The 401(k)suffers from a branding problem. If the name were more descriptive or catchy, people would pay closer attention to these savings tools. They are hugely beneficial–often including free money (yes, free) –and are currently the bedrock for most retirement savers. However, despite the benefits, two-thirds of workers do not take advantage of their company’s employer-sponsored 401(k)plans. Before we review the optimal ages for 401(k) withdrawals, and when you are required to make them, let’s look at the history behind 401(k)s.
401(k) plans are employer-sponsored, retirement saving vehicles. They provide some tax advantages:
- They reduce your taxable income in the years you make contributions, and
- Taxes are deferred on the earnings until you withdraw from them.
Employees are allowed to contribute a specific amount each year to their 401(k) plans. In 2017, the maximum amount most employees can contribute is $18,000 of pretax income (also referred to as an elective deferral limit). If you’re age 50 or older by year-end, you can contribute an extra $6,000 as a catch-up contribution. Employers manage the administrative portion of the plan while you choose the investments. Many employers will match a portion of your contribution. That’s the free money we mentioned before.
There are rules and best practices about how the money goes in and grows in a 401(k), but in this article, we tackle the rules related to employee age at the time of withdrawal. By withdrawal, we mean taking money out of the plan (preferably gradually), paying your taxes on the withdrawal amount and spending the rest. The object of the withdrawal game is to play to minimize taxes and penalties and get the maximum income from your nest egg. This is the fundamental mission of a decumulation –as opposed to accumulation –strategy.
The government requires you to start withdrawing your money by age 70½. And in doing so, you pay ordinary income tax on the portion you withdraw. The government considers this a good deal for you since it graciously allowed you to reinvest your earnings for years without paying taxes on them. A little history puts this in perspective.
In 1978, a simple provision was written into the tax code to clarify the way tax professionals and the IRS were treating benefits like stock options and profit sharing bonuses, which at the time applied to only a small number of employees in a small number of businesses. Taxes were deferred until realized, much in the same way you don’t owe taxes on an appreciating asset like a stock that increases in value –you don’t pay taxes until you sell it. But the rules weren’t entirely clear, so the 401(k) provision was written into the tax code. As mentioned, it applied to a very small class of income and deferring these taxes was considered a negligible loss of revenue for the IRS.
But then, a law enacted in 1980 that allowed employees to contribute to their 401(k) plans through salary deductions opened the floodgates to these tax-advantaged savings accounts. And, in turn, as an unintended consequence (and a gift to business owners), employers saw an opportunity to reduce the funding of pension plans. Since employees were now funding their own retirement, they figured they could relieve themselves of this burden. What was intended by Congress to be a retirement-savings add-on has become a core way for Americans—52 million of them with $4.8 trillion in assets (Investment Company Institute)–to save for retirement.
Once you’ve saved it, the question becomes how and when can you access it? That’s where the age-related 401(k) rules come into play.
The 401(k) age-related rules
Like most things the government puts together, the rules are not simple. Here’s how it works when you go to take money out.
1. If you are 70½ or older in almost all situations, you must start withdrawing Required Minimum Distributions (RMDs) to avoid penalties. You can withdraw more than the required amount –but not less.
2. If you have a 401(k) plan sitting with a former employer, you can begin accessing those funds as early as age 59½. And, if you left that employer on or after your 55th birthday, you might be able to access the funds even earlier. See the next point for details.
3. Under special circumstances, you can withdraw from a 401(k) between the ages of 55 and 59½ without being penalized. Here’s how it works: if you are between the ages of 55 and 59½ when you leave (voluntarily or not) the employer that is your 401(k)’s plan sponsor, you can withdraw funds penalty-free provided you leave the money in that 401(k) plan. This special early age withdrawal provision applies as early as age 50 for certain types of public safety workers such as federal fireman, federal law-enforcement, and air traffic controllers. Remember, this same rule does NOT apply to IRAs (which are not company-sponsored plans). If you withdraw from an IRA before age 59 1/2, you’ll be hit with a 10% early withdrawal penalty tax in addition to ordinary income taxes (unless you qualify for an exception to the early withdrawal penalty tax.)
4. If you want access to 401(k) funds from a plan sponsored by a current employer, you may not be able to get your hands on it, even if you are 59½ and older. (Now you see why banks and investment firms are such big fans of 401(k)s –they get to hold on to your money for a long time!) In you’re in this situation, you will need to check with the plan administrator to see if your plan allows for an “in-service” withdrawal. Some plans allow it; others do not.
5. If you roll your previous 401(k) into your new employer’s 401(k) or an IRA (note a rollover is not considered a withdrawal for tax and penalty purposes), you cannot withdraw money until you’re 59½ without incurring penalties. So, if you terminate after age 55 but before 59½ there may be a good reason to leave your 401(k)with your former employer so you can access those funds in case of emergency.
6. Once you are age 70½, you have to start taking required minimum distributions (RMDs) from your employer-sponsored 401(k) plan-with one exception. If you are still working at age 70 ½ (some of our clients are), and you are not a 5% owner of the company, you may be able to delay your RMD from your current employer plan until April 1 of the year after you retire. Check with your plan administrator to see if your plan allows this. You will still be required to withdraw funds from plans sponsored by previous employers and from any IRAs you have.
7. The Required Minimum Distribution (RMD) is based on a formula. It’s a simple calculation based on your total account balance on December 31 of the previous year divided by a “distribution period,” yielding a fixed percentage, based on age. At age 70, this fixed percentage is your prior year-end balance divided by 27.4 (3.65percent), but by the time you are 115(!), it is the balance divided by 1.9 (52.6 percent). As you age, you must withdraw a larger portion of your remaining balance each year.
8. Note, in this article we are talking about rules that apply to traditional tax-deferred 401(k) balances. A few years ago, a new type of 401(k) account called a Designated Roth Account, came into being. A different set of rules applies to Roth accounts.
Be aware, take caution
Do not retire earlier than 55 thinking that you can access your 401(k) funds penalty-free once you are 55. For example, if you retire at 54, thinking in one year you can access funds penalty-free, you will still be hit with a 10 percent penalty fee. You needed to leave your employer after age 55 for that provision to apply. When you leave your employer before age 55, the earliest you can access funds penalty-free will be age 59 ½.
Once you start withdrawing, you can stop and start up until age 70 ½. Once you’re 70 ½, you must withdraw a specific portion, the RMD, from your nest egg each year.
It would be nice if you could choose to withdraw only as much as you need, but if a substantial portion of the 4.8 trillion dollars in 401(k)plans were allowed to remain untapped, there would be an enormous amount of tax revenue lost that would balloon the federal deficit. Therefore, the RMD makes sure that most of the income is taxed in your lifetime (of course).
The IRS imposes a 50 percent tax penalty on RMDs that are not withdrawn from your 401(k). This is quite a costly oversight if you neglect to withdraw amounts you are supposed to withdraw.
It’s all about decumulation planning
Minimizing taxes and maximizing income when withdrawing from tax-deferred savings plans can be as effective as an additional two percent rate of return on your savings -yes two percent. Decumulation planning helps retirees get more income from their retirement savings by carefully managing timing and amounts of withdrawals. Traditional financial advisors focus on the accumulation of assets and often have little knowledge about drawdown strategies. Sensible Money focuses on how and when to withdraw to get the most out of your accumulated savings in retirement. To learn more about how planning for retirement is different, read the 5-star rated book Control Your Retirement Destiny.
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