There’s no doubt that the 401(k) plan is one of the best tools Americans have to build long-term retirement wealth. But if you really want to maximize the value of the account, it’s important to fully understand all of the rules, restrictions and ramifications that come with it.
This is particularly true when it comes to withdrawing money. In some cases, taxes and penalties on distributions can be onerous. You’ll also have to factor in the damage that you’ll be doing to your long-term savings goals. Of course, you can avoid most of these problems by waiting until after you retire to take your withdrawals. Regardless of when you take money out of your 401(k), though, here are some of the steps you should take before you proceed.
Make Sure You’re of Age — or Prepare To Pay the Penalty
The biggest caveat when it comes to 401(k) withdrawals is that you’ll be hit with a 10% early distribution penalty if you take money out before you reach age 59.5. This is on top of the ordinary income tax that goes along with all regular 401(k) withdrawals. If you’re in a high-tax state, taxes and penalties could easily top 50% of your distribution, a stiff price to pay for accessing your money early.
Qualify for a Withdrawal If Not of Proper Age
The good news when it comes to avoiding the early distribution penalty is that you can’t generally access your 401(k) money before age 59.5 anyway. Exceptions are limited and include death, disability, plan termination, severance from employment and hardship withdrawals.
Important to note, however, is that even hardship distributions are subject to the early withdrawal penalty if you’re under age 59.5. One quirky method of withdrawal that does avoid the early distribution penalty is if you take your money in a series of substantially equal payments over time.
Understand the Tax Consequences
Even if the money you earn in your 401(k) is entirely from capital gains, you’ll still have to pay ordinary income tax on your distributions. So, for example, if your all-stock 401(k) account has $100,000 in gains and you take out the entire balance all at once — which is not advisable — you’d owe as much as 37% in federal tax on your withdrawal, plus state tax. If you instead held that money in a regular investment account, you’d only owe the long-term capital gains tax rate of either 0% or 15%, depending on your income.
Realize You’re Diminishing Your Future Balance
One often-overlooked aspect of taking money out of your 401(k) plan is that you’re sacrificing your future gains. This consequence can be larger than many people imagine.
For example, imagine you take out a $10,000 hardship withdrawal at age 35. While $10,000 may not seem like a lot of money at the time, if you had instead kept that money in your 401(k) plan and earned an 8% return on it until age 65, it would have grown to over $109,000, or almost 11 times the amount you withdrew.
You might think twice about taking out “only” $10,000 from your 401(k) at a young age if you instead imagine the $109,000 you’re essentially taking out of your future retirement account balance.
Incorporate Your Other Sources of Income
At some point, you’ll be forced to start taking minimum distributions from your 401(k) plan. However, the IRS recently raised this age limit to 72. If you have other sources of income that can satisfy your needs, such as money from other investment accounts or Social Security, it’s generally a good idea to push your 401(k) distributions as late as possible.
This way, you can continue to enjoy tax-deferred growth in your account for longer. You can also defer the tax bill that comes with these withdrawals until a later date.
Consider a Loan If Permitted
One way to avoid the problems that come with some 401(k) distributions is to simply take a loan instead. While not all employers allow loans, they are not forbidden by the IRS.
Loans cannot exceed the lesser of 50% of your vested account balance or $50,000. But the beauty of a 401(k) loan is that you pay back both the principal and the interest to your own account, rather than your employer, a bank or any other lender. Of course, you’ll still have to deal with the fact that your money will be out of your account until you pay it back, diminishing your future returns.
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