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? In short, it’s 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.
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, Roth IRAs, investments, cash value built up within a whole life insurance policy and cash reserves. Your retirement plan will also include income 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 72
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 72. The same goes for any other tax-deferred retirement accounts you may have. (Note that while RMDs are required for a Roth 401(k), you can get around this by converting these funds to a Roth IRA. However, you won’t owe any taxes on the money in a Roth 401(k), and it’s distributed proportionately.)
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 help you think about how to be effective with your distributions.
YOU WILL BE TAXED ON 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, when you begin taking distributions from your 401(k), you’ll have to pay tax because the IRS treats this money as ordinary income. 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 owe income tax on money that you withdraw from a traditional 401(k), you will not owe tax on money that you have saved in a Roth 401(k). If your savings is in a traditional account, it’s possible to do a Roth conversion, where you will 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 to an IRA, ultimately it’s up to you and how you want to use your lifetime of savings to generate the income you need to fund the things you’ve been dreaming about for your retirement. An experienced financial advisor who understands the ins and outs of retirement income and tax planning can help.