How do you withdraw money from a 401(k) when you retire?

As you plan your retirement, you should think about how you are going to live off your retirement savings once you are out of employment. You will need to figure out how to withdraw your retirement savings in your 401(k) post-retirement, and the best withdrawal strategies so that you don’t exhaust your retirement savings.

When withdrawing your retirement savings from a 401(k), you can decide to take a lump-sum distribution, take a periodic distribution (either monthly or quarterly), buy an annuity, or rollover the retirement savings into an IRA.

Usually, once you’ve attained 59 ½, you can start withdrawing money from your 401(k) without paying a 10% penalty tax for early withdrawals. Still, if you decide to retire at 55, you can take a distribution without being subjected to the penalty. However, any distribution you take after retirement is taxed, and you must include the distribution as an income when filing your annual tax return.

Withdrawing Money from a 401(k) After Retirement

Once you have retired, you will no longer contribute to the 401(k) plan, and the plan administrator is required to maintain the account if it has more than a $5000 balance. If the account has less than $5000, it will trigger a lump-sum distribution, and the plan administrator will mail you a check with your full 401(k) balance minus 20% withholding tax.

Before you can start taking distributions, you should contact the plan administrator about the specific rules of the 401(k) plan. The plan sponsor must get your consent before initiating the distribution of your retirement savings. In some 401(k) plans, the plan administrator may require the consent of your spouse before sending a distribution. You can choose to receive non-periodic (lump-sum distributions) or periodic distributions from the 401(k) plan.

For required minimum distributions, the plan administrator calculates the amount of distribution for the qualified plans in each calendar year. The 401(k) may provide that you either receive the entire benefits in the 401(k) by the required beginning date or receive periodic distributions from the required date in amounts calculated to distribute the entire benefits over your life expectancy. 

Options for Withdrawing Money from a 401(k) When You Retire

After you’ve retired, you can choose one of these options for withdrawing your retirement money from a 401(k):

Lump-sum distribution

If you need a large sum of cash immediately, you should consider taking a lump-sum distribution. This option involves cashing out the entire 401(k) plan. Unless you invest the money elsewhere, you will need to budget wisely to make sure the money lasts until your death.

Taking a lump-sum distribution has two main limitations i.e. the money will not grow further tax-free and you will owe ordinary income taxes in the tax year in which the distribution is taken. Taking a large sum at once pushes you to a higher tax bracket, and therefore, a sizeable portion of the money will go into paying taxes. The distribution will be subject to 20% withholding on disbursement, and the withholding will be applied to the tax bill for the tax year.

Periodic Distributions from 401(k)

Instead of cashing out the entire 401(k), you may choose to receive regular distributions of income from your 401(k). Usually, you can choose to receive monthly or quarterly distributions, especially if inflation increases your living expenses. If the 401(k) is your main source of income, you should budget properly so that the distributions are enough to meet your expenses.

For example, if you have accumulated $1 million in retirement savings, you can choose to receive $3,330 every month, which amounts to approximately $40,000 annually. You can adjust the amount once a year or every few months if your 401(k) plan allows it. This option allows the remaining savings to continue growing over time as you take periodic distributions.

Buy an Annuity

You can also opt to buy an annuity based on part or all of your 401(k) balance. This option guarantees you a fixed stream of payments for the rest of your life. If you buy an annuity with survivor benefits, your partner can receive a stream of income even after you die.

Since annuities are not inflation-adjusted, the returns will be lower than if you invested the money on your own. Also, if you die a few years after buying an annuity, the insurance company will benefit from the bulk of your retirement savings.

Roll Money into an IRA

If you are not satisfied with the 401(k) investment options, you can rollover the money into an IRA since the latter has more investment options and offers greater control. You can reallocate your portfolio of investments to help you grow your investments further in years to come.

If you have a string of old 401(k)s when you retire, you should consolidate them into an IRA for better management of your retirement savings. Also, you can reduce the administration fees of your retirement money, and even qualify for discounts on sales charges.

Strategies for Withdrawing Money from a 401(k)

If you want to start making withdrawals from your 401(k), you should establish a savings withdrawal strategy that provides sufficient income without exhausting the 401(k) balance too soon. Here are the key retirement withdrawal strategies to consider:

The 4% withdrawal rule

The 4% rule says that you can withdraw 4% of your savings in the first year, and calculate subsequent year’s withdrawals on the rate of inflation. This rule is based on the idea that you should withdraw 4% annually, and maintain the financial security in retirement for 30 years. This strategy is preferred because it is simple to compute, and gives retirees a predictable amount of income every year.

For example, if you have $1 million in retirement savings, 4% equals $40,000 in the first year. If the inflation rises by 2.5% in the second year, you should take out an additional 2.5% of the first year’s withdrawal i.e. $1000. Therefore, the withdrawal for the second year will be $41,000.

Fixed-dollar withdrawals

This strategy involves taking a fixed income from the accumulated 401(k) retirement savings over a specific period. For example, you can take $35,000 annually for the next 5 years, and reassess the withdrawals when the five years lapse based on the remaining retirement savings. This strategy provides a predictable annual income, which you can budget to meet your living expenses.

However, this withdrawal strategy does not protect against inflation, and you can quickly exhaust your savings within a few years. In a down market, the investments may be down due to market volatility, and you may be forced to liquidate more assets to meet the fixed-income withdrawals.

Fixed percentage withdrawals

This strategy calculates the withdrawals based on a fixed percentage of your portfolio. The total annual income will fluctuate from one period to the next, as the value of the investments in the portfolio change.

The fixed-percentage withdrawal strategy can help your retirement savings grow over time if the set percentage is below the anticipated rate of return. This means you will be cashing out the returns earned while allowing the principal amount to grow. However, if the percentage of withdrawals exceeds the rate of return, you risk eroding the retirement savings sooner than you expect them to last.