When to Withdraw 401(k) and IRA Savings for Retirement
If you watch the news, it seems like the biggest issue facing retirees and those soon to be retired is inadequate savings.
But that’s not actually the case.
According to research by the Blackrock Retirement Institute, most current retirees still have 80% of their retirement nest egg available two decades into retirement. That figure is constant across all income levels and is expected to continue until 2030.
The challenge for Baby Boomers isn’t accumulating savings for retirement, it’s decumulating in the most efficient way. In other words, for most people in their 50s, the most pressing concern is when to withdraw 401(k) and IRA savings in retirement.
On the surface of it, that seems like a good problem to have, but mistakes can be costly. If you don’t withdraw your 401(k) and IRA savings at the right time, you could owe penalties and unnecessary taxes. Even worse, poorly timed withdrawals could shorten the life of your nest egg or reduce the income generated by your investments, impacting your lifestyle later in retirement.
Here’s what you need to know about when to withdraw 401(k) and IRA savings for retirement and develop an effective decumulation strategy.
401(k) and IRA withdrawal basics
Most people intuitively understand that retirement savings should be left alone until you actually retire. For those who are tempted to tap those funds before retirement, the government established rules and a 10% penalty for early withdrawals.
Avoiding early withdrawal penalties
You can avoid the 10% early withdrawal penalty by waiting until age 59-½ to take IRA and 401(k) withdrawals. If you want to retire early—before 59-1/2—the “rule of 55” applies.
If you retire, quit, or are fired from your job any time during the year you turn 55, you may be able to access your retirement account without a withdrawal penalty. However, there are two points to keep in mind:
The penalty exception only applies to money in the 401(k) you have with your current employer. If you have money in an account with a past employer, you can’t access those funds before age 59-½. You can avoid this rule by rolling over any funds in other accounts to your current 401(k) before you retire.
The exception doesn’t apply to IRAs, only 401(k) accounts. If you rolled your 401(k) funds into an IRA and retire at 55, you will still owe the 10% early withdrawal penalty on IRA distributions until age 59-½.
The SEPP escape hatch
Rule 72(t) provides exceptions to the 401(k) or IRA early withdrawal penalty if you take at least five substantially equal periodic payments (SEPPs). Under rule 72(t), SEPP amounts are based on life expectancy and calculated according to IRS guidelines. The payments must take place for five years or until the account owner reaches age 59-½, whichever is longer.
SEPPs are usually considered the option of last resort since they offer the lowest overall retirement payout. Generally, if you need to take an emergency early withdrawal, it’s best to explore other IRS exceptions before pursuing SEPPs because they can have a significant impact on the lifespan of your retirement account.
401(k) and IRA withdrawals by age
An efficient decumulation strategy begins with understanding the IRS rules that apply at each stage of retirement.
Under age 55
The 10% early withdrawal penalty usually applies to any withdrawals prior to age 55. In addition, withdrawals can only be taken from 401(k) accounts with past employers. You generally aren’t allowed to take withdrawals from your current employer’s 401(k), although your employer may allow loans or hardship withdrawals.
Ages 55 to 59-½
The 10% early withdrawal penalty applies unless you meet the “rule of 55” exceptions related to early retirement or job loss listed above.
Ages 59-½ to 72
If you’re still employed, you may not be able to take withdrawals from your current employer’s 401(k), although you can take withdrawals from your IRA and any previous employer’s 401(k) you haven’t rolled over to your current plan. Some employer plans do allow “in service” withdrawals, however, so you need to check with your HR department. Traditional IRA and 401(k) withdrawals are taxed as ordinary income, but you don’t pay income tax on Roth IRA distributions.
Ages 72 and over
Once you reach age 72, required minimum distributions (RMDs) kick in. The SECURE Act, signed into law in December 2019, changed the age for RMDs from 70-½ to 72 for those who turn 70-½ after January 1, 2020. Once you turn 72, you need to take annual RMDs based on your account balance and life expectancy or pay a penalty equal to 50% of the distribution.
You may be able to delay RMDs from your 401(k) past age 72 if you are still employed, but only if you aren’t an owner of the company. Those employed at 72 can typically delay their first RMD from their current employer plan until April 1st the year after they retire.
Money in Roth IRAs is not subject to RMDs.
Developing your 401(k) and IRA drawdown strategy
An efficient decumulation strategy starts with your income needs. This figure is different for everyone and depends on the age you retire and your expected lifestyle in retirement. The first step is calculating your fixed and variable expenses.
Next, add up your income from guaranteed sources—Social Security, annuities, pension payments, bonds, and dividend stocks. If this figure is higher than your expenses, your decumulation strategy should be focused on wealth preservation and estate planning.
If your expenses exceed your guaranteed income, you’ll need to calibrate your distributions and drawdown strategy to ensure you don’t outlast your savings.
Plan for healthcare
If you retire prior to reaching age 65, you’ll want to make sure you plan for substantially higher healthcare costs until you’re on Medicare. Private healthcare costs are outrageously high; premiums can be more than $1,000 per month per individual.
This is when you’ll want to pay special attention to 401(k) and IRA withdrawals. If you are able to keep your modified adjusted gross income below certain thresholds, you may be able to qualify for healthcare subsidies through the Affordable Care Act thereby reducing the cost of health insurance until you go on Medicare. The potential result could be tens of thousands of dollars in savings on healthcare premiums.
To reduce your income, consider avoiding 401(k) or IRA distributions until after you go on Medicare. Instead, consider taking your income from alternative sources such as taxable brokerage accounts or your Roth IRA.
Qualifying for Affordable Care Act credits takes serious attention to detail when it comes to portfolio withdrawals. One mistake and you could end up paying thousands of dollars out of pocket. Be sure to talk with a financial advisor who specializes in retirement income strategies.
Are you charitably minded? If so, you’ll also want to rethink your giving strategy. Many people give to their local church or favorite charity by writing a check or giving cash. While this is a wonderful act of kindness, it can be a serious financial mistake. Instead, consider implementing a Qualified Charitable Distribution or QCD to help reduce your tax burden or increase how much you give.
A QCD is an IRS-allowable strategy that lets you make charitable gifts directly from your IRA to your favorite charity. If executed correctly, IRA withdrawals for charitable purposes will be tax-free upon reaching age 70 or older. When you turn 72, the QCD can count toward your required minimum distribution for the year!
Here is a helpful Qualified Charitable Distributions checklist to help guide you through the process.
Professional guidance for your IRA and 401(k) withdrawals
For today’s current and near-future retirees, the retirement planning life cycle is about more than just accumulating the right mix of assets to ensure income in retirement. It’s about developing a smart, tax-efficient drawdown strategy that supports your retirement lifestyle and preserves your wealth for your heirs and the charities you care about.
A financial advisor for retirement can evaluate and fine-tune your retirement plan and create a drawdown strategy that serves your goals and objectives. Even better, a professional advisor monitors the economy and market conditions to keep you on track when circumstances change.
Covenant Wealth Advisors is an independent, fee-only retirement planning firm. Working together, we help you prioritize your goals and develop a decumulation strategy to help you achieve them. If you’re not sure when you should take your 401(k) and IRA withdrawals, schedule a free consultation today.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors.