3 of the Best Tips for 401(k)-Withdrawal Strategies

3 of the Best Tips for 401(k)-Withdrawal Strategies

While a 401(k), even with an employer match, is generally not enough to cover retirement expenses, it remains the cornerstone of income for the majority of retirees. Therefore, you must be strategic when withdrawing from your 401(k), meaning you must balance the need for immediate income with the possibility of running out of money during retirement. You need to be able to make your retirement income last as long as possible while still maintaining an acceptable quality of life.

Each household will likely have a different withdrawal plan depending on other sources of income, the amount saved, expenses, and life expectancy. Some important tips to keep in mind when it comes to creating a 401(k)-withdrawal strategy include the following:

1. Account for required minimum distributions.

Once you turn 72, the IRS forces you to take required minimum distributions from your 401(k). The exact amount that will need to be taken out depends on the size of the balance and is based on an IRS calculation. Failure to take the distribution on time results in a 50 percent tax penalty on the amount short of the distribution.

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These distributions can create problems with withdrawal strategies, especially if you work into your 70s. Some employees may qualify for an exemption if the 401(k) is through a current employer, but distributions will still need to be taken on any other 401(k) accounts, as well as traditional individual retirement accounts (IRAs). It’s important to keep these required distributions in mind when discussing strategy.

In some cases, it can make sense to minimize or even eliminate required minimum distributions. You can do this by converting a traditional 401(k) to a Roth account. This process involves paying taxes on all the money converted. You can do this over time before turning 72 to avoid paying one large tax payment. Having some money in a Roth account provides more options when it comes to withdrawal strategies as funds from these accounts are not taxed upon withdrawal and grow tax-free.

2. Approach withdrawal strategies with flexibility.

A key thing to remember with any withdrawal strategy is that it can change over time, and it will likely need to as your situation shifts.

Many retirees adhere to the 4 percent rule. This rule tells people to withdraw 4 percent of total savings in the first year and then adjust the same amount for inflation with each subsequent year. This strategy can be a good start, but it does not account for expense fluctuations in retirement. Some years, you may need more money, while in others, you may need less.

According to a JPMorgan Chase report, more than half of retired households experience spending volatility. People often spend more money early in retirement as they travel or engage in new hobbies and then spend less in these areas as they age. However, health expenses can increase later in retirement. While predicting expenses is impossible, you will need to stay flexible.

In general, you should revisit your withdrawal strategy at least annually, and adjust as unexpected expenses arise or the market shifts. Keeping tabs on your strategy ensures that you are making the best decisions for your present and future. Many retirees rebalance their withdrawals from traditional and Roth accounts as the markets change. If you are working with a professional, meet yearly to discuss strategy.

3. Plan for taxes while considering strategy.

A 401(k) is a tax-deferred account, which means that you pay taxes when withdrawing rather than depositing. Taxes can have a significant impact on your overall strategy, so it is important to consider these implications.

The exact taxation rate depends on the amount withdrawn and also where you live, as different states have varying tax rates. In some places, individuals who plan adequately can sometimes avoid paying taxes altogether, but this generally takes a lot of planning and possibly a relocation to a more tax-friendly state.

The biggest thing to consider when it comes to tax planning is the overall bracket. Since Roth accounts do not count toward tax brackets, you can lean more heavily on them once you approach a new tax bracket to avoid paying more than you thought you would.

Tax planning can push people to adopt a very different strategy from year to year, especially in early retirement when they may still be working and need to minimize their income. Often, it pays to consider taxes from the very beginning, especially if you think you will be in a position of needing a Roth account since converting traditional 401(k)s will involve paying taxes. However, this strategy provides more tax flexibility, especially since it decreases required minimum distributions. In other words, paying the taxes upfront can save on taxes down the line. Discussing any tax plans with a professional first, however, is always a great strategy.