be assessed on top of the income tax.

Taking Money from Your 401(k)

Once a decision is made about where the 401(k) funds will be held in retirement, the next step involves understanding how to withdraw money. Retirees can choose from different types of withdrawals, such as periodic payments, partial withdrawals, or a full lump-sum withdrawal. Periodic payments involve receiving a set amount at regular intervals, like monthly or quarterly, to manage cash flow in retirement. Partial withdrawals allow for taking specific amounts as needed for flexibility.

The process for requesting a distribution involves contacting the plan administrator or the financial institution holding the retirement account. This requires completing specific forms that outline the desired withdrawal amount, frequency, and direct deposit information. Account holders may also need to specify tax withholding preferences at this stage. Accurate submission of all required documentation avoids delays in receiving funds.

When withdrawing funds, individuals might consider the order in which different types of contributions are accessed, especially if they have a Roth 401(k) or a traditional IRA with after-tax contributions. For traditional pre-tax accounts, all withdrawals are taxable. For Roth accounts, qualified distributions of both contributions and earnings are tax-free, but non-qualified distributions may result in taxes on earnings. Understanding these distinctions can influence a strategic withdrawal approach.

Taxation of 401(k) Withdrawals

The tax treatment of 401(k) withdrawals is a consideration for retirees. For traditional 401(k)s, contributions are made on a pre-tax basis, meaning they are taxed as ordinary income upon withdrawal in retirement. The amount of tax owed depends on the individual’s income tax bracket in the year the distribution is received. A large lump-sum withdrawal could push an individual into a higher tax bracket, resulting in a greater tax liability.

Withdrawals made before age 59½ are subject to a 10% additional tax, known as an early withdrawal penalty, on top of regular income taxes. However, several exceptions allow for penalty-free withdrawals, even if the individual is under 59½. Relevant exceptions for retirees include separation from service at or after age 55, or if the withdrawal is due to total and permanent disability. Other exceptions exist for specific circumstances like unreimbursed medical expenses exceeding a certain percentage of adjusted gross income.

For Roth 401(k) accounts, the tax rules are different because contributions are made with after-tax dollars. Qualified distributions from a Roth 401(k) are entirely tax-free and penalty-free. To be considered a qualified distribution, two main requirements must be met: the account must have been established for at least five years, and the distribution must occur after age 59½, or due to disability or death. If these conditions are not met, earnings withdrawn from a Roth 401(k) may be subject to income tax and the 10% early withdrawal penalty.

In addition to federal income taxes, state income taxes may also apply to 401(k) withdrawals, depending on the state of residence. While some states do not tax retirement income, many do, and the tax rates can vary. Factor in state tax implications when planning withdrawals. Federal income tax withholding applies to distributions, with a mandatory 20% federal withholding for eligible rollover distributions not directly rolled over. Retirees can adjust their withholding to better manage their tax liability throughout the year.

Required Minimum Distributions (RMDs)

Required Minimum Distributions (RMDs) are mandatory annual withdrawals that individuals must take from most tax-deferred retirement accounts, including traditional 401(k)s, once they reach a certain age. These rules ensure deferred taxes are collected. The SECURE Act 2.0 legislation changed the age at which RMDs begin.

For individuals who turn age 73 in 2023 or later, RMDs begin in the year they reach age 73. However, the first RMD can be delayed until April 1 of the year following the year the individual turns 73. If this delay option is used, both the first and second RMDs would need to be taken in the same calendar year, which could result in a higher taxable income for that year. For those still working past age 73, RMDs from their current employer’s 401(k) plan can be delayed until retirement, provided they are not a 5% owner of the business.

The calculation of an RMD is based on the account balance at the end of the previous year and the account holder’s life expectancy, as determined by IRS life expectancy tables, such as the Uniform Lifetime Table. Financial institutions provide the RMD amount to account holders. Failing to take the full RMD by the deadline can result in a penalty. The penalty for insufficient or missed RMDs is 25% of the amount not withdrawn. This penalty can be reduced to 10% if the missed RMD is corrected and the tax return is filed promptly.

RMD rules apply to various tax-deferred accounts, including Traditional IRAs, SEP IRAs, SIMPLE IRAs, 403(b)s, and 457(b) plans, in addition to 401(k)s. Roth IRAs do not have RMDs during the original owner’s lifetime. Due to changes from the SECURE Act 2.0, most Roth 401(k)s are no longer subject to RMDs for the original owner, aligning them with Roth IRA rules.