The 401(k) is an attractive retirement vehicle. If you work for an employer that offers this type of retirement benefit, taking advantage of it warrants serious consideration.
So, what exactly are the benefits of owning a401(k) account? And at what age should you start withdrawing money from your401(k)? We’ll work to answer those questions and more to help you prepare for retirement.
The History of the 401(k)
The first401(k) retirement plan was founded in the 1970’s by employees of the Kodak corporation. You remember them: the guys who made all of those old-style cameras and film?
So, in the early 1970’s, according to Wikipedia, a group of high-earning Kodak employees went to Congress. They wanted Congress to pass a law stating they could invest part of their salary into the stock market and have that money be exempt from income taxes.
This law eventually morphed into what we now know as the401(k). Today’s401(k) is used by individuals all over the world as a way to save for retirement.
Here’s How the 401(k) Works
So, how does the401(k) work? Here are the basics.
With a401(k), you can make tax-deferred contributions to a retirement account. The contributions are withheld pre-tax and grow tax free. Taxes are paid only at the time of withdrawal and you’re taxed at your tax rate at the time of withdrawal.
There are certain rules to contribution and withdrawal with the401(k). Here are the basics.
401(k) Contribution Limits
Depending on your age, you’ll have certain limits on how much you can contribute to your401(k) account each year. Limits are as listed below:
- Adults age 18 to 49 can contribute $18,500 per year to their401(k) account
- Adults age 50 and over can contribute an additional catch-up contribution of $6,000 per year
Note that these numbers are quite a bit higher than IRA contribution limits. With IRAs, adults age 18 to 49 can contribute up to $5,500 per year. This is in addition to the401(k) limits. Adults age 50 and older can add an additional catch-up contribution of $1,000 per year to their IRAs.
Now, it’s important to remember that the above-mentioned contribution limits pertain to the account owner’s contributions. Some employers will match an employee’s 401k contributions. This is where the fun can begin with a401(k).
Most employers that offer a match program will match an employee’s401(k) contribution up to .50 percent and 6 percent of the employee’s salary.
This means that you’re automatically earning a positive return on your401(k) when your employer offers a match. So, if you contribute 5 percent of your income to your401(k), and your employer offers a 100% match up to 5 percent, you’ve effectively doubled your money immediately.
Of course, this “doubling” doesn’t include market fluctuations. Depending on how you choose to invest your401(k) earnings, you could make even more. Or, you could lose money. Invest right and add compounding interest into the equation though, and you could be looking at some serious retirement cash.
Now let’s go over the rules regarding401(k) withdrawals.
401(k) Withdrawal Rules
The401(k) account has withdrawal rules to go along with its contribution limits. Here is a description of the withdrawal rules of the401(k).
Regular Withdrawals out of Your 401(k)
You can begin taking regular withdrawal out of your401(k) at age 59 ½. If you take money out of your401(k) before that age, you could be subject to the IRS’s 10 percent penalty rule.
So, if you take $50,000 out of your401(k) at age 45, you’ll have to give $5,000 of that money to Uncle Sam.
Note that there are some exceptions to the 59 ½ rule. You can take early withdrawals out of your401(k) in some instances, and without penalty too.
However, special circumstances must apply in order to take these early withdrawals. For instance, if you leave your current employer between age 55 and 59 ½, and that employer is the sponsor of your plan, you can take unpenalized withdrawals. However, you have to leave the401(k) with that employer in order to do so.
This rule applies to people in certain public safety positions too, such as federal firefighters, and law enforcement personnel. It can also apply to air traffic controllers.
Why am I singling out these professions? Because their early withdrawal age starts at age 50, not at age 55. Note that this rule applies whether your employment separation is voluntary or not.
If you choose to take early withdrawals, you’ll be subject to the 10 percent penalty, and you’ll have to pay taxes on the income based on your current tax rate. Keep this in mind before taking an early withdrawal on your 401(k).
Required Minimum Distributions
The IRS also has rules about “late” withdrawals. The rule is that you have to start taking money out of your 401(k) by the calendar year in which you turn 70 ½.
And there are rules regarding how much money you have to take out of your 401(k) account each year after you turn 70 ½. From the IRS website:
“The required minimum distribution for any year is the account balance as of the end of the preceding calendar year divided by a distribution period from the IRS’s ‘Uniform Lifetime Table’”.
In other words, the minimum distribution you must take (again, minimum distributions are required after age 70 ½) is dependent on several factors.
See the IRS’s Uniform Lifetime Table for more information.
Note that in some cases you can avoid having to start withdrawing money from your 401(k) even if you are 70 ½.
If you are still employed with the employer that sponsors your 401(k) plan when you reach age 70 ½, and you’re not an at-least 5 percent owner of the company, you may be able to delay your RDM requirement until April 1st of the year following your retirement.
With more and more people working into their seventies and beyond, this could be a good way to be able to keep your money in your 401(k) if you qualify to do so.
Check with your tax expert for more information on this exception.
What if I Don’t Take the Required Minimum Distribution
It’s important to know that if you don’t take your required minimum distribution (RMD) from your401(k), the penalties are stiff. The IRS will fine you a hefty 50 percent on RMDs you didn’t make in time. Ouch!
Moral of the story: when you get to the age when you must start taking 401(k) RMDs, get it done. Failing to do so, whether by accident or on purpose, will be costly.
At What Age is it Best to Start Withdrawing Money from My 401(k)?
So, you know when you have to start withdrawing money from your 401(k) – at age 70 ½. But when should you start withdrawing; before then, or should you wait?
That answer is going to vary depending on your individual financial situation. There are several factors you should take into consideration before making that decision.
How Much Money do I Need?
One question you can ask yourself is how much money you need to survive and pay the bills each month. If you have a plush non-retirement savings account – or you’re still earning some income, you may be able to put 401(k) withdrawals off for a while if you’re not yet 70 ½.
Do I Have Other Sources of Income?
This question kind of relates to the question above. If you’re not yet 70 ½ and you have other sources of income, you may not need to take the money from your 401(k).
If you don’t have a substantial amount saved in your 401(k), you may want to leave it there as long as possible. This way the money will have more time to accrue interest.
What are the Tax Benefits of Delaying or Speeding up 401(k) Withdrawals?
Depending on your individual situation, it might benefit you to start withdrawing 401(k) monies right away at age 59 ½. Or, you may be better off waiting until you’re age 70 ½.
Each person’s financial situation is different. Therefore, you’ll want to talk to a tax expert to find out what’s best for you.
Depending on how much you have saved in the various investment vehicles, how much you have saved in non-retirement vehicles and on many other factors, the right withdrawal time can vary.
So be sure to consult with financial experts to determine what the best method for funding your retirement might be. Companies like Blooom specialize in helping people like you manage your 401(k) plan in the way that is best for your individual situation.
Worried that you aren’t saving enough to fund your retirement? Consider the tips below for saving more.
How to Save More for Retirement
Maybe you’re not so much concerned with when you should withdraw from your 401(k). Your concern might be whether or not you’ll have saved enough to live in. Consider these tips for saving more money for retirement.
Make it Automatic
Whether you’re saving in a 401(k), an IRA, a Roth IRA or some other retirement vehicle, automatic deposits are vital. When you treat your retirement savings like a bill, you lessen the chances of not having enough at the end of the month to save.
Automating your retirement fund contributions can be a great way to discipline yourself to save more for retirement.
Reduce Current Expenses
Another way to find more money to save for retirement is to reduce your current expenses. Beware, though: it’s important to make sure that “found” money gets into your retirement accounts quickly.
Otherwise you may be tempted to spend it other places. Just as you would with a debt snowball, take any extra funds you find and get them securely placed in your retirement accounts.
Some of the ways you might be able to reduce current expenses might include:
- Cutting your grocery budget by menu planning and taking advantage of coupons
- Trading in expensive entertainment plans for free or cheaper options (i.e. have a movie night at home instead of going out to the movies)
- Reducing salon expenses by doing manicures and pedicures at home
- Eliminating gym membership costs by working out at home or outside
For more information on reducing your current expenses, see our article on the Challenge Everything Budget.
Take Advantage of Your Employer’s Match Program
If you work for an employer that offers a 401(k) matching program, and you’re not already doing so, you should be contributing up to the maximum match percentage.
For instance, let’s your employer will match your 401(k) deposits 100 percent up to six percent of your income. If you’re only contributing 3 percent of your income to your 401(k), you’re leaving money on the table.
Increase your contributions up to that 6 percent and take full advantage of your employer’s generous match offer. Your employer’s benefits center should be able to help you do that.
Use Catch-Up Contributions
If you’re age 50 or older and need to save more for retirement, you can take advantage of catch-up contributions. As I mentioned earlier, you can save an additional $1,000 per year in your IRA if you’re 50 or older.
You can save an additional $6,000 per year in your 401(k) (over the maximum $18,500) if you’re 50 or older. Take advantage of the catch-up contributions rules if you’re over 50.
Target Unexpected Funds Toward Retirement
Another way to save more money for retirement is to put any unexpected money into your retirement accounts. This might mean the $50 you get for your birthday from grandma or the $3,000 tax refund you got this year.
If it’s not money that’s a normal part of your income and expenses, commit to putting it into retirement accounts. Don’t be tempted to use it to splurge on vacations or big-ticket purchases. Instead, invest it in your future.
The subject of retirement and retirement withdrawals can be a tricky one. It’s important to be sure you’re planning the accrual and usage of your retirement funds wisely. A wise financial advisor can help you to do this.
How are you doing on retirement savings and planning? What are your tips for saving enough? When do you plan on starting to withdraw money from your 401(k)? Share in the comments below.