How Does a 401(k) Work When You Retire?

Over the course of your working years, you diligently contribute to your 401(k) in preparation for retirement. But what happens once you actually get there? Retirement marks a major life transition—which includes switching from saving your money to generating income with your savings.

So how does a 401(k) work when you retire? While it will be an essential source of income when you exit the workforce it’s a good idea to build a more comprehensive plan to create your retirement income. Here’s what you can expect from your 401(k) when you retire.

How does a 401(k) work when you retire?

It’s important to note that there are no hard-and-fast rules for how you should use your 401(k) when you retire. You may choose to keep your 401(k) with your employer and simply take distributions from it. Or, if you’d like to take advantage of better investments or annuity options, you can roll over your 401(k) when you retire. How and when you choose to access those funds will depend heavily upon your individual retirement plan—which is something you’ll want to have mapped out well before you retire.

Here are some key ideas you’ll want to keep in mind as you make plans for using your 401(k) in retirement:

A 401(k) is one source of retirement income

Remember that a 401(k) on its own is not a retirement income plan. While it’s certainly a smart way to save for your future and plays an integral part in building your nest egg, a 401(k) is just one source of income you’ll probably be relying on in retirement. The key to maximizing what you’ve saved in your 401(k) is deciding how you’ll use it in conjunction with other sources of income in retirement.

Your plan might also include withdrawals from other accounts like IRAs, other types of assets and cash reserves. It may also take into account annuities, pensions and Social Security as well. Having multiple streams of income lets you more efficiently generate retirement income by strategically leaning on different sources at different times. This approach can help you minimize the impact taxes while balancing the need to grow your investments and generate reliable income that will last through your retirement.

Working with a financial advisor—both to create and execute the plan—can help ensure that you’re getting the most out of each of your sources of income and protecting yourself against risks.

You can begin withdrawing funds penalty-free at age 59½

When you withdraw funds from your 401(k) before you turn 59½, you’ll typically be hit with a 10 percent penalty. But once you turn 59½, that penalty is waived. At this point, you can begin taking withdrawals (technically known as distributions) as you please.

Can you take all of your money out of your 401(k) when you retire? Sure. However, just because you're allowed to take distributions doesn’t mean you have to right away. In fact, if you don’t need income from your 401(k), it may be worth leaving that money alone for the time being. Not only is this important from a tax perspective (more on why in a moment), but it also means this money can keep growing in your 401(k) until you’re ready to use it.

You must begin taking distributions at age 73

Even if you don’t need the money, the IRS will require you to start taking withdrawals from your 401(k) if you’re retired beginning at age 73—a requirement known as required minimum distributions (RMDs). (If you’re still working at age 73 and you are not a 5 percent owner of the company, you are exempt from RMDs until retire.) RMDs also apply to some other tax-deferred retirement accounts you may have, like traditional IRAs. But there’s good news: The RMD age will bump up to 75 in 2033.

The RMD amount you’re required to withdraw depends on your retirement account balances and your life expectancy. While these IRS worksheets can help you do the math, a financial advisor can provide personalized guidance on how to be effective with your distributions. Your advisor might recommend converting 401(k) savings into a Roth IRA to get around RMDs or suggest another strategy that maximizes what you’ve saved.

Either way, you’ll want to stay on top of your RMDs. If you fail to take them, you’ll have to pay added taxes on the distributions. If you don’t take your RMD by the IRS deadline, you’ll have to pay a 25 percent tax on any funds you didn’t withdrawal but should have. This penalty may be reduced to 10 percent if you withdraw your RMDs by the end of the second year following the year in which it was supposed to be taken.

You will owe tax on your 401(k) distributions

Traditional 401(k) contributions are often made on a pretax basis, which means they lower your taxable income during your working years.

Because the money wasn’t taxed when you contributed it, you’ll have to pay income tax on your distributions—regardless of your age. This is where some strategy comes in. You can choose to take smaller withdrawals over a long period of time or group withdrawals into larger lump sums. But be careful. If you withdraw too much in a given year, you could push yourself into a higher tax bracket—meaning the government will take a larger portion of your savings. To help make sure you can keep more of what you’ve saved, your financial advisor can help you look at strategies to reduce your taxable income in retirement, and thus, reduce your income tax rate during retirement.

How do I avoid paying tax on my 401(k) withdrawal?

Unfortunately, there’s no way to get out of paying taxes completely. But there are things you can do to be smart with your savings and reduce the impact of taxes on what you’ve saved. One way to manage the tax impact on this money is to convert your 401(k) to a Roth 401(k) or Roth IRA. If you roll over your traditional 401(k), you’ll owe income tax on the amount you convert in the year that you convert it. But then in retirement, you can enjoy tax-free distributions. (This can also help you manage your taxable income in retirement, which impacts what you’ll owe in taxes.)

If you’re close to retirement and thinking of doing a Roth conversion—make sure you keep Medicare in mind. Medicare IRMAA—the Medicare income-related monthly adjustment amount—an adjustment to the subsidy for those paying into Medicare, is based on your income the two years prior. So, if you convert to a Roth two years before you’re planning to enroll in Medicare, you may significantly reduce your subsidy and increase what you’ll pay for Medicare in that tax year. However, this adjustment only applies for one year, and in some instances, an added cost for one year may be worth the longer-term benefit of converting funds

What to do with your 401(k) when you retire

So how does a 401(k) work when you retire? In short:

• Once you’re 59½, you can begin taking withdrawals without penalty.
• With a traditional 401(k), you’ll have to pay income tax on your withdrawal.
• If you haven’t started taking withdrawals by age 73, you’ll need to begin doing so in the year you turn 73.

You’ll have many options for how to use your 401(k) when you retire, but how much you put into your 401(k) and what you do with it when you retire are ultimately up to you. You won’t be able to move funds until you leave your job, but once you retire, most employer plans allow for different distribution options, such as:

• Leaving the money in your 401(k) plan and taking it out as a lump sum, in regular installments or in individual withdrawals as needed
• Purchasing an annuity within the plan or rolling money out of the plan into an annuity
• Rolling money out of the plan into an IRA or Roth account to get more investment options as well as potentially better advisor management and better control over withdrawal decisions

Ultimately, working with a financial advisor can help you make the best decisions about what to do with your 401(k) and how to get the most out of it. Your advisor can discuss the pros and cons with you and help you look at your complete financial picture. They’ll make recommendations that both help you reach your goals and protect your savings against risk.

Our financial advisors at Northwestern Mutual can help you take a look at what you’ve got saved and help you to get to where you want to be. Your advisor will work with you to design a strategy that’s uniquely tailored to you and encompasses more than retirement and your 401(k). From starting to save for retirement to legacy planning and everything in between, our advisors can help you keep your eye on the big picture and prepare for all the milestones ahead of you.

Financial representatives do not render legal or tax advice. Consult with a tax professional for tax advice that is specific to your situation.

RMD requirements and tax implications are as of date of publication, and subject to change.

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.