When people approach the retirement age, they begin to think about what to do with their 401(k) after they retire. There are several options, and people should understand each option before making a decision.
The three main options are to cash out, roll over to an Individual Retirement Account (IRA) or leave the account with the employer. They should take into consideration their goals after retiring such as income and expenses, lifestyle, health care, housing and if they want to spend their money or pass some on to heirs.
1. Leave the 401(k) with the Employer
The most obvious option is to leave the 401(K) with their employer. This is the easiest thing to do because the retiree knows the investment options, and the money remains in a tax-deferred account.
Since most 401(k)s do not charge a fee for transferring money between investments, the retiree can easily rebalance the account every year. In many cases, retirees can borrow from the 401(k).
They need to ask their employer to see if there are any restrictions. If, for any reason, they can’t repay the loan, they will have to pay the 10 percent early withdrawal penalty.
If the retiree has several accounts with different employers, it could be a lot of work managing them all. Also, if the money is invested in the company’s stock, the retiree needs to be sure they agree with that.
Leaving the money with the employer will give limited investment choices. The plan needs to be checked regularly because the employer can change it at any time.
2. Transfer the 401(k) to an IRA
If the money is in an IRA account, the retiree will have more control over it. There are also more investment choices especially if it is rolled over to an investment management company.
Also, the fees with an investment management company are much lower than in most 401(k)s. If the retiree has several accounts with different employers, putting them together in an IRA makes them easier to manage.
There may be a 10 percent early withdrawal fee for rolling over the account if the retiree is under 59 ½ years old. Some expenses that do not require a fee are higher education, disability, medical insurance and first home.
The investment firm that is selected may have a financial advisor who will assist the retiree with selecting investments, but they may recommend investments that pay them a commission. However, the retiree doesn’t need to take their advice.
An IRA will have trading costs when investments are made, and the retiree will need to take more responsibility over their portfolio. If the retiree wants to invest everything in one company, that’s their choice.
3. Taking a Lump Sum
Cashing out is very attractive because it gives the retiree a huge lump sum of money. There will probably be no fee for cashing out if the retiree is in his or her 60s, but there will be tax consequences.
The withdrawals from a 401(k) are taxed as ordinary income, which could take a substantial sum of money. The Internal Revenue Service takes 20 percent up front, and the rest is figured into the annual income tax return.
Unless the money is put into a tax-deferred IRA, the only choice is a taxable account. The government gives retirees 60 days after they withdraw the money from their 401(k) to decide what to do with it. After that time, they will be taxed on it. One way to reduce the income tax is to withdraw just the amount needed at one time.
If the lump sum is invested, the retiree will most likely have to pay taxes on the dividends earned, but in a tax-deferred account it can grow tax-free and there is no taxes on the dividends.
When thinking about what to do with a 401(k) after retirement, the person needs to consider other sources of income. For example, if the retiree takes their 401(k) at one time or in increments, the distributions will be added to their ordinary income.
This may impact how their Social Security benefits are taxed. A single person may pay taxes on up to 85 percent of their benefits if their modified adjusted gross income (MAGI) is more than $34,000 and for married couples who file jointly, $44,000.
Many financial advisors recommend that retirees roll over their 401(k) to an IRA account sooner rather than later. They can leave the 401(k) with the employer for a little while if the employer has a good plan.
In the long term, it is considered better to have the control of the money that they would have in an IRA. Unless the retiree needs a large sum of money urgently, it is not recommended to cash out. Also, they lose the tax-deferment advantage.
By Andre Bradley