How to withdraw money from a 401(k) account
As your career begins winding down and you approach your golden years, it’s time to move your focus away from living on your income and move it instead towards living on your savings. You’ve spent the greater portion of your life saving for the day you can retire, but many new retirees feel hesitant to break open that retirement piggy bank we call a 401(k). Even more don’t know what to do with funds in their 401(k) account after they retire. In fact, a recent study by the Employee Benefit Research Institute reported that nearly a third of workers don’t have a concrete plan in place for what to do with their hard-earned savings .
Before panicking—and certainly before taking any distributions—it’s important to plan out how and when you’ll withdraw funds from your retirement account.
What are the requirements for withdrawing from a 401(k)?
Distributions from 401(k) accounts are highly regulated—designed to discourage savers from tapping into their retirement savings early. The first thing you’ll want to know to help you plan out how and when to collect 401(k) distributions is when your plan allows you to begin collecting in the first place.
In many cases, you must be retired to begin collecting penalty-free distributions from a 401(k) account. Some 401(k) plans do allow for in-service distributions or hardship withdrawals that allow you to tap into the funds while still working, but we’ll get to that in a minute.
We’ll start with withdrawing funds once you retire. If you retire after the age of 59 ½, you’ll be eligible to start receiving penalty-free distributions from your 401(k) account, but any withdrawals made before reaching this age are subject to a 10 percent early withdrawal penalty tax. However, if you choose to retire after the age of 55 due to job termination, you would be eligible to receive distributions that are still exempt from the 10 percent early withdrawal penalty tax.
As you can see, there’s no “one size fits all” solution for knowing when and how to begin collecting 401(k) funds. It’s important to have a game plan lined up before reaching retirement age, and the first step in crafting that game plan is to know your options.
How to take money out of a 401(k) account when you retire
· Leave the money in your account
You may be able to leave funds in your 401(k) account after you retire, but the option ultimately depends on your account balance and the terms of your plan. The IRS allows 401(k) plans to automatically distribute small account balances, so if you have less than $5,000 in the 401(k) account, you’ll want to check your plan’s Summary Plan Description for applicable distribution regulations.
If you aren’t in dire need of the money in your 401(k) account, and you can afford to do so, leaving the money in the plan may be a good option to consider. You’ll still be able to grow your savings tax-free and take advantage of compounding, which can generate extra funds for your retirement account even after you stop working.
However, you’ll eventually have to start taking distributions from your 401(k) account – even if you can afford your lifestyle without tapping into those funds. If you’re retired, you must start taking mandatory annual distributions—with the specific distribution amount calculated based on your life expectancy and account balance—from your 401(k) when you reach age 70 ½. However, if you have reached age 70 ½ and are still in the workforce, you won’t be required take Required Minimum Distributions (RMDs) until you do retire.
But the rules change again if you own five percent of the business, in which case you’d be required to take RMDs when you turn 70 ½ regardless of whether you’re still employed or not. And the price you pay for avoiding Required Minimum Distributions (RMDs) is costly. If you choose not to take the RMD from the account, the IRS will impose a 50 percent tax penalty on the remaining RMD funds that were not withdrawn but should have been.
· Take a lump sum distribution
If you retire after you reach the age of 59 ½, you’re eligible to take a lump sum distribution of any and all funds in your 401(k) account. However, it may not be in your best interest to do so.
You’ll not only lose out on the benefits of tax-deferred compounding, but you’ll have to pay income tax on the distribution for the tax year in which you take it. That may not sound like a huge deal at first glance, but if you have a sizeable retirement account balance and choose to take a lump sum distribution, you may be bumped into a higher tax bracket—depleting a larger percentage of the funds before you even see them.
Options for borrowing from a 401(k) while still working
If you’re still in the workforce and need to access your 401(k) funds for one reason or another, you may still have options. These pre-retirement withdrawal options include in-service distributions, hardship withdrawals, and plan loans.
In-service distributions allow you to withdrawal your vested money before retirement and are sometimes referred to as an “early retirement” option in the plan. This is generally allowed at age 59 ½ because distributions of your 401(k) deferrals before that age are subject to a 10 percent penalty tax.
Hardship distributions are allowed for special reasons such as medical care, purchase of your home, tuition, funeral expenses, payments to prevent eviction, and damage to your principal residence. The distribution is limited to the amount you need, and your employer will need to see some proof of the hardship. Hardship distributions are subject to income tax and the 10 percent penalty tax for distribution before 59 ½.
Plan loans occur when you borrow money from your 401(k) balance, but the amount you can withdraw is limited to the half of your vested balance and cannot be more than $50,000. The loan will have to be paid back to the plan with interest, and the loan period cannot exceed five years in most cases. That being said, loans taken out for principal residence can be longer than five years.
Before deciding to take a loan, hardship withdrawal, or in-service distribution, consult your 401(k) plan document to ensure you’re able to even do so. Regardless, taking any withdrawal from your retirement account before reaching retirement isn’t ideal. Why? Because the money will be out your 401(k) plan and you’ll miss out on the snowballing effect of compound tax-deferred interest on those funds. Plus, hardship and in-service distributions cannot be repaid to the plan. It becomes clear, then, that early withdrawals can and will have a huge impact on your 401(k) balance when you are retirement ready and should be used on a last resort basis.
What you need to know before taking a hardship withdrawal from your 401(k)
One of the top rules of retirement planning hasn’t changed—taking money out of a qualified retirement savings account before you reach full retirement age could be a costly mistake. Withdrawals, such as hardship distributions, could affect the funds available to you when you are set to retire. Experts warn that a 401(k) hardship withdrawal should be your absolute last resort and should only be used when you have used or explored all other options.
Why you should consider a 401(k) loan instead of hardship withdrawal
If you’re in need of extra funds and have no other options outside of your 401(k) plan, consider taking a plan loan. First, check out your 401(k) plan document to see if it allows for plan loans. If allowed, you can borrow up to 50 percent of the vested portion of your 401(k) balance. You’ll pay interest as you’re paying the loan off, but it is credited back into your account. And as long as you pay the loan back, it’s not taxable. In addition, you can still contribute to the 401(k) plan and pay back the loan at the same time, although it may be wiser to put that additional money toward the principal to get it paid off in a shorter time – saving on interest charges.
A loan is better than a hardship distribution because with a loan, you can restore your 401(k) balance by paying the loan back. But there are no payback provisions for hardships; once the hardship distribution is made, it’s out your 401(k). You will need to make other arrangements to cover any shortage in your retirement savings objective due to the hardship distribution.
What are the consequences of taking a hardship distribution?
Whether you’re a Millennial or Baby Boomer, a hardship withdrawal could have a significant impact on your retirement outcome. As a Baby Boomer, your years of “catching up” will be shorter. In some cases, you may never entirely catch up to where you once were prior to the withdrawal. It could also mean you may need to postpone your retirement until you are financially more stable, dramatically setting you back on your retirement goals.
As a Millennial, things aren’t quite as bleak. While a hardship disbursement will certainly set you back, you will have many more years in the workplace to make up the difference. However, they are still costly in the short term when you pay taxes, and participants that are not 59 ½ or older may be subject to a 10 percent penalty tax.
Here’s the bottom line: the decision to take a hardship distribution is truly a personal one and is often surrounded by extenuating circumstances. Because of the impact on funds for retirement, hardship distributions should be your absolute last resort for withdrawing funds from your 401(k) retirement fund.