The 401(k) is the primary—in many cases, the only—savings vehicle for many millions of working Americans.
Because they rely on the 401(k) (or the equivalent 403(b) offered by education and nonprofit institutions, and the 457 offered by public and nonprofit employers) to provide financial security in retirement, plan participants will benefit from understanding the rules about taking distributions. With the right information, retirees can avoid making a 401(k) withdrawal that results in penalties and a hefty tax bill.
These frequently asked questions will answer many questions you might have about plan distributions. Before making decisions that could result in an avoidable penalty or taxes, review your options with a qualified tax adviser.
- When I retire, what happens to my 401(k) account?
- What is a taxable lump-sum distribution?
- What if I decide to roll my 401(k) over to an IRA (individual retirement account)?
- Is a lifetime annuity advisable for my 401(k)?
- Is it possible to continue 401(k) participation when I retire?
- Can I withdraw funds from my 401(k) if I retire before I reach age 59½?
- When I retire, at what age must I begin withdrawing funds from my 401(k)?
- What is the penalty if I do not withdraw funds at age 70½?
- Is it possible to continue to participate in my 401(k) program after I'm 70½?
- Where can I find more information?
When I retire, what happens to my 401(k) account?
When you retire anytime after age 59½, you can:
- Take the proceeds of your 401(k) as a lump-sum distribution (and pay normal income taxes).
- Roll the money over into an IRA (individual retirement account).
- Put the money into an annuity (if your plan offers this option).
- Leave the money where it is (if you have at least $5,000 in your account).
If you leave the money where it is, you can begin taking periodic distributions at any time, or you can choose to take a non-periodic, or lump-sum, distribution at some point. (You must begin taking distributions by age 70½.)
Before making decisions affecting taxation of your 401(k) money, review your options with a qualified tax adviser.
If you take your 401(k) balance as a lump-sum distribution, you will owe income taxes on the full amount. No matter what your tax bracket, 20% of your distribution will be withheld for federal taxes. If you are younger than age 59½, you may have to pay a 10% early withdrawal penalty (see next question for more about this).
Rollover to an IRA ensures your money will continue to be sheltered in a tax-deferred account, and you will avoid the 20% federal withholding and any early withdrawal penalties that would result from taking the 401(k) proceeds as a lump-sum distribution.
You can withdraw money as you need it, subject to the IRA minimum distribution rules, and pay income tax only on the amount you withdraw.
If you do not plan to later move your assets into a new employer’s 401(k) plan, you do not have to worry about keeping your 401(k) money separate from your traditional IRA (you can commingle the funds). While new rules allow you to move your 401(k) funds into a new employer’s plan even after the money has been commingled with your traditional IRA, it might be a good idea to keep the money separate to avoid difficulties. In this case, simply open a new traditional IRA specifically for the purpose of rolling over your 401(k), if the plan allows it.
To initiate the rollover, submit a distribution request (get instructions from your human resources department) providing all the necessary IRA information to the 401(k) plan administrator. Tell the administrator you want to make a "direct rollover" to your IRA.
Some 401(k) plans offer the option of receiving your distribution as a lifetime annuity, purchased from a private insurance company. This annuity will pay you a monthly benefit for your lifetime. If you have established a joint-and-survivor annuity, you and your designated beneficiary will receive the monthly payment for your lifetimes. You cannot change the annuity once you start it.
Though an annuity provides a guaranteed lifetime benefit that could amount to more than you paid into your account, it also carries some drawbacks, such as potentially high fees. Further, once you and your spouse (for a joint-and-survivor annuity) die, the annuity ceases, leaving nothing for any beneficiaries of your estate.
If you annuitize, you might be given the option of selecting either a fixed annuity, which provides a consistent income but exposes you to inflation risk, or a variable annuity, which provides an income that will fluctuate based on the performance of the investments you choose.
Annuity payments are subject to ordinary income tax. For example, if your annuity pays you $1,000 a month beginning January 1, 2013, you will owe taxes on the $12,000 annuity income for the year.
For more information, consult your financial adviser.
You won’t be able to add to your 401(k) after you stop earning a paycheck from your company. However, if your plan allows it (usually permitted if you have a minimum amount in the account; ask your employer), you have the option to leave all or some of your funds in the plan.
Continued participation in your employer's 401(k) plan makes sense if you like the investment options it offers (some plans offer access to low-cost mutual fund shares that aren’t available on the open market, or to funds closed to new, non-plan investors). Also, if you take early retirement, you can tap the money in a 401(k) without penalty by following certain IRS distribution requirements (see the next question for more information), while you usually can’t withdraw IRA assets without penalty before age 59½.
Still, many people who don’t plan to withdraw funds before age 59½ prefer to roll over their money to an IRA so that they can choose from a wider menu of investment options.
The truth is, depending on your plan, you may be able to withdraw funds from your 401(k) anytime, no matter what your age. You will, however, owe taxes. And, if you are younger than age 59½, you may have to pay a 10% early withdrawal penalty.
You can avoid the 10% withdrawal penalty if you have a qualifying disability, can prove an immediate and heavy financial need (such as for large medical or funeral expenses, purchase or repair of a principal residence, or tuition, but not for a boat or television), or are at least 55 years old and leave your employer (the plan sponsor).You also can avoid the penalty if you are younger than 59½, leave your employer, and take substantially equal periodic payments, based on life expectancy, beginning after separation from service and made at least annually based on the life or the life expectancy of the employee, or on the joint lives or life expectancies of the employee and his or her designated beneficiary. The payments must continue for at least five years or until you reach age 59½, whichever is the longer period. For more information and a complete list of exceptions, go to irs.gov (scroll to "Tax on early distributions").
After you reach age 70½, you are required to withdraw a minimum amount each year depending on your life expectancy. You must begin receiving these payments by April 1 of the first year after the later of the following years: the calendar year in which you turn 70½, or the calendar year in which you retire.
To determine your required minimum distribution, the plan administrator will divide your 401(k) account balance by your life expectancy or the joint life expectancy of you and your designated beneficiary. (The calculation using joint life expectancy may be more advantageous.) Information about calculating the minimum distribution amount is included in IRS Publication 575, Pension and Annuity Income.
After the first distribution, made by April 1, subsequent annual distributions must be made by December 31 of each year.
You must pay income tax on each of these mandatory distributions. You cannot roll the distributions into an IRA.
If you do not withdraw the mandatory minimum amount beginning at age 70½, you will have to pay a penalty tax of 50% of the amount that should have been distributed.
After age 70½, if you are still working for the employer sponsoring the plan, you are eligible to participate. You do not have to start withdrawing money from your 401(k) if you continue to work at that same company past the age of 70½ unless the plan requires you to take distributions because you are a 5% owner of the employer.
These IRS Web pages and publications may be helpful as you decide how to handle your 401(k) when you retire:
- 401(k) Resource Guide-Plan Participants-General Distribution Rules
- Publication 575, Pension and Annuity Income
- Publication 590, Individual Retirement Arrangements
- Form 4972, Instructions, Tax on Lump-Sum Distributions (10-year forward averaging)
Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.
Published February 6, 2012