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How Your 401(k) Works After Retirement

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Key Takeaways

  • After retirement you have three options for your 401(k): keep it with your former employer, roll the account over into an IRA, or cash out your funds.
  • Each option carries its own pros and cons depending on your personal circumstances. 
  • IRS rules, employer 401(k) rules, account fees and expenses, and potential tax consequences should all be considered when choosing what to do with your 401(k).

Your Post-Retirement 401(k) options

When you’ve made the big decision to retire, deciding what to do with your 401(k) can be a confusing endeavor. 401(k) accounts are now typically the largest retirement asset for many retirees, which makes it even more important to effectively plan for what you’ll do with yours to prepare for retirement. So, what are your options and what should you consider when deciding what to do next?

Leave your 401(k) with your Former Employer

Legally, you are allowed to leave your 401(k) with a former employer even if you leave that job or retire. You’ll want to make sure your former employer has a low-fee plan with the right investment choices for you. If your employer was particularly large, it likely leveraged the size of its headcount to negotiate lower account fees and expenses for the 401(k) plan on behalf of its employees. Lower fees and expenses mean more funds stay and grow in your account. However, this isn’t the case for every 401(k), so make sure you evaluate your plan before deciding to leave your money there. 

Additionally, you may prefer to keep your 401(k) with your former employer to keep your funds invested in the options you are already familiar with; this can be a good choice if you are happy with your 401(k) options, but remember that IRAs generally offer a wider selection of investments than 401(k)s. 

401(k)s can also offer continued protections from creditors and in bankruptcy thanks to the Employee Retirement Income Security Act of 1974 (more commonly known as ERISA).

Depending on your age, another benefit of leaving your 401(k) with a former employer is the ability to avoid IRS early withdrawal penalties. This will be addressed in more detail later, but if you are 55 or older and you left your previous employer after reaching age 55, you can take an early withdrawal and avoid the usual early withdrawal penalty.

Roll Your 401(k) into an IRA

Another available option is to roll your old 401(k) over into a new Individual Retirement Account (IRA). Rolling over your account essentially means transferring the funds into a new account type, which should also give you the option to change what those funds are invested in.

The first benefit of rolling over is the additional control an IRA provides. These accounts usually offer a much wider selection of investment fund options than what your former employer may have offered. Depending on your former company’s rules, an IRA may offer more withdrawal options like installments rather than just quarterly or annual withdrawals from your employer’s 401(k) plan. Additionally, you also have control over which IRA provider you choose next – either to simplify your finances by consolidating your accounts under the same roof or by finding the lowest fee offerings.

Another benefit of rolling over your 401(k) is that you do have the ability to continue making contributions to your new IRA, even after you’ve left your previous employer. The caveat is that you must have earned income to make a contribution. If you decide to work part-time in retirement or try your hand working within the “gig economy”, you can still make contributions to an IRA with those wages. However, you are required to take withdrawals – called required minimum distributions, or RMDs – from that IRA if you’re working past age 72.

The ability to continue contributing to your retirement savings is particularly important if you’re planning on saving as much as possible in the final years before entering retirement. Using a retirement income calculator can help you figure out how much you’ll need to have saved before retiring to help determine if you need to save more.

Cash Out

Finally, you do have the option to fully cash out your old 401(k), but this is commonly advised against by financial advisors. This is the nuclear option and really should only be considered if there is an immediate critical need for cash, and there are no other options available. If you liquidate your 401(k) prior to age 59 ½, you can expect to pay a 10% early withdrawal penalty for that tax year on top of the income tax on those funds except in limited circumstances. In addition, if you fully cash out your 401(k) without a comprehensive plan for how those funds will be used, it may cause longer-term harm to your overall retirement picture.

When to Take Qualified Distributions

It’s important to note that there are other considerations related to your 401(k) when planning for retirement. The first is understanding when you can start taking qualified distributions – that’s the technical phrase for tax-free and penalty-free withdrawals from an IRS-designated qualified retirement plan. To pass as qualified distributions, funds are typically withdrawn after age 59 ½ or under some specific extenuating circumstances.

Although there is no penalty to withdraw your money from a traditional pre-tax 401(k) after age 59 ½, you will still pay ordinary income tax on those qualified distributions.

Retiring Early? Avoid the 10% Early Withdrawal Penalty

If you’ve decided to retire or have been forced into an early retirement, you do have options available to help avoid the 10% early withdrawal penalty. You are not subject to the 10% penalty if you take a hardship withdrawal. Some of the more common hardship withdrawal exceptions include being deemed totally and permanently disabled, losing employment when you’re at least age 55, or having a distribution mandated from a Qualified Domestic Relations Order following a legal divorce.

Required Minimum Distributions

One more consideration is that having a 401(k) means you need to plan for IRS Required Minimum Distributions (RMDs). RMDs are a way for the federal government to force minimum liquidations of certain retirement accounts to generate taxes to be paid on those funds. RMDs apply not only to 401(k)s but also 403(b) retirement accounts along with traditional IRAs.

Congress recently passed the SECURE Act in 2019 which made major changes to the RMD rules. According to the Act, 401(k) account holders are mandated to withdraw the minimum amount before April 1st after they turn age 72 to avoid a 50% penalty on that required withdrawal amount at tax time. This penalty is on top of the taxes you’ll have to pay at ordinary income tax rates on the amount you should have originally taken out.

The RMD calculation comes from Distribution Tables provided by the IRS but for planning purposes you can calculate your own RMD liability. One thing to note – for those working past age 72, you are not required to take an RMD from your 401(k) until April 1 of the year after you retire.

Final Thoughts

When it comes to the decision of what to do with an old 401(k), there are numerous factors that are unique to your situation and retirement, making the best choice different for everyone. Remember that any additional taxes, penalties, and extra account fees are adverse to you fully enjoying your retirement. To help avoid these, it’s in your best interest to talk to a financial professional to discuss your goals and retirement plans to see what options may make the most sense for you.

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