How Does a 401(k) Work When You Retire? Here Are Your Options

As you approach retirement, understanding how your 401(k) works is crucial for ensuring a smooth transition into your golden years. This retirement savings plan, sponsored by employers, offers tax advantages that can help you grow your nest egg throughout your working life.

But the question remains: How does a 401(k) work when you retire?

At Advance Capital Management, we understand that for many people today, workplace retirement accounts are the primary source of income for their golden years. As financial advisers, our aim is to guide you in selecting the most suitable options for your assets to create the retirement income necessary for your needs.

Here are some important considerations to help you make informed decisions about your 401(k) upon retirement.

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

Before diving into the specific options, it's important to grasp the basics of how a 401(k) works upon retirement.

Withdrawal Rules

At age 59 ½, you can start withdrawing funds from your 401(k) without facing the 10% early withdrawal penalty. You can withdraw any amount at any time.

Importantly, the Rule of 55 offers an exception, allowing you to withdraw funds without penalty starting at age 55, under certain conditions. This rule applies if you leave your job during or after the year you turn 55, providing a potential strategy for accessing your savings earlier if needed.

Tax Implications

Withdrawals from a traditional 401(k) are taxed as ordinary income. It’s essential to consider how these withdrawals will affect your overall tax situation in retirement.

Required Minimum Distributions (RMDs)

You must begin taking required minimum distributions (RMDs) from your 401(k) account by no later than April 1 following the year you turn 73. These withdrawals are subject to ordinary income tax rates. Learn more about RMDs here.

Options for Using Your 401(k) When You Retire

First, it’s important to note that there’s no hard and fast rule for how you should use your 401(k) when you retire. It all comes down to your specific situation.

Here are four options to consider for your 401(k) savings:

1. Leave Your 401(k) with Your Employer

If your plan allows, you can leave your 401(k) with your former employer. This option may be appealing if you're satisfied with your plan's investment options and fees. However, you'll still need to start required minimum distributions (RMDs) at age 73, which are taxable.

2. Roll Over Your 401(k) to an IRA

A popular choice is rolling over your 401(k) into an Individual Retirement Account (IRA). This move can offer a broader range of investment options and potentially lower fees.

With an IRA, you retain the tax-deferred status of your savings and have more control over withdrawals and investments. This includes having the ability to hire a financial adviser to help manage your funds.

3. Take a Lump-Sum Payout

Another option is taking a lump-sum payout, which means withdrawing all or a portion of your 401(k) funds at once. This approach provides immediate access to your money but can lead to a significant tax bill and diminish the funds available for your retirement years.

4. Annuitize Your 401(k)

Some 401(k) plans provide the choice to convert your savings into an annuity. This is usually referred to as an immediate annuity, which transforms a lump sum from your 401(k) balance into a guaranteed income stream.

It’s important to recognize that an annuity may not suit everyone. For one, the guaranteed payments depend on the financial strength and claims-paying ability of the issuing company. Additionally, opting for an annuity means you might lose direct access to your principal, which could be a concern if you face unexpected financial needs. There’s also the risk of receiving less in total payments than your initial principal if you pass away sooner than anticipated.

Therefore, this option requires careful consideration of your financial situation and the terms and costs involved.

Deciding What to Do with Your 401(k) After You Retire

Making an informed decision about your 401(k) after retirement requires weighing various factors to align with your financial goals and needs.

Here are some questions to help navigate this process:

How much income do you need in retirement?

Most financial planners suggest that you'll need approximately 70-80% of your pre-retirement yearly salary to maintain your standard of living when you retire. This rule of thumb accounts for the fact that certain expenses (e.g., commuting costs) may decrease, while others (e.g., healthcare) might increase.

What other income sources do you have?

Now, evaluate all your financial resources. This includes other investments, retirement accounts and potential income sources, such as part-time work, pensions and Social Security benefits. Understanding the full scope of your assets and income will clarify how much you need to rely on your 401(k).

If you have sufficient income from other sources, you might not need to tap into your 401(k) immediately. This strategy allows your 401(k) investments more time to grow, potentially increasing your financial stability in later retirement years.

What type of investment and retirement accounts do you own?

Take stock of the nature of your contributions (traditional or Roth) and other accounts you hold. This can help determine an appropriate withdrawal strategy. For example, prioritizing withdrawals from taxable accounts first, followed by tax-deferred accounts, may help optimize your tax situation.

You may want to consider withdrawing from Roth accounts early in retirement to benefit from tax-free distributions and allow your traditional 401(k) savings to grow tax-deferred for as long as possible. This approach can potentially minimize your lifetime tax liability and keep more money in your pocket over the long term.

Bottom Line

So, how does a 401(k) work when you retire? It depends on your unique financial situation, goals and needs.

Deciding on the best approach for managing your 401(k) after retirement comes down to knowing what you have, estimating what you need, and strategically planning withdrawals to potentially minimize taxes and preserve your savings.

If you’re feeling overwhelmed, seeking advice from a financial adviser can provide clarity and direction tailored to your situation. You can take the first step right now: Schedule a free financial consultation with an Advance Capital Management financial adviser.