Making Sense of 401 K Distributions in Retirement

By on May 25, 2018

When it comes time to retire, you will have to decide what to do with the money in your 401 k (or similar pension plan). If you retire before age 59½ any withdrawals may be subject to an additional penalty, after that, you will have a range of choices to manage your nest egg. Then, once you hit 70½ you will be required to take minimum distributions until the account is empty.

Generally speaking, you will have some, if not all, of the following choices: leave the money where it is, cash out, roll funds into an IRA or annuity, or take periodic distributions. The key to keeping as much of your pension in your pocket and saving on taxes, fees or penalties is to plan, plan, plan!

Your trusted retirement planner or financial advisor will be able to guide you through the short and long-term advantages of each option before deciding which path is best for you. You may find that a combination of strategies will work to your best advantage.

Please consult your plan documents for information on the specific kinds of distributions that are allowed. And always consult a tax professional before taking any action that could trigger a taxable event.

Leave Your Money in the 401k until 70½

Financial advisors often recommend retirees tap taxable accounts first so that tax-deferred funds can continues to grow for as long as possible. So if you are retiring and have money outside of your 401 k that you plan to live on, you may leave your account untouched until you’re 70½. At that point the government will require you to take mandatory annual distributions on any 401 k (or traditional IRA).

If you’re satisfied with your plan’s investment menu, it provides enough diversity for you to reallocate your portfolio as needed in years to come and you are satisfied, staying put may be a viable option.

Distributions Taken in Retirement After Age 59½

Retirees over age 59½ will not be subject to the 10% penalty on distributions, however, all money is considered earned income and could bump the recipient into a higher tax bracket. Now you should have several options to tap into your money:

Lump Sum Distribution aka Cash Out

If you need access to your cash right away for daily living, pay off a debt, etc., this option will serve that purpose. A check will be made directly to the account holder, the employer will withhold 20% and an additional 2% to 8% in federal and state income taxes — you will receive a 1099R for your tax purposes, detailing this information.

There are two major drawbacks to taking out all of the funds at once:

  1. you forfeit the benefits of compound savings in a tax-deferred account
  2. a large withdrawal could result in an income spike pushing you into a higher tax bracket

Rollover Funds into an Individual Retirement Account (IRA)

If your plan has been performing poorly or you want greater control over your investment choices, you may be better off rolling over your employer-sponsored account to an IRA.There is no income tax on the transfer, and once you rollover into an IRA the account owner can continue to invest on a tax deferred basis.

If you have a string of 401 k or similar accounts when you retire, you might be better served by consolidating your accounts into an IRA for two reasons: a consolidated account may be easier to manage in terms of administration and efficiency; and the larger your IRA account balance, the better your chances of qualifying for discounted mutual funds.

*This process may function similarly if you want to rollover funds into the 401 k of a new employer should you decide to go back to work.

Fund an Annuity

Some pension plans allow you to buy an annuity which will pay a monthly benefit for the expected lifetime. Like an IRA rollover, no taxes are assessed with the transfer to the income annuity, but annuity distributions would then be subject to ordinary income tax.

You are guaranteed income for the rest of their life and will not have to worry about how the source of that income is invested. In addition, if the policy includes joint-and-survivor benefits, your spouse can receive a portion of your payments after you die.

Set a Schedule for Periodic Distributions

Of course, you can always set up a plan to receive a regular stream of income from your 401 k. Typically, plans let you select an amount to receive monthly or quarterly, and you are allowed to change that amount once a year. If these distributions are your main source of income you will need to be careful to manage your distributions so you do not outlive your dollars.

There are generally three ways to take installment distributions:

  1. Fixed: A set dollar amount is paid until the account is emptied. The funds that remain in the plan until future distribution continue to be invested, so the rate of return will impact how long the money will last. This may be a good option for those who want to know exactly how much they will receive each time an installment is paid, similar to a paycheck.
  2. Variable: A variable dollar amount is paid over a fixed period of time. Each payment is determined by dividing the account balance (typically based on the preceding December 31 value) by the requested number of payments. This may be a good option for someone who needs income for a set time period and are not as concerned with knowing the exact amount they will receive.
  3. Lifetime Expectancy: A variable dollar amount is paid over the account holder’s expected lifetime or until the account is emptied (whichever happens first). Typically, plans use an IRS calculation to estimate life expectancy (subject to change each year). The initial payment is determined by dividing the current account balance by the expected number of payments. This would be ideal for those who want payments to last all or most of their lifetime – and possibly continue during their beneficiary’s lifetime.

In most cases, if the installment period is more than 10 years, the payments are not eligible for a rollover into an IRA or annuity in the future. It is also important to remember that the account balance will be affected by the market, so it is difficult to know to the exact dollar how much or how long your disbursements will be issued.

Required Minimum Distribution (RMD) after age 70½

During the April following the calendar year you reach age 70½ and are no longer employed, you will be required to take a set amount from your account until it is empty. The Required Minimum Distribution (RMD) rule is in place to ensure that retirees actually withdraw from retirement accounts rather than using them as a vehicle to pass money to heirs.

Each person’s required distribution amount will be calculated based on the preceding December 31 value of the account balance and life expectancy tables. And if you are late taking your distribution there is a 50% tax penalty – so be sure to begin the process on time.

If you have a 401 k, 403 b or similar employer-sponsored retirement account and you are coming close to leaving the workforce behind, then hi-time you sat down with your retirement planner, plan manager, tax accountant and other trusted financial advisors to build a timeline for managing your investments and withdrawals.

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About Harold Goldman

I am the founder of FinancialSafetyNet.org, and a Retirement Planning and Long-Term Care specialist. I am also the President of Emes Insurance Services, Inc., a Murrieta based insurance agency designed to help people with Retirement Planning and funding for College. I believe in educating my clients to become financially competent in an effort to develop plans for guaranteed income, protection against loss and tax-advantaged growth. To contact me Call (844)-376-2265

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