At What Age Should I Start Making 401(k) Withdrawals?
There are plenty of best practices about how money goes in and grows in a 401(k), but in this article, we tackle the rules related to the age at which you can withdraw from 401(k) plans.
By withdrawal, we mean taking money out of the plan (preferably gradually), paying your taxes on the withdrawal amount, and spending it. A rollover to an IRA or a transfer to a new 401(k) plan is not the type of withdrawal we’re talking about here.
The object of the withdrawal game is to minimize taxes and get the maximum after-tax income from your nest egg. This is the fundamental mission of a decumulation strategy (as opposed to accumulation, which is what we’re focused on during most of our earning years).
The 401(k) age-related rules
Like most things tax-related, the rules are not simple. Here’s how it works when you go to take money out.
- You’re not age 55 yet. A penalty tax normally applies to any withdrawals taken before age 59 ½. And normally you can only withdraw from 401(k) plans at previous employers. For a 401(k) offered by the employer you still work for, usually you can’t take withdrawals while still employed there. Some plans allow 401(k) loans or hardship withdrawals. You must check with your plan administrator to see if they allow these options.
- You’re age 55 to 59 ½. 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 leave your employer between the ages of 55 (actually any time during the year of your 55th birthday) and 59½, then you can withdraw funds penalty-free provided you leave the money in that 401(k) plan. This rule applies whether it is voluntary termination or not. This special early age withdrawal provision applies as early as age 50 for certain types of public safety workers such as fireman, law-enforcement, and air traffic controllers. Remember, this same rule does NOT apply to plans from previous employers that you may have left long ago. And it 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.) So, if you terminate during the year you turn 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 if needed.
- You’re age 59 ½ to age 70. If you have a 401(k) plan sitting with a former employer, you can begin accessing those funds as early as age 59½. You’ll pay ordinary income taxes on amounts withdrawn, but no penalty tax. When you rollover funds to an IRA, that is not a taxable move – so no worries about taxes if you retire and consolidate accounts. Usually consolidating makes managing the withdrawal process much easier. When you start withdrawing, you can take a little or a lot, depending on your needs that year. Once you’re age 70 ½, you must withdraw at least a specific portion, the Required Minimum Distribution (RMD), from your nest egg each year. We cover that in item five below.
- While you are still employed, if you want access to 401(k) funds from a plan sponsored by your current employer, you may not be able to get your hands on it, even if you are age 59½ or older. If 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.
- You are age 70 ½ or older. Once you are age 70½, you must 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 take your RMDs from plans sponsored by previous employers and from any IRAs you have. The IRS imposes a 50 percent tax penalty on RMDs not withdrawn from your 401(k) on time. Ouch! That’s a hefty penalty. Don’t neglect to withdraw amounts you are supposed to withdraw!
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 401(k) accounts.
Be aware, take caution
Do not retire earlier than age 55 thinking that you can access your 401(k) funds penalty-free once you turn 55. For example, if you retire at 54, thinking in one year you can access funds penalty-free, you’ll have missed the mark. To avoid the penalty from age 55 – 59 ½, you needed to leave your employer no earlier than the year you attained the age of 55. When you leave your employer before the year you reach age 55, the earliest you can access funds penalty-free will be age 59 ½.
If you roll your previous 401(k) into a new employer’s 401(k) or to an IRA, you void the early access rule! Once it’s rolled over, you cannot withdraw money until you’re 59½ without incurring penalties unless you qualify for an exception or use an odd tax code provision called 72(t) payments.
Given all this, what is the best age to start taking money out of your 401(k)? For those with no pension or other guaranteed sources of income, it often makes sense to take money out in years where you are in a low tax rate rather than waiting until age 70 1/2. For those with pensions or other income sources, it often makes sense wait and only withdraw when you are required to do so. The right age depends on a lot of factors, and without a full analysis it is impossible for anyone to recommend the best option for you.
It’s all about decumulation planning
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 our Founder, Dana Anspach’s 5-star rated book Control Your Retirement Destiny. It gives you a step-by-step outline of how to plan for a transition out of the workforce.