Whether you’re getting ready to retire or considering a pre-retirement withdrawal, it’s important to understand the rules for each withdrawal type.
You’ve been contributing regularly to a retirement plan, maybe with matching contributions from your employer. Without even thinking much about it, you’ve built up a nice nest egg in a diversified investment portfolio. But what happens when it’s time to withdraw that money?
In general, there are two types of withdrawals: those taken during retirement to meet living expenses, and those taken before retirement for emergencies or major life changes.
Whether you’re or considering a pre-retirement withdrawal, it’s important to understand the rules for each type.
1. Taking qualified distributions from your retirement plan
Deciding how to withdraw your savings in retirement can be tricky due to two unknowns: market performance and your longevity. Fortunately, there are several distribution options to choose from, though there may be fees or tax implications depending on the distribution you choose. (Also keep in mind that not all retirement plans offer all distribution options. It’s a good idea to check with your plan administrator to see if your plan has any distribution limitations.)
Of an amount certain: Receive equal, periodic payments on a monthly, quarterly, semiannual or annual basis until your balance is $0. The number of payments you receive will depend on the value of your investments.
Of a period certain: Receive payments on a regular basis according to the frequency you choose (monthly, quarterly, semiannual or annual). The payment amounts will depend on the frequency and length of time you choose to receive payments and the value of your investments. Your payment amount is calculated by dividing your current account balance by the number of remaining payments. With this payment method, your balance will be zero by the end of the term you select.
Partial: Take out a portion of your balance at any time whether or not you are taking a periodic payment.2 You may elect partial lump-sum payments at different times, or a series of partial lump-sum payments, as you need.
Full: The entire value of your account will be distributed. You can roll over all or a portion of your account to another qualified plan or have the distribution paid to you (which could mean significant tax impacts).
While the options listed above offer ways to start thinking about retirement withdrawals, none of them are a “one-size-fits-all” solution. Given that your situation is unique to you, it’s a good idea to meet with a financial professional who can help you build a personalized plan that reflects your specific financial situation and goals.
Additional considerations to keep in mind:
2. Pre-retirement (or emergency) options
Congress authorized tax-advantaged retirement plans and accounts — such as 401(k) plans and >IRAs — to encourage Americans to save for the long term. To further incentivize people to save, they instituted penalties such as a 10% tax penalty on withdrawals made before age 59½. But Congress also realized that stuff happens, and you might have a good reason to crack open your nest egg early.
Penalty-free withdrawals
Several situations allow you or your heirs to withdraw retirement savings early without penalty. You’ll still need to pay income tax on that money (unless you’re withdrawing principal from a Roth account). Also be aware that the loosened restrictions that applied to withdrawals and loans under the CARES Act have expired.
Here are the most common expenses you can cover with penalty-free early withdrawals:
You can also withdraw funds early if you’re totally and permanently disabled. And if you die, your beneficiaries can withdraw funds without penalty, although spouses generally need to wait until they’re 59½.
This early withdrawal retirement calculator can help you understand how these types of withdrawals could potentially impact your nest egg.
Taking a loan from your 401(k)
You can usually take out a loan from a 401(k) account without taxes and penalties, typically up to $50,000 or 50 percent of the assets, whichever is less. Generally, you must repay the loan within five years with interest.
Remember, the money you borrow could miss out on potential growth. That’s why it’s generally not a good idea to take a loan for discretionary purchases and to do so only when you’re confident you can pay it back quickly.
The bottom line on early withdrawals
Taking money out of retirement savings should be a last resort. Even if you avoid penalties, you still face ordinary income tax — as well as the possibility that your retirement savings won’t recover enough to maintain your standard of living in retirement.
There are other options you may want to consider first: reducing your spending, taking advantage of government programs such as unemployment insurance, taking a home equity loan, refinancing, or negotiating different payment terms with lenders and landlords.
