How Does a 401(k) Work When You Retire?

Over the course of your working years, you diligently contribute to your 401(k) in preparation for retirement. But what happens once you actually get there? Retirement marks a major life transition — and it’s also a time to switch from saving your money to generating income with your savings.

So how does a 401(k) work when you retire? For starters, it can be an essential source of income when you exit the workforce. But before you start withdrawing money from your 401(k), it’s a good idea to build a plan to create your retirement income. Here’s what you can expect from your 401(k) when you retire.

How does a 401(k) work when you retire?

A 401(k) is one source of retirement income

Remember that a 401(k) on its own is not a retirement income plan. While it’s certainly a smart way to save for your future and plays an integral part in building your nest egg, a 401(k) is just one source of income in retirement.

A plan to create income in retirement will certainly take your 401(k) into consideration. But it should also include income withdrawals from other accounts like IRAs, investments, cash value built up within a whole life insurance policy, and cash reserves. Your retirement plan will also take into account funds from Social Security, and may include income from annuities and pensions. By having multiple streams of income, you can more efficiently generate retirement income by strategically leaning on different sources at different times. This approach can help you minimize taxes while balancing the need to grow your investments and generate reliable income that will last through your retirement.

You can begin withdrawing funds at age 59½

When you withdraw funds from your 401(k) before you turn 59½, you’ll typically be hit with a 10 percent penalty. But once you turn 59½, that penalty is waived. At this point, you can begin taking withdrawals (technically known as distributions) as you please.

However, just because you're allowed to take distributions doesn’t mean you have to right away. In fact, if you don’t need income from your 401(k), it may be worth leaving that money alone for the time being. Not only is this important from a tax perspective (more on why in a moment), but it also means this money can keep growing in your 401(k).

You must begin taking distributions at age 73

Even if you don’t need the money, you’ll have to start taking required minimum distributions (RMDs) from your 401(k) beginning at age 73. The same goes for any other tax-deferred retirement accounts you may have, like traditional IRAs. Also note that the RMD age will bump up to 75 in 2033. While RMDs are required for a Roth 401(k) (this requirement will end in 2024), you can get around this with a Roth IRA conversion. The good news is that you typically won’t owe any taxes on the money that’s distributed from a Roth account.

The amount you’re required to withdraw depends on your retirement account balances and your life expectancy. While these IRS worksheets can help you do the math, a financial advisor can provide personalized guidance on how to be effective with your distributions. Either way, you’ll want to stay on top of your RMDs. Failing to take them will result in a 25 percent penalty (or 10 percent if you withdraw the required funds by the end of the following year).

You will owe tax on your 401(k) distributions

Traditional 401(k) contributions are often made on a pretax basis, which means they lower your taxable income during your working years.

Because the money wasn’t taxed when you contributed it, you’ll have to pay income tax on your distributions. That means you won’t get to keep everything you’ve saved. And if you withdraw too much in a given year, you could push yourself into a higher tax bracket — meaning the government will take a larger portion of your savings.

While you will be taxed on money that you withdraw from a traditional 401(k), you will not owe tax on money you have saved in a Roth 401(k). If a portion of your nest egg is in a traditional account, it’s possible to do a Roth conversion. That means you’ll owe income tax on the amount you convert in the year that you convert it. With a Roth IRA, you can enjoy tax-free distributions in retirement.

So how does a 401(k) work in retirement? While it can be rolled into an IRA, what you do with it is ultimately up to you — and how you want to use your life savings to fund the things you’ve been dreaming about for your retirement. A financial advisor who understands the nuances of retirement income and tax planning can help.

The primary purpose of life insurance is to provide a death benefit. Using permanent life insurance cash value to supplement retirement income will reduce the death benefit and may affect other aspects of the policy.

Financial representatives do not render legal or tax advice. Consult with a tax professional for tax advice that is specific to your situation.

RMD requirements and tax implications are as of date of publication, and subject to change.