A 401(k) is a great tool to save for retirement. You won’t owe tax on your contributions or while your money grows. But because of its tax advantages (and the fact that the account is meant to help people save for retirement), there are a few rules surrounding how and when you can take your money out of your 401(k).
WHEN CAN I TAKE MONEY OUT OF MY 401(K)?
During your working years, it may be possible to take a loan from your 401(k) depending on what your plan allows. Loans must be paid back within five years with interest and are typically capped at half of your savings up to $50,000 in a 12-month period. While this can be an option, it’s typically only something to consider as a last resort as funds in a 401(k) are meant for retirement.
It may also be possible to withdraw 401(k) funds, however, if you do so prior to age 59½, you will typically owe a 10 percent penalty on top of income taxes unless you qualify for an exception. Once you turn age 59½, you’re allowed to take money out of your 401(k) — technically known as a distribution — as you wish, without owing a penalty.
But just because you can take out the money penalty-free starting at that age, the real question is, should you? Your 401(k) will likely be one of your essential sources of retirement income, so it’s important to have a financial plan that lays out how you’re going to draw down from it — particularly if you’re planning to take out the money early.
BENEFITS OF TAKING MONEY OUT OF YOUR 401(K) EARLIER
Your 401(k) is likely a centerpiece of your retirement income plan. Taking distributions sooner than a typical retirement age around 65, like in your early 60s, can have benefits.
It can make an early retirement possible. Depending on your financial situation, you may have the financial freedom to step out of the workforce by the time you’re 60. It’s your nest egg, and you’ve worked hard to build it by making regular contributions during your working years. 401(k) distributions, along with other sources of retirement income, can set the stage for this new phase of your financial life.
It can help you delay taking Social Security. You can’t begin claiming Social Security until age 62. Still, generally, it can be beneficial to delay taking Social Security. That’s because your monthly benefit will increase every year that you wait until age 70. Since Social Security pays guaranteed income that will last for as long as you live, a larger monthly benefit could pay off over time.
DRAWBACKS OF TAPPING YOUR 401(K) EARLIER
Retirement income generally has a lot of moving parts. Dipping into your 401(k) at 60 could have a ripple effect that impacts your overarching income plan.
You’ll be taxed on 401(k) distributions. Since traditional 401(k)s are funded with pretax dollars, distributions are taxed as ordinary income. No matter when you take money out of your 401(k) in retirement, it’s a good idea to do so in the context of other income sources — which may have different tax treatment. For instance, it may make sense to use a mix of 401(k) funds and Roth funds to manage your tax brackets in retirement.
You’ll miss out on tax-deferred growth. Because your money isn’t taxed as it grows in your 401(k), leaving your funds in your 401(k) allows them more time to grow and compound before you owe tax on them.
YOU WILL EVENTUALLY BE REQUIRED TO TAKE MONEY OUT OF YOUR 401(K)
If you decide not to tap into your 401(k) early, there will come a time when you will be forced to start taking distributions. Once you turn 72, you must take required minimum distributions (RMDs). Just like you owe penalties for taking money out of your 401(k) early, you will owe penalties if you fail to take RMDs and leave money in your 401(k) too long.
Ultimately, a solid plan for retirement will show you how to use your savings and other financial tools to generate enough money to live comfortably for the rest of your life. A financial advisor can work with you to build a plan that can allow you to generate reliable income for as long as you live.
This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation. All investments carry some level of risk including the potential loss of all money invested.