As you near retirement, it can be tempting to use 401(k) distributions to fund big purchases. There are, however, lots of rules to follow and tax implications that you must be aware of before making a decision.
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Dear New Frugal You,
My wife and I are nearing retirement. We’ve been big-city renters most of our lives, but now we’d like to move to the country and buy our own place. Since we don’t own a home our biggest asset is my 401(k) plan. We’d like to use it to pay for our country spread. Please help me understand 401(k) distributions. — Nigel
That’s a good question that lots of people will be asking in the years to come. According to the Administration on Aging, the portion of the U.S. population aged 65 and older will grow by 33 percent between 2010 and 2020. Let’s see what we can tell you (and the 10,000 boomers who retire every day) about 401(k) retirement distributions.
Before we dive in, let me sound a loud warning: You’re making a decision that will have a major impact on your life, one that has both tax and personal finance components. I have only generic advice to offer. Make sure you get competent, professional advice specific to you before taking any action.
On to the business at hand. You’re dealing with a couple of different variables, so let’s break it down into smaller pieces.
To begin with, you’ll have two sets of rules to follow, as both the federal government and the plan administrators will have something to say about how you withdraw the funds.
You’ll need to contact your plan administrator to find out any plan rules. If you don’t know who the administrator is ask your HR department or use the contact info on your most recent 401(k) statement.
Your plan may require you to withdraw your money from the 401(k) when you leave your employer. If that’s the case, you’d have the option of moving the investments to a rollover IRA, taking a lump sum of cash or using the money to buy an annuity.
Next, let’s talk about taxes. Your CPA can answer any questions about them. The money in your 401(k) plan has never been taxed, so every dollar you withdraw is added to your taxable income in the year that you withdraw it.
You didn’t say how old you are. Your age makes a difference in how much you’ll pay in taxes and (maybe) penalties on your withdrawal. If you take any money out before you reach age 59-1/2, you’ll face a 10-percent penalty payable to our friends at the IRS. There is an exception if you’re between 55 and 59 1/2 and you leave your company. This could apply to your situation if you’re taking early retirement.
On the other hand, you may have delayed retirement. Federal law requires you to begin taking distributions the year you reach age 70-1/2. The amount you’re required to take depends on your life expectancy. It begins at about 4 percent per year and increases gradually as you get older.
Now that we’ve looked at some of the basic rules and requirements, let’s consider your timing strategy. Higher incomes face higher tax rates, so you’ll need to decide whether you want to make the purchase before you retire. If so, you’ll be adding any 401(k) distribution to your regular paycheck income. That could boost you into a higher tax bracket.
The way to avoid that is to wait until the year after you retire so that the 401(k) distribution is only added to your pension or Social Security income. Presumably this will be less than you were earning as an employee.