How a 401(k) Works Once You Retire
A 401(k) is a helpful retirement savings vehicle, and with all its benefits, it can potentially help you build wealth over time. Let’s say you have been diligently saving in a 401(k) throughout your working years, and now you have finally retired. What do you do now? Do you stay invested, or do you finally start withdrawing your money? What are the rules you need to follow? Let’s understand how a 401(k) works after retirement.
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What happens to a 401(k) when you retire?
Well, the money stays there and remains yours, but what happens to it in terms of options is something you need to understand. You have a few different options for 401(k) after retirement.
You can leave the money in the existing plan, withdraw a lump sum, start taking Required Minimum Distributions (RMDs) once you reach age 73, transfer it to an Individual Retirement Account (IRA), or convert it into an annuity. There are no strict hard-and-fast rules on which option you must choose, and you can decide what works best for your financial needs and retirement goals. After all, it is your money. Working with a financial advisor can help you better understand these options and decide on the right course of action for your retirement.
For now, let’s understand each of these options in detail, so you know exactly what happens to 401(k) when you retire.
Option #1: Leave the money as it is with no withdrawals
The first option is to leave the money in your 401(k) account after retirement. You can do this if your employer’s plan allows it. Leaving the money in the account can offer some advantages. For instance, you get creditor protection. Many 401(k) plans offer legal protection from creditors, which safeguards your money in unprecedented situations. Moreover, your money continues to grow tax-deferred for as long as it remains in the account.
Generally, Required Minimum Distributions (RMDs) must begin at age 73 for traditional 401(k)s. Roth 401(k)s are treated differently. Here, account holders are exempt from RMDs during their lifetime under federal law, effective 2024, meaning the money can remain invested for as long as the account holder chooses.
Before you decide to leave your money in the account, there are some rules to keep in mind, though. In most cases, if your balance is at least $7,000, you may leave the money in the plan after retiring or leaving the company. If your balance is lower than that, the employer may require you to withdraw your money or move to another retirement account.
There are some downsides to leaving your money in a 401(k). You may still be paying administrative or management fees tied to the account, which can increase your expense load in retirement. You are also restricted to the investment options offered within the plan. If you want more flexibility and a wider range of funds, staying in the same 401(k) will not work. You should also remember that once you leave the company, you generally cannot continue contributing new money to that 401(k). The account can continue to grow through investment returns, but you or your employer would not be able to make any additional contributions.
Option #2: Withdraw a lump sum from your 401(k)
Another option for a 401(k) after retirement is to withdraw your money as a lump sum. You can either take out the entire balance or a large portion of it in one go. Lump sum withdrawals can be helpful if you are looking for a large sum of money up front. The money can be used to cover expenses, such as house purchase or repair, extensive travel plans, health-related costs, and more. However, there are a few considerations to keep in mind here.
Let’s start with the most obvious one – tax. If you have a traditional 401(k), the money you contributed was made with pre-tax dollars. Because of that, withdrawals are treated as ordinary income when you take them out. So, if you withdraw a large amount all at once, you will end up in a high tax bracket that year.
The second thing you need to consider is the time of your withdrawal. There are some 401(k) withdrawal rules after retirement that you must follow. If you are under the age of 59½ and make a lump sum withdrawal, the Internal Revenue Service (IRS) will charge a 10% early withdrawal penalty. Additionally, you will also pay regular income taxes. There is an exception, though. If you leave your job or retire during or after the year you turn 55, you may qualify for penalty-free withdrawals from your current employer’s 401(k). But you would still owe regular income taxes.
You also do not necessarily have to withdraw the full balance at once. Many retirees choose partial withdrawals instead. This way, you can access money as needed while potentially lowering your taxes. That said, there are situations where a lump-sum withdrawal may make sense. In such a case, the option should be approached carefully. Speaking to a financial advisor can be advisable here.
Option #3: Start taking Required Minimum Distributions (RMDs) once you reach age 73
There are mandatory withdrawals called Required Minimum Distributions (RMDs) that you must start taking from your 401(k) once you reach age 73. These apply to traditional 401(k) contributions, as these are made with pre-tax dollars. Roth accounts may follow different rules depending on the account type and whether the funds have been rolled into a Roth IRA.
Your RMD is calculated using a formula based on a few factors. These include your age, your retirement account balance at the end of the previous year, and an IRS life expectancy factor. For example, your first RMD is usually based on your 401(k) balance as of December 31 of the previous year. The deadline for taking that first distribution is typically April 1 of the year after you turn 73. After that, future RMDs must be taken by December 31 each year. If you delay your first RMD until April 1, you may end up taking two RMDs in the same calendar year. One would be the delayed first withdrawal, and the second would be the regular RMD due by December 31. This could increase your taxable income for the year and potentially push you into a higher tax bracket.
Make sure you understand and discuss the different 401(k) distribution rules and strategies with your financial advisor to avoid such scenarios. It is also important not to ignore RMD deadlines and to avoid missing an RMD to avoid penalties. Withdrawing less can also lead to penalties.
There is a special exception for some people who continue working later in life. If you are still employed at age 73 and you do not own more than 5% of the company sponsoring the plan, you may be able to delay taking RMDs from that employer’s 401(k) until the year you retire.
Option #4: Transfer it to an Individual Retirement Account (IRA)
Another common option after retirement is to transfer, or roll over, your 401(k) savings into an IRA. In a rollover, your money is moved from your old 401(k) into an IRA. You generally have two main choices when rolling over your 401(k) – a Traditional IRA or a Roth IRA.
If you roll your 401(k) into a Traditional IRA, your money continues growing on a tax-deferred basis. Taxes are usually paid later when you begin taking withdrawals in retirement. With a Traditional IRA, you may gain access to a much wider range of investments. You are no longer tied to the investment options selected by your former employer. However, Traditional IRAs still come with RMDs.
Whether or not you are still working, you generally must begin taking RMDs from a Traditional IRA once you reach age 73.
The second option is rolling your 401(k) into a Roth IRA. Since Roth accounts are funded with after-tax money, converting pre-tax 401(k) savings to a Roth IRA usually results in an upfront tax bill on the amount transferred. But with a Roth IRA, there are no RMDs during your lifetime, and so your money can continue growing tax-free for longer. A Roth IRA may also offer a broader range of investment options than your old 401(k).
Choosing between a Traditional IRA and a Roth IRA is a tale of two tax situations. You can opt for any of these options, depending on which tax situation suits you best.
Choosing the right option for a 401(k) after retirement
Does the mirror on the wall tell you the fairest option of them all? Well, no. This is not a game of guesses. It is a financial decision that can impact the rest of your life, which is why choosing the right option matters.
The best choice depends on your financial situation, retirement goals, lifestyle needs, and future plans. Before making a decision about your 401(k), it is important to properly assess your situation and understand your available options. Speaking with a financial advisor can help you make the right choice based on your needs. You may use our advisor directory to find a suitable financial advisor near you.
Frequently Asked Questions (FAQs) about how a 401(k) works after retirement
1. What are some 401(k) withdrawal rules after retirement that I should know?
There are a few important withdrawal rules to keep in mind once you retire:
- If you have a traditional 401(k), RMDs begin at age 73.
- If you have a Roth 401(k), qualified withdrawals during retirement are generally tax-free.
- If you withdraw money from a 401(k) before age 59½, you are liable to pay a 10% early withdrawal penalty in addition to regular income taxes.
It is advisable to speak with a financial advisor to understand these rules and other related rules in detail.
2. Should you roll over your 401(k) to an IRA?
Rolling over your 401(k) to an IRA can offer investment flexibility and access to a wider range of investment options. A Traditional IRA allows your money to grow tax-deferred, while a Roth IRA may offer tax-free qualified withdrawals and no lifetime RMDs. However, converting pre-tax 401(k) savings to a Roth IRA usually results in upfront taxes on the amount transferred.
The right choice depends on your tax situation, retirement goals, and future income needs. Before making a decision, it can help to discuss the tax implications and long-term impact with a financial advisor.
3. How do you choose the right 401(k) option after retirement?
The right option depends entirely on your personal financial situation. Evaluate your retirement goals, tax situation, healthcare costs, income needs, and other similar factors to arrive at a sound decision. Speaking with a financial advisor can help you better understand your choices.
To learn more about the most suitable tax-saving strategies for your specific financial requirements, visit Dash Investments or email me directly at dash@dashinvestments.com.
About Dash Investments
Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.
Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. Additionally, each client receives comprehensive financial planning to ensure they are moving toward their financial goals. CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.
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