Handling your 401(k)
One of the things that make retirement planning a bit complicated is that it continues even when you have already retired. It’s comparable to walking a tight rope. You want to be able to live comfortably when you retire but you want to make sure that you don’t deplete your account before you pass on—hopefully to a dimension where retirement planning is not as complicated or even necessary.
Perhaps your anxiety wouldn’t be as high if you could just leave the principal alone and spend only the earnings. But if you are like most regular retirees, you will have to draw down your account since you will have thirty to thirty-five years of retirement to think about. As you can see, it takes a bit of savvy and know-how to be able to spend your 401(k) without outliving it.
Now that you have retired, managing your 401(k) effectively will mean the difference between a comfortable and stress-free twilight years and one that’s fraught with worry and the constant fear if you will have enough to last you through your retirement years. What you do with your 401(k) depends on how old you are when you retire and how soon you intend to use the money. If your vested balance is $5,000 or more and you haven’t reached the plan’s retirement age then you can choose to just let it remain in the plan, provided of course, that you like the direction your employer is going as far as investments are concerned.
What are the advantages of leaving your 401(k) with your former employer? For starters, it is given greater protection from your creditors than an IRA. Since a 401(k) is covered by Federal law, you don’t have to worry that it will be included in the assets that will be seized in the event that you need to file for bankruptcy. Meanwhile, this kind of protection for your IRA depends on the law in the state where you live in.
But there are disadvantages. Leaving money in a 401(k) plan under your former employer means that your investments will be in their control. The investments they choose for your plan may have been fine before you left but they can change that any time. It is also easy for them to merge with other companies or sell the business entirely. What happens to your 401(k) plan then? Searching for a former employer can be a difficult and impossible task. It is best to get your 401(k) plan and put it in an IRA when you retire so you will have better control of your investments and more flexibility.
Taking out money from your 401(k) plan is another option. However, this has to be done carefully since there are taxes and sometimes, penalties, associated with early withdrawals. You should also know if your plan follows an “all-or-nothing” policy when it comes to taking money out. This means that you have to take out everything or take out nothing at all.
Taking out funds from your 401(k) before you’re 59 ½ years old can result in income taxes and a 10 percent penalty. Actually, if you are at least 55 years old when you leave your employer then you don’t have to pay a penalty on any money you get from your 401(k) plan but taxes will still be levied on your withdrawals. Also, some plans do not allow you to get money from it until you reach the normal retirement age of 65 years old. So before you can even think about taking money from your 401(k), you should make it a point to know when your employer’s plan allows you to make the withdrawals.
But what if you need money before you turn 59 ½? You may be able to make withdrawals for certain reasons, although you will still most likely be hit with the penalties and taxes. These hardship withdrawals include drawing money for sudden disability, the purchase of a first home, burial or funeral costs, repair of damages to your principal residence, payment of higher education expenses, payments necessary to prevent eviction or foreclosure, and money for certain medical expenses exceeding 7.5 percent of your income.
If you would like to withdraw money from your 401(k) without having to pay the penalty, you can make 72(t) withdrawals. In this arrangement, you’re actually making use of substantially equal periodic payments, also known as SEPP withdrawals. The number refers to Internal Revenue Service (IRS) rule 72(t) which allows you to take withdrawals for at least 5 years or until you reach 59 ½, whichever is longer. For example, if you are already 57 years old and you go for this option, you’ll receive your SEPP withdrawals until you reach 62 years old (5 years). But if you are, say 50 years old, you continue receiving the SEPP withdrawals until you turn 59 ½. The amount which you can withdraw is fixed each year and this is arrived at based on your life expectancy.
What are the pros and cons? While you don’t have to pay the 10 percent early withdrawal penalty for 72(t) withdrawals, you will still have to pay taxes on the amount withdrawn. You also lose out on the earnings that you would have received had you let the money grow. Plus, the younger you are when making these withdrawals you’re not likely to receive much.
Understanding Required Minimum Distributions (RMD)
By the time you turn 70 ½ years old, you need to begin making withdrawals from your 401(k). This is known as your Required Minimum Distributions (RMD). They are required because the government has to tax you at some point. How does an RMD work?
When you turn 70 ½ years old, you have to start getting your RMD. For the first year, you are given until April 1 of the next year to make your withdrawal. Thereafter, you have until December 31 every year to take your RMD. Remember that you will be taxed for this 401(k) withdrawal so it would not be wise to wait until April 1 of the next year to make your first RMD. This is because you will still need to make your second RMD by December 31 of that year. As a result, you will have made two RMDs on the same year which raises your taxable income.
What is your minimum RMD? To determine how much you can withdraw for a particular year, you need to know how much your balance was for the previous year. Then, you have to get an IRS life expectancy table which you can download from Publication 590 of the IRS. This can be downloaded from http://www.irs.gov/pub/irs-pdf/p590.pdf. There are three tables here which can be used for different groups of people to help in determining the minimum RMD.
Table I is for use by beneficiaries; Table II is for use by owners whose spouses are more than 10 years younger and are the sole beneficiaries of their IRAs; and Table III is for use by unmarried owners, married owners whose spouses are not more than 10 years younger, and married owners whose spouses are not the sole beneficiaries of their IRAs.
Let’s use an example to illustrate how to compute for your RMD: You’re 71 years old and your wife is 67 so you use Table III to find the Distribution Period for a 71-year-old. In the table, it is 26.5. Assuming that you have an account balance of $600,000 in your 401(k) by the end of the year, simply divide your balance with the Distribution Period (600,000 ÷26.5). You will arrive at an answer of $22,641.51—this will be your RMD for that year. In the following year, you will need to do a new calculation based on your new account balance and the Distribution Period when you turn 72. Take note that this is only the minimum RMD so you can always withdraw more. However, don’t withdraw less or else the IRS will slap you with a 50 percent penalty from the money in your RMD that you did not take out.
Tips for Managing Retirement Investments
When you were younger, your concern was to beef up the funds in your 401(k) so that you will be able to retire comfortably. Now that it’s time for you to cash in, you assume that getting your RMD is all you ever need to do. It isn’t. You continue to manage your money during your retirement so that it will not run out while you’re still up and about. Here are some tips to help you manage your retirement investments more effectively.