401(k) accounts are one of the primary retirement savings vehicles in the U.S. As of June 30, 2020, 401(k) plans had an estimated asset value of $6.3 trillion, which is approximately one-fifth of the total $31.9 trillion U.S. retirement market. Even though these accounts offer various advantages for retirees, they also have strict implications in terms of withdrawals. Improperly planned withdrawals from a 401(k) account can cause a big dent in your retirement savings, owing to the tax charges and penalties. However, if you plan prudently, it is possible to efficiently withdraw from a 401(k) without incurring any charges or impacting your retirement savings in the long-run.
Here is a guide that will help you efficiently withdraw from your 401(k) account:
- Do not opt for early withdrawals
- Be careful with withdrawals
- Be mindful of the Required Minimum Distributions (RMDs)
- Tap on Net Unrealized Appreciation (NUA)
- Use tax-loss harvesting
- Consider an IRA rollover
401(k) accounts hold savings for your future non-working years. Hence, it is advised not to take out money from this account to fund your other expenses. This can erode your future years' financial foundation and result in hefty penalties for early withdrawals, which in turn will impact your savings. As per the IRS (Internal Revenue Service), you can start taking penalty-free withdrawals at the age of 59.5. That said, any drawings made before this age, unless specifically exempted by the IRS, will attract a 10% penalty. Further, these early drawings are treated and taxed as ordinary income. All of which will reduce your wealth in the long-run. But there are some specific cases where the IRS may forgo this penalty. These include total and permanent disability, loss of employment (not before the age of 55), hardship distributions (subject to approval by the employer), and a few other conditions. These are also known as qualified distributions. That said, instead of taking early withdrawals, the strategy should be to delay withdrawals until you are required to take mandatory distributions or use the drawings for qualified distribution purposes only.
It is one thing not to take early withdrawals, but another critical aspect is to ensure that even when you take out money from your 401(k), your purpose is justified. The objective is to withdraw prudently so that you have sufficient funds for your present life as well as your retired years. For this purpose, you can follow the 4% rule. As per this rule, you can only take up to 4% of the total value of your 401(k) funds in the first year of retirement. As you progress further, you can adjust your drawings according to the rate of inflation. So, if by the 4% rule, you take out $40,000 from your $1million 401(k) balance, then in the second year, you can adjust this amount for inflation and withdraw the additional sum. This can continue till the time your savings last. But an important part of this rule is to reduce your withdrawal rate if there is no inflation or if the general consumer price index falls. Further, you must consider your fluctuating expenses and be slightly flexible about withdrawals while also being disciplined about your spending habits.
As general advice, it is always good to leave your 401(k) retirement savings alone and not use them unless specifically needed. The longer you allow your money to stay invested, the better return potential you can get. This also helps to avoid taxes. However, the IRS mandates all 401(k) contributors to start taking RMDs at the age of 72. The RMD will depend on your 401(k) balance and additional factors like life expectancy. It is possible to delay RMDs by applying some exceptions. Moreover, the IRS does not mandate RMDs, in case you are still working. However, the exact definition of ‘still working’ is subject to approval by the IRS. Also, this exception does not fit your purpose if you own 5% of the business/company that sponsors your 401(k) plan. Further, some organizations allow employees to defer their RMDs until the next year, if they retire after the age of 72. That said, if you do not qualify for any exceptions and fail to take the RMD or the total amount of your RMD or the RMD before the set date, the amount not taken out will be taxed at 50%. This could dent your retirement funds, and you could run out of money faster than anticipated. But for 2020, the CARES act has waived RMDs for all retirement plans such as Individual Retirement Accounts (IRAs), 401(k)s, 403(b)s, etc., owing to the COVID-19 situation.
Another favorable strategy for your 401(k) withdrawals is to use the NUA privilege. Some employers allow employees to own stocks in their company. This gives employees a sense of ownership. The value of NUA is the difference between the actual cost of employer shares and the current market value of the stock. In case you have company stock that has appreciated in value, in your 401(k) holdings, and you are distributing it from your 401(k) account, you can make use of the NUA advantage. The IRS offers favorable capital gain tax rates on the NUA of the employer at the time of distribution. However, this is subject to some specific qualification criteria.
A primary issue with 401(k) withdrawals is taxes. You can minimize or evade these taxes by applying tactics like tax-loss harvesting. Tax-loss harvesting minimizes your annual tax liability by offsetting your capital gains with specific investment losses. As per this approach, the losses you incur can counterbalance the taxes you owe on your 401(k) drawings. But tax-loss harvesting can get slightly complicated, especially when you have multiple securities and retirement savings accounts.
If you do not wish to withdraw your 401(k) funds or can afford to keep them vested in the account for a longer period, it is beneficial to consider rolling your existing 401(k) into an IRA. The idea is to withdraw your 401(k) funds and then transfer them to a new, more tax-advantaged plan like an IRA. An IRA offers long-term, tax-deferred growth of funds and a wider range of investment choices as compared to a 401(k) account. Further, an IRA allows you to take out your savings before the age of 59.5, without paying the penalty. However, the purpose of withdrawals should be a first-time home purchase or higher education. According to the IRS, you can do a 401(k) rollover within 60 days from the receipt of your 401(k) retirement plan distributions. You can choose to open an IRA with a bank or a brokerage firm. But you should understand the features, terms, fees, and other expenses linked to an IRA. Usually, an IRA has lower fees and lesser rules. Also, if you own an IRA, you can easily open a Roth account, which is the most advantageous of the retirement savings tools. A Roth IRA allows you to pay taxes on your amount now and get tax-free withdrawals later in the non-working years of your life.
To sum it up
Even though a 401(k) account offers numerous advantages and is widely popular among retirees, it cannot completely guarantee a secure retirement if you do not plan your withdrawals efficiently. Make use of the above-mentioned ways to structure and use your 401(k) distributions.It is also a good idea to consult an experienced professional financial advisor to secure your golden years and ensure your 401(k) savings last for a long time.