How to Withdraw Money From 401(k)s and IRAs During Retirement
If you’ve built a nest egg big enough for retirement, congratulations!
You may have thought saving enough to retire would be the hardest part.
For some people, figuring out how to withdraw from a 401(k), IRA or other retirement savings is more difficult.
Once you understand some basic concepts, things become more clear.
Figuring Out How Much to Withdraw
Here's the trick part:
You need to make your money last for the rest of your life.
There's a popular study that provides some guidelines -- based on historical data -- for calculating how much to withdraw (and when).
While this won’t necessarily work in the future, it has worked in the past. Remember, past results aren’t indicative of future returns.
The study says:
- A person with a portfolio with a mix of stocks and bonds can withdraw 4% of the value of the portfolio in the first year.
- Each year thereafter, the person can increase their withdrawal by inflation. Inflation is defined as the consumer price index, often called CPI.
- If a person follows this, historically, there was a 95% chance of success. Success is defined as having money 30 years after starting a retirement drawdown.
While this oversimplifies the art of figuring out how much to withdraw, you can use it to determine a specific plan based on your specific situation.
Your investments, pension income, Social Security income and many other factors will likely result in choosing an individualized number based on your situation.
Figuring Out What Order and Where to Withdraw Money From
Figuring out where to withdraw money from is usually a bit easier than figuring out how much to withdraw.
Of course, there are many ways you can structure your withdrawals.
These options depend on your goals, spending plans, and tax situation.
1. Required Minimum Distributions (RMDs)
The first thing you need to do is see if you’re subject to required minimum distributions.
A required minimum distribution (RMD) is the amount that you must withdraw from certain retirement accounts by April 1st of the year following the calendar year in which you reach age 70 ½.
In general, accounts such as traditional 401(k)s, 403(b)s, traditional IRAs, SIMPLE IRAs, SEP IRAs are subject to RMDs.
If you’re subject to RMDs, make sure you take these as your first distribution.
Applicable retirement accounts
RMDs are typically required for pre-tax retirement accounts.
These accounts are ones which you put money into the account before paying federal income taxes on it.
If you never withdraw the money, the federal government never gets to collect the income tax on the money. So, they created RMDs to force you to withdraw money and pay federal income tax.
You aren’t required to take an RMD from a workplace retirement plan if you’re still working at that job and don’t meet other certain limitations.
Even so, you must take RMDs from IRAs and other workplace retirement plans you no longer work for.
When you don't take an RMD
If you are subject to RMDs, it is extremely important to withdraw this money by the deadlines.
If you don’t take an RMD:
You’ll be subject to a penalty of 50 percent of the value of the RMD, which is basically giving money away.
You don’t have to spend the money, but you do have to remove it from the retirement plan it is in according to the rules.
You can learn more about RMDs, how they’re calculated in regards to life expectancy and everything else you need to know at the IRS’s RMD resource page.
After you take your RMD, you have a few other places you can withdraw money from, as well.
2. Taxable Investment Accounts
If you have any money in taxable investment accounts, this may be your next best spot to withdraw funds from.
Taxable investment accounts don’t offer tax breaks for contributing to them.
However, selling securities from these accounts can have benefits.
If you have owned the security you’re selling for more than a year, you may qualify to pay long-term capital gains taxes. Long-term capital gains tax rates are lower than ordinary income tax rates.
Additionally, you’ll only pay the tax on the gain in value of the asset from when you bought it to when you sold it. You don’t have to pay the tax on the total sale price.
This means taxable investment accounts can provide you with a decent amount of income without adding a ton of tax burden if you play your cards right.
3. Traditional Retirement Accounts In Excess of RMDs
You can also withdraw more money from traditional retirement accounts in excess of the RMDs.
Money withdrawn from these accounts will qualify as ordinary income and require you to pay ordinary income tax on the withdrawal amount.
4. Roth (Post-tax) Retirement Accounts
The holy grail of retirement accounts in retirement are Roth accounts like a Roth 401(k) and Roth IRA and other Roth retirement accounts.
These accounts require you to pay taxes on the money before you contribute it to these accounts.
That means money withdrawn after you reach age 59 ½ will be federal income tax free.
Watch Out for Penalties
If you retire before traditional retirement age, you’ll need to be extra careful where you withdraw the money from.
Withdrawing from certain accounts before you reach the retirement age required could result in a 10% penalty for early withdrawals or early distributions.
You can withdraw money from IRAs and 401(k)s without a penalty after reaching age 59 ½. Withdrawing before that age could result in penalties on 401(k) and IRA distributions.
There is a special rule for 401(k) accounts that may allow you to withdraw funds at age 55 without an early withdrawal penalty.
If you were still working at the employer that held your 401(k) in the calendar year you turn age 55 and retire, quit or are fired, you can withdraw money from that account without penalties.
This only works for money in the 401(k) at that employer, though.
Make Sure to Consider Tax Consequences
Now that you understand the major buckets you can withdraw retirement funds from, you must come up with a strategy to do so.
One of the major things to consider is how each type of withdrawal will impact your taxes.
You have to take RMDs, so you’ll have to pay income tax on that money. After that, you can explore the types of investment accounts you have.
Make a plan to withdraw money from the different types of accounts to keep your tax bill as low as possible over the long-term. This may mean you need to have a spending plan for the future to know how much income you’ll need each year.
A spending plan can help you determine when it’s most advantageous to withdraw money from each account.
The plan can offer guidance for when withdrawing from tax-free Roth accounts or when withdrawing from a traditional retirement account makes more sense.
Accessing Money Before Traditional Retirement Age
But what happens if you retire before age 59 ½? Can you access your money early without penalties?
You could use the 401(k) option discussed above.
You must retire from the company with the 401(k) in the calendar year you turn 55 for this to work.
If the 401(k) option doesn’t work for you, there is another option called Rule 72(t). This rule requires you to follow strict guidelines. That said, it allows you to take penalty-free withdrawals from traditional retirement accounts.
To do so, you must take substantially equal periodic payments.
Early withdrawals from Roth retirement accounts
You may be able to withdraw funds from Roth retirement accounts early without penalties, too.
In general, you can withdraw only the money you contributed without paying taxes or penalties. This is because you already paid income taxes on this money.
Things get more complicated if you withdraw earnings early. In some cases, you can withdraw earnings penalty and income tax free, too.
To withdraw earnings from a Roth IRA without paying penalties or income tax, you must take the withdrawal:
- at least five years or more after you open the account, and
- be withdrawing money because you suffered a disability, or
- you’re using up to $10,000 for a first home purchase within 120 days of withdrawal.
Finally, don’t forget about your taxable investment accounts.
Since these aren’t retirement accounts, there are no penalties for early withdrawals.
What’s The Perfect Way to Withdraw Funds?
The perfect way to withdraw the money needed to fund your retirement is a unique solution for you.
Remember to take RMDs if you’re required to.
After that, there are plenty of options you can mix and match based on the types of accounts you hold.
Keep in mind:
You’ll need the money to fund your entire retirement.
Don’t use up all of your tax advantages in the beginning unless that’s what makes the most financial sense for you.
Consult a Fiduciary Fee-Only Financial Planner
If you feel lost, don't be afraid to talk to a professional to get advice about your specific situation.
A fiduciary fee-only financial planner charges a flat rate for services. Other advisors may charge a commission or a percentage of assets under management.
Both types of financial planners can help draft a financial plan. This plan can help you meet your retirement goals.
However, using a fee-only fiduciary adviser can provide a plan without paying ongoing fees or biased advice.