How a 401(k) Works Once You Retire

A proper financial plan can make a significant difference when you are on the cusp of retirement. When you retire, it is crucial to have a portfolio of assets that will allow you to maintain your standard of living and further grow your wealth.

One financial tool that has almost become synonymous with retirement in the US is the 401(k) plan. As one of the most popular forms of retirement plans in the country, 401(k) offers employees the opportunity to set aside a significant portion of their earnings towards savings. The plan offers tax benefits, withdrawal options, and predetermined contribution limits. If you wish to learn about the 401k, its different types, contribution limits, and the different ways you can use this retirement plan, consult with a professional financial advisor who can guide you on the same.

Let’s read more about what a 401(k) is and how it works post-retirement.

What is a 401(k)?

The 401(k) plan is a retirement savings plan extended to salaried persons by American employers. The installments are automatically deducted from the paychecks of the employees. The sum withdrawn is invested in a form that suits the employees. The type of investment is chosen from a predetermined list of options, such as mutual funds and exchange-traded funds.

The basic idea behind a tax-advantaged retirement plan like the 401(k) is to empower individuals with enough income when they no longer draw a regular salary. There are two types of 401(k) plans – traditional 401(k) and Roth 401(k). They differ based on their tax structures. In a traditional 401(k) plan, money is deducted from the employee’s salary before taxation. Taxes are levied when the funds are collected upon retirement. On the other hand, in a Roth 401(k) plan, the contributions are collected after taxation. So, no additional taxes are charged when money is withdrawn during retirement.

When can I withdraw from a 401(k)?

You do not have to wait until you retire to withdraw money from your 401(k) plan. As per Internal Revenue Service (IRS) rules, you can tap into the 401(k) funds before turning 59.5 years old, even if you haven’t retired. However, you will have to pay a 10% penalty under the early withdrawal option.

You can only be exempt from paying the withdrawal penalty if you have been removed from service by your employer. In this case, you don’t have to pay the fine to withdraw a sum (from the 401(k) extended by the employer who terminated your job). The penalty, however, will apply if you withdraw from 401(k) plans extended by previous employers. But, by withdrawing from the 401(k) plan in advance, you will have a smaller savings pool when you actually retire. So, it is advisable to leave your 401(k) plan untouched till you retire or have an emergency.

[See – What is a 401(k), and how does a 401(k) work?]

Ways to use your 401(k) plan after retirement

If you find yourself at the tail end of your career, it is important to have a clear idea of what to do with a 401(k) when you retire. There is no best way to use 401(k) in retirement. It depends on various factors, such as your financial requirements, economic status, and risk tolerance.

Here are some ways to use the 401(k) after retirement:

1. Let the money remain in the 401(k) account

You can withdraw your entire 401(k) plan after retirement. But this, again, can only be a good idea if you have a proper financial plan where you are reinvesting the withdrawn money. It is easy to run out of savings quickly if you are not managing your finances wisely. Note that if you’re not drawing any money from the 401(k) plan, the sum is not subject to taxation. The tax is levied once you begin to take distributions.

2. Convert the 401(k) plan into an IRA plan

If you have invested your money wisely, chances are that you have more than one source of compensation after retirement. But can you still contribute to a 401(k) after retirement? The answer is yes, but you will need to convert the 401(k) into an Individual Retirement Account (IRA). An IRA, as the name suggests, is a retirement savings account that offers tax advantages to individuals.

However, you must remember that contributions to this IRA plan must come from an earned income. You cannot add money into the IRA account from investments of any form. To contribute a sum, the IRA requires you to have taxable compensation. This can be in the form of a salary, wage, commissions, or net income drawn from self-employment.

There are two ways to convert your 401(k) plan to an IRA account. You can arrange for your employer to send the assets under the 401(k) to the entity managing your IRA. This mode of fund transfer, free from tax cuts and penalties, is known as a direct rollover. Else, you can collect the 401(k) compensation and deposit it into your IRA within two months (60 days). However, this sum will be subject to taxation.

3. Diversify your portfolio and spending

It is important to remember that the 401(k) plan is just one source of retirement income. Ideally, your retirement plan should feature various investment models that ensure that you draw an income or build wealth from different sources. This can be investments with varying levels of risk, cash reserves, or even a basket of dependable physical assets such as real estate. If you have the opportunity or the required funds to diversify your portfolio, you can tap into your 401(k) savings and use a portion to invest in different asset classes. It is advisable to thoroughly research or take assistance from a wealth manager to help you decide how you can use this sum. Make sure that the withdrawn money goes into an investment model that suits your needs and matches your risk tolerance.


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4. Create a monthly payout plan

The 401(k) can also be used as a surrogate salary. You can do so by using the 401(k) plan to create a monthly pension plan. Instead of withdrawing a lump sum once a year or every few months, having this monthly budget will allow you to plan your lifestyle around this sum. It can also ease your transition from being a salaried person to a retiree. A financial advisor can help you understand how long your 401(k) savings will last if divided into monthly payouts. 

5. Include Required Minimum Distributions in your post-retirement plan

On turning 72, the IRS mandates that you claim minimum distributions from your 401(k). This is known as required minimum distributions (RMDs), and this sum usually depends on factors such as the age of the investor, withdrawal year, and balance amount. These values are coupled with a life expectancy number to arrive at the RMD amount for a particular year.

Upon withdrawing this amount, you can either use it towards your expenses or reinvest it, based on your financial plan. While there are various ways to use 401(k), it is also easy to get carried away and over-commit on expenses. Therefore, it is essential to remember that retirement is not the end of your 401(k) journey but a beginning where you use your saved funds to live your post-retirement life.

To conclude

The savings accumulated through a 401(k) plan can be used to make the retirement process less stressful. The best way to use a 401(k) plan in retirement is to avail of it in a manner that meets your needs. However, since 401(k) plans offer you financial security after a steady form of income stops flowing in, you must have a proper plan before investing or withdrawing from a 401(k) account. You can leave the funds untouched or use them to diversify your portfolio. How you use the 401(k) depends on your financial goals, which should take into account your immediate needs, emergency fund requirements, and long-term financial goals.

Use the free advisor match tool to match with an experienced and certified financial advisor who can guide you on 401(k)s and their management. Give us basic details about yourself, and the match tool will connect you with 1-3 professional financial fiduciaries that may be suited to help you.

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