401(k) Retirement Accounts: All Things Considered

Qualifying for Medicare doesn't mean that your health care costs will be covered. Fidelity estimates that a couple who retires in 2013 will need as much as $240,000 beyond their Medicare coverage to pay for health care costs in retirement.^[1] So it's crucial to have adequate savings set aside for your retirement.

Assuming you have saved good amounts of money in 401(k), let's look at what the options you have when you retire.

Key Facts

Your 401(k)s—tax-deferred retirement plans—are before-tax investments and can continue to grow tax-free. Companies also often match your contributions up to a limit. For example, the matching contribution from Oracle is equal to 50% of your first 6% in 410(k) Contributions. which is capped to $5,100 in 2013. However, you do pay Social Security (FICA) and other employment taxes on your 401(k) contributions.

At the time of 401(k) withdrawals, it will be taxed as your regular income. There is not a mandatory 401(k) retirement age. However, you may pay penalty taxes if you withdraw it earlier. After your have reached age 59½, you may withdraw all or a portion of your Account without incurring any penalty.

Here are quick summary of 401(k) facts:^[16]

• Before you turn 59½
• If you try to take money out of your 401(k) before you turn 59½, the funds are taxed as regular income — plus, you'll get hit with a 10 percent early withdrawal penalty.  Based on [25], this is a bad idea.
• In some states, additional penalties may apply. For example, in California there is an additional 2½% penalty.
• Age 55 (or 50; see below) is the earliest age to access 401(k) penalty-free^[8-10]
• Instead of a regular withdrawal you may be able to take a 401(k) loan, or qualify for a hardship withdrawal, if your 401(k) plan allows them.
• You can also check with your plan administrator to see if they have a special provision that allows for something called an “in-service” withdrawal. “In-service” means you are still employed by the company sponsoring the plan.
• The Pension Protection Act of 2006 made an additional change to the above rule: The age limit is reduced to 50 for retiring police, firefighters, and medics – so they can take distributions from their plans penalty-free at that age or after.
• After you turn 59½
• You have three options:^[2]
• Take the money and run
• Leave it be
• Roll it over

• After you turn 70½
• Required Minimum Distributions (RMD)
• If you fail to take the required amount each year from pre-tax accounts, like 401(k)s and IRAs, by that age, you may face a hefty tax of 50 percent on the amount you withdraw.
• To mitigate the tax bite from the RMD, there are several strategies:^[24]
• Purchase a qualified longevity annuity contract (QLAC) inside your IRA or 401(k). 
• Convert your traditional IRA into a Roth IRA.(more common way)

Now, let's look at the benefits and disadvantages of each option.^[2]

Take the Money and Run

If you're age 59½ or older (or age 55, if you meet certain criteria), you won't owe an early-withdrawal penalty on a withdrawal of 401(k) assets, though you'll still owe ordinary income tax on the distribution.

• Benefits
• Free to invest or spend the money in anyway you want after withdrawal.
• Disadvantages
• You won't be able to take advantage of tax-deferred compounding over the course of your retirement.
• You'll owe ordinary income tax on the whole kitty—you won't have the opportunity to spread the tax hit over many years.

Leave It Be

It can make sense to leave the money in your old 401(k) if your former employer offered a gold-plated plan with lots of low-cost options, some of which were exclusive to your company. For example, some plans provide access to ultra-cheap institutional share classes, and you won't find a stable-value fund outside of the confines of a 401(k) plan, either.

• Benefits
• Continue to enjoy tax-deferred compounding on your money.
• For people who will need to tap their 401(k) assets prior to age 59½ are also better off leaving the money in the plan rather than rolling it over to an IRA, because they can avoid the penalty on early withdrawals once they hit age 55 and are separated from service during or after the year in which they turned 55.
• Assets in a 401(k) often have better creditor protections than assets in an IRA, though the protections vary by state.
• If employer stock consumes a big share of your 401(k), you may save on taxes by leaving the money inside of the plan rather than rolling it over.
• Disadvantages
• Some 401(k) plans are costly and subpar. 

Roll It Over

Provided you're not paying any administrative costs that override the benefits of those exclusive options, sticking with an old 401(k) plan can make sense.  If your plans are costly and subpar, you'll be better off rolling the money over into an IRA, where you'll enjoy full discretion over your investment selection rather than having to stick with a preset menu.

If you roll it over to IRAs, be aware of these regulations:

Federal tax law requires that you make the Rollover Contribution within 60 days from the date you receive your distribution from your prior employer’s plan or special conduit IRA. In order to comply with this 60-day requirement, You plan administrator must receive your distribution and all additional required documentation no later than 45 days after you receive your distribution.

• Benefits
• Allow you to enjoy tax-deferred compounding as long as the money remains in the account.
• The new IRA may be cheaper and with more options.
• Disadvantages
• IRA assets don't always have the same creditor protections that 401(k) assets do.
• You may opt for more risky and/or narrowly focused options, which may lose money in some circumstances.

Conclusions

There are 3 reasons for you to invest in 401(k):^[5]

1. To reduce your taxable income
2. To provide tax deferred growth and allow you to defer taxes
3. To get you free money (i.e., company matches)

If you have saved a good amount of money in your 401(k) and are at age of 59½ or older, you have 3 options:

1. Take the money and run
2. Leave it be
3. Roll it over

If you choose to withdraw money from your 401(k), here are general distribution rules (check with your Plan Administrator for further information):

• Your Account is payable 30 days after you terminate your employment with the Company for any reason.
• Once you reach age 65, or if you terminate your employment after your reach age 65, your Account is payable as soon as practicable after your termination.

Also, when your Account is payable to you, you may elect to take payment in a lump sum or in a series of equal installments. Installment payments shall be paid over a period not extending beyond your life (or life expectancy) or your life and the life of your beneficiary (or the joint life expectancies).

Finally, a new Gallup survey shows that many baby boomers are reluctant to retire.^[6,20] If you are one of them, pay special attention to the Required Minimum Distributions to avoid a hefty penalty. 

References

1. What Health Care Will Cost You (AARP)
2. What Should You Do With Your 401(k) When You Retire?
3. 10 myths that could ruin your retirement
4. Can you avoid paying taxes on a 401(k) cash-out?
5. 3 Reasons To Use An Employer-Sponsored Retirement Plan
6. Baby Boomers Reluctant to Retire; What About the Fed's Retirement Thesis?
7. Social Security Tax Breaks Drive New Retirement Strategy
8. 401k Retirement Age - 55, 59 1/2, or 70 1/2 - Different Rules Apply
9. Did you know you can access your 401(k) penalty-free at age 55?
10. 401(k) Withdrawals at Age 55
11. UNC Asheville (formerly the North Carolina Center for Creative Retirement)
12. The Next Chapter
• The Next Chapter™ projects are community coalitions across the country that are working to help people in the second half of life set a course, connect with peers, and find pathways to meaningful work and significant service.
13. The Lifetime Income Series: Making Sense of the Retirement Plan Alphabet Soup: myRA, IRA, Roth, SEP, SIMPLE, PSP, 401k, 403B, DBP, etc. (Audio)
14. Make Sure You Know the Ins and Outs of Your 401(k)Plan (Wiser)
15. Retirement Account Winners and Losers
16. 5 Retirement Penalties to Avoid
• IRA early withdrawal penalty (59½, penalty: 10%)
• 401(k) early withdrawal penalty (59½, penalty: 10%)
• Penalty for failing to take retirement distributions (70½, penalty: 50%)
• Early Social Security penalty (62, penalty: 30%)
• Medicare late enrollment penalties (65, penalty: 10%)
17. The Lifetime Income Series: Which Is Which: Roth and Traditional IRAs (video)
• Rollover IRA is the same as traditional IRA.  But, they are kept separated for ease of bookkeeping.
18. Individual Retirement Arrangements (IRAs)
• Contribution limits
• Deduction limits
19. Retirement planning (must-watch video; start at 28:00 mark for the interview with Dr. Michael Finke, Professor & Director of Retirement Planning and Living at Texas Tech)
• Retirement stages: 80 seems to be a big dividing line when it comes to physical and mental ability.  That's the time when we start to slow down and spending data statistics supports that theory.
20. Plan a Satisfying Retirement (good)
21. 25 Things I Know Now That I'm 60
22. Key Question For Millennial Job-Switchers: What To Do With Your Old 401(k)?
23. What should you do with that 401(k) when you retire?
24. Happy Half-Birthday, Boomers! Now Pay This Tax …
25. The Single-Worst Retirement Move