Everything has led to this: You’ve contributed to your 401k, you’re invested the assets, and finally the time has come to withdraw the money. In this episode of The Agent of Wealth Podcast – the third in a three-part series on 401ks – host Marc Bautis shares some of the biggest mistakes people make at retirement age, when taking withdrawals from their account(s).
In this episode, you will learn:
- Various tax implications to consider when creating a withdrawal strategy for retirement.
- Issues to consider before taking a loan from your 401k.
- What Rule 72(t) periodic payments are.
- The six retirement options you have when you leave your job.
- And more!
Part 1: Mistakes to Avoid When Contributing to Your 401k | Part 2: Mistakes to Avoid When Investing In Your 401k | Schedule an Introductory Call | Bautis Financial: 7 N Mountain Ave Montclair, New Jersey 07042 (862) 205-5000
Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. In today’s episode, we’ll talk about mistakes I see people make when withdrawing or taking distributions from their 401k. This is the third part in a three-part series on 401ks. In the first episode, we talked about mistakes when contributing to 401ks, and in the second episode, we talked about mistakes when investing in your 401k.
There are different reasons at different times for people to start drawing from their 401k. Here are a few things you want to consider to withdraw effectively.
Mistake #1: Not Considering Tax Implications on 401k Withdrawals
The first mistake is not considering taxes on your 401k withdrawals. You want to look at this from a couple of different angles, and the first is that because of taxes, you’re probably going to need more money in your 401k than you think.
For example, let’s say you have a million dollars in your 401k, you’ll have to plan for less than that after drawing from it. Remember, every time you make a contribution to your 401k – assuming that it’s a pre-tax contribution and not a Roth contribution – you get a tax deduction in the year that you make it. If you earn $100,000 a year and you contribute $10,000 to your 401k, you’ll actually pay tax on $90,000 at the end of the year.
Another tax benefit is you get to defer paying taxes while the money is in the 401k. However, when you take money out in retirement it comes out as ordinary income, getting lumped into every other income source like social security, a pension, interest dividends, etc. After everything is combined, that amount determines your tax bracket, which is the tax rate you’ll pay.
A lot of people figure that when they’re in their high income earning years, they’re going to be in a higher tax bracket. They’ll get the deduction into the 401k at a higher tax bracket, and when they take out from the 401k, they’ll take it out at a lower tax bracket. But because we don’t know what tax brackets will be in the future, we don’t know if that will be true. For some people it will, but for others it won’t, and they might be in an even higher tax bracket in the future. In that case, it may have not even made sense to contribute to a 401k at all.
But as far as distributions, you want to know what your after tax retirement savings picture looks like, and you probably want to know that before you start taking withdrawals so that you can determine how much to take out without running out of your assets by the time you pass away.
If you have been making contributions of the Roth style to your 401k, your after tax retirement savings picture will be pretty straightforward, because Roth contributions are made with after tax money. While you don’t get a deduction when you make a contribution, you can withdraw the money without paying taxes, assuming you meet the criteria (no penalty). So Roth 401ks make planning more straightforward.
So we talked about the pre-tax 401k and the Roth style 401k. Another example of post-tax money is your savings and investment accounts. However, with these, if you take distributions, you may incur capital gains tax based on the yearly accruing interest or dividends from the accounts. So savings and investment accounts have their own tax consequences. Then there are things like social security, pensions and annuities.
All in all, you need to understand your tax picture before going into retirement. The rule of thumb used to be that you take from after tax accounts first, like savings and investment accounts, then your tax deferred accounts, like pre-tax 401ks or traditional IRAs, and then your tax-free accounts, like Roth accounts. But this rule of thumb no longer holds true because every situation is different.
If you need more help here, I hosted a webinar on how tax planning changes during the four stages of retirement. Watch it here.
Mistake #2: Issues When Taking a Loan From Your 401k
Next I want to talk about loans. You are able to take a loan from your 401k while you’re still working at the company that sponsors the plan. You cannot change jobs and take a loan from an old 401k. Now, it’s not necessarily a mistake to take a loan. Sometimes it’s the best option available when you need funds, for whatever reason. But there are a couple of things that you want to consider.
First, the obvious one, it may impact your retirement. The way a loan works is you can take up to 50% or $50,000 from your 401k, whichever is smaller, and usually it gets amortized. You then pay it back over a five-year period. If you leave your job before that five year period is up, you have to repay that loan. Otherwise it becomes a distribution.
If you’re younger than 59½, it is not only a taxable distribution, but you also have to pay a 10% penalty on top of it. Depending upon when you take it out and what happens in the market, it can have a significant impact on your retirement savings, because what happens a lot of times is people will take a loan out and they don’t repay it. So you really want to make sure you have the means or the ability to repay the loan if you do go this route.
The next thing to consider is that the interest that you pay back on your loan is double taxed. Let’s say you take out your loan and you have to pay a thousand dollars of interest each year. So you pay tax on your income, and then you pay the interest back to the loan. However, when you take out money from the 401k in the future, you’re paying ordinary income tax on that withdrawal, including the interest that you paid back into the 401k that you were already taxed on. So your interest is double taxed.
Mistake #3: Not Taking Advantage of Rule 72(t) Periodic Payments
The next thing I want to talk about is 72(t) periodic payments. Some people don’t take advantage of these, or make mistakes when using them.
I see a lot of people who have built up significant assets in their 401k, and they don’t want to wait until age 59½ to tap them. But they also don’t want to pay that 10% early withdrawal penalty. So Rule 72(t) is a way that you can take funds from your retirement account before age 59½. As long as you follow this strict set of rules and take a series of substantially equal periodic payments (SEPPS), you’ll pay income tax on the withdrawals, but you’ll avoid early withdrawal penalties.
You should consult with a financial professional before doing this, because there are some nuances to the rules to take into account. This is commonly used when one spouse wants to retire early and the couple is working to determine how they can bridge until the other spouse retires or starts receiving Social Security. So there are instances where taking 72(t) payments makes sense, but you should seek out an expert to make sure you follow the strict guidelines.
The way 72(t) payments work is that you take these payments for a period of five years, or until age 59½, whichever is longer. If you start taking these payments at age 40, you’d have to continue them for 19½ until you’re 59½. And then from there, you can start taking normal distributions. If you start at age 58, you’d have to take them until you’re 63½, the same five-year period. There’s three methods that the IRS allows you to do this: the amortization method, the minimum distribution method or the annuitization method. Just because this is an option, it doesn’t necessarily mean it’s the right thing for you. But like I said, there are certain situations where this could be a strong option.
Related: Updates to 72(t) Rules
Mistake #4: Not Considering All Your Options When You Leave Your Job
Next I want to talk about one of the most important retirement decisions you’ll ever make, which is what to do with your old retirement account when you leave your job. A lot of people think it’s an easy choice, but depending upon your situation you may have up to six options to choose from.
- Leave the assets in your existing plan.
- Roll the assets over into another plan, like another 401k.
- Roll the assets over into an IRA.
- Take a lump sum distribution (the nuclear option).
- Make an in-plan Roth conversion.
- Convert your plan assets to a Roth IRA.
There are different reasons for making each of these decisions, but the Roth options are growing in popularity as people notice the drop in their 401k account performance in the last year. If you do decide to do a conversion, you’re converting at a lower amount with the expectation that at some point the market (and your 401k balance) will recover. However, if you do consider one of these options, you really want to look into the following areas:
- Fees and Expenses.
- Creditor Protection.
- Estate Planning Options.
Making a mistake while withdrawing from your 401k can be catastrophic. You could pay anywhere from hundreds to thousands more depending on how you withdraw, what order you withdraw and the amount you withdraw.
As I mentioned in the first episode of this series, for many people, 401ks are their biggest asset – they are what people lean on the most for income during retirement. So you definitely want to make optimized decisions when it comes to withdrawing.
If you have any specific questions, you can schedule a consultation with our advisors below. Thank you to everyone who tuned into today’s episode.