Here’s That Rainy Day: How Your 401(K) Works When You Retire

Duringyour working years, you contributed to your 401(k)—or, if you worked at a public school or charity, your 403(b)—to help fund your retirement. But what happens when you get to the finish line and retire?

Surveys show nearly half of older participants in 401(k) or 403(b) plans have no idea how they will get cash out of their accounts and how much, if any, is taxed. Even some defined contribution plan participants who have taken distributions are uncertain whether they took the distributions in the form of a lump sum payment or in the form of a stream of annuity benefits.

A 401(k) or a 403(b) is not a total retirement income plan, just one source of income in retirement. A plan to create income in retirement should consider your 401(k), but it should also include income withdrawals from other accounts such as IRAs, investments, and Social Security, and may include income from annuities and pensions. By having multiple streams of income, you can more efficiently generate retirement income by strategically leaning on different sources at different times. This approach can help you minimize taxes while balancing the need to grow your investments and generate reliable income that will last through your retirement.

After you retire, you may transfer the money in your 401(k) to another qualified retirement plan such as an IRA. This may be a good idea if you are looking for more options. To transfer your 401(k), a direct rollover is tax- and penalty-free.

How Long Do You Have?

Contemplating how long we will live is not something many of us feel comfortable doing. Even so, to determine the amount of your annual retirement account withdrawal, it’s essential to estimate, as accurately as possible, how many years your money needs to last.

According to the Centers for Disease Control, the average life expectancy in 2021 was 73 for men and 79 for women. Consider these averages a starting point only. You’ll also want to factor in the health and longevity of your nearest family members when gauging your lifespan. If your mother and father lived into their 80s, that’s an indicator you may as well. Online calculators are another helpful tool in arriving at an accurate life expectancy estimate. Ultimately, it’s a good idea to err on the side of caution and assume you’ll live longer than expected.

When Can You Take Withdrawals?

You can begin withdrawing funds at age 59 and a half. When you withdraw funds from your 401(k) before that age, you will typically be hit with a 10% penalty. Once you turn 59 and a half, that penalty is waived, and you can begin taking distributions. However, just because you can doesn’t mean you should. It might be worth leaving that money alone to continue to grow.

Even if you don’t need the money, once you turn 73, you will have to start taking required minimum distributions (RMDs) from retirement accounts such as IRAs, 401(k)s, and any other tax-deferred retirement accounts. RMDs must be taken annually by April 1 of the year after you turn 73 and by December 31 in subsequent years. Also note that the RMD age will bump up to 75 in 2033.

When you calculate your RMD, be aware that it will change from year to year. That is because it is determined by your age, life expectancy (the longer it is the less you must take out), and account balance, which will be the fair market value of the assets in your account on December 31, the year before you take a distribution.

The penalty for not following the rules is severe. Failure to make on-time RMDs triggers a large 25% excise tax. If you miss an RMD from an IRA, but you correct the mistake quickly and refile your taxes, the penalty may be reduced to 10%.

If you have a significantly younger spouse who is expected to inherit your IRA, you may be able to reduce your required distributions, thereby trimming taxes and making your retirement funds last longer.

RMDs are calculated using factors that include your life expectancy as determined by the IRS. But if you have named a spouse as the sole beneficiary of your IRA, and he or she is at least 10 years younger than you, then your RMD is computed using a joint-life expectancy table. That will reduce the amount you need to distribute in any given year. For more information on this situation, see IRS publication 590-B.

Withdrawal Rate

An important consideration is how much you can safely withdraw from your account each year. The sustainability of your savings depends not only on your asset allocation and investment choices, but also on how quickly you draw down the account(s). Basically, you want to withdraw at least enough to provide the income you need, but not so much that you run out of money quickly, leaving nothing for later retirement years. The percentage you withdraw annually from your savings and investments is called your withdrawal rate. The maximum percentage that you can withdraw each year and still reasonably expect not to deplete your savings is referred to as your “sustainable withdrawal rate.”

A common rule states that a withdrawal amount equal to 4% of your savings each year in retirement (adjusted for inflation) will be sustainable. However, this method has critics, and other strategies and models are used to calculate sustainable withdrawal rates as well. For example, alternatives include:

• withdrawing a lower or higher fixed percentage each year
• using a rate based on your investment performance each year.
• choosing a rate based on age.

Factors to consider include the value of your savings, the amount of income you anticipate needing, your life expectancy, the rate of return you expect from your investments, inflation, taxes, and whether your retirement income needs to provide for one or two retired lives.

Can’t Avoid Taxes

Taxes can impact your available retirement income, especially if a significant portion of your savings and/or income comes from tax-qualified accounts such as pensions, 401(k)s, and traditional IRAs; most, if not all, of the income from these accounts is subject to income taxes.

It matters which retirement account you withdraw from first. In fact, studies have found that tax-efficient retirement withdrawals can make your savings last longer.

You will owe taxes on your 401(k) distributions. Traditional 401(k) contributions are often made on a pretax basis, which means that they lower your taxable income during your working years. Because the money wasn’t taxed when contributed, you will have to pay taxes on your distributions.

Generally, it’s wise to withdraw from Roth accounts first and keep traditional 401(k) contributions untouched as long as possible. Since you generally wouldn’t owe taxes on Roth withdrawals in retirement, this order of liquidation can reduce taxation over your lifetime.

Roth Conversion and Qualified Charitable Contributions

If a portion of your nest egg is in a traditional IRA or 401(k), it’s possible to do a Roth conversion. That means you will owe income tax on the amount you convert in the year that you convert it. When thinking about a Roth conversion and taxes, you should consider what your marginal tax rate will be in retirement and when you plan to take Social Security. With a Roth IRA, you can enjoy tax-free distributions in retirement.

The law lets individuals aged 70-and-a-half or older make tax-free donations, known as qualified charitable distributions (QCDs), of up to $100,000 annually directly from their IRAs to a charity. This applies to the sum of QCDs made to one or more charities in a calendar year. QCDs can be counted toward satisfying your RMDs for the year if certain rules are met. If you file a joint return, your spouse can also contribute up to $100,000.

Such a distribution does not count as income, which reduces any liability to the donor. However, if you make the tax-free charitable distribution, you won’t be able to itemize them as a charitable contribution. You basically get one or the other.

Annuities and ‘Period Certain’

Some 401(k)s have annuity contracts embedded within them. An annuity is a type of insurance contract that provides you with income during your lifetime. Annuitization is the process by which your annuity is converted into regular income payments.

When you annuitize payments, the insurance company agrees to pay money to you on a fixed schedule. You might receive those payments for a set number of years or for the rest of your natural life. The amount you receive from annuitized payments can depend on how much you paid in premiums to purchase the contract, your life expectancy, and the annuity’s rate of growth. An annuity option called period certain allows the customer to choose when and how long to receive payments, which beneficiaries can later receive.

A guaranteed monthly income for life sounds attractive on the surface. However, it’s possible that saving and investing your 401(k) balance on your own or with the help of a financial adviser can make more financial sense in the long run.

Conclusion: It Helps to Have a Plan

So how does a 401(k) work in retirement? Although all these tips offer varying levels of retirement savings wisdom, think carefully about how they might apply to your own personal financial situation.

What you do with this information is ultimately up to you based on how you want to use your life savings to fund your retirement. Before making any decisions, consider developing a customized and comprehensive financial plan that will integrate all facets of your financial life and address your specific needs, goals, and circumstances. As always, see a financial adviser for help.

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