Our Advice on 401(k) Withdrawals: What You Need to Know Before You Take the Money
Taking money out of a 401(k) sounds simple: you request a withdrawal and the money shows up in your bank account. The problem is that how, when, and from which type of 401(k) you withdraw can dramatically change the tax consequences.
Our advice is to understand how withdrawals work before you start taking money out. A poorly planned withdrawal can create federal income taxes, state income taxes, an additional 10% early-distribution tax, or simply cause you to withdraw retirement savings faster than you intended.
Here are the major things you need to know to avoid costly taxes and penalties.
Traditional 401(k) Withdrawals Are Generally Taxable
If your money is in a traditional 401(k), distributions of previously untaxed contributions and earnings are generally included in your taxable income.
That means a $50,000 withdrawal isn’t necessarily $50,000 available to spend.
The withdrawal can increase your federal taxable income and may also create state income taxes depending on where you live. A larger withdrawal can potentially push some of your income into a higher federal tax bracket as well.
This is why we generally don’t recommend looking at a traditional 401(k) like a checking or savings account. You need to consider the after-tax amount you actually get to keep.
Pros
You have flexibility and can generally determine how much you withdraw once your plan permits distributions. You can also coordinate withdrawals with Social Security, pensions, annuity income, and other retirement assets.
Cons
Withdrawals are generally taxable, and large withdrawals can create a substantial tax bill.
Who Could Benefit?
Retirees who need periodic access to their accumulated retirement savings and have enough other resources that they aren’t concerned about eventually exhausting the account could benefit from taking traditional 401(k) withdrawals.
Who Might Not Benefit?
Someone who wants a predictable lifetime paycheck may prefer to convert part of the retirement account into a structured lifetime-income strategy instead of continually deciding how much to withdraw.
Roth 401(k) Withdrawals Can Be Tax-Free—But You Have to Follow the Rules
Roth 401(k) money works differently.
A qualified Roth 401(k) distribution is federally tax-free when the IRS requirements are satisfied. Generally, the distribution must occur after the applicable five-year period and after age 59½, disability, or death.
Don’t assume every Roth 401(k) withdrawal is automatically tax-free simply because the account says “Roth.”
If a Roth 401(k) distribution isn’t qualified, part of the distribution can represent contributions and part can represent earnings. The earnings portion may be subject to taxes, and an additional 10% tax can potentially apply to taxable amounts when you’re under 59½.
One additional advantage today is that Roth 401(k) owners are no longer required to take lifetime required minimum distributions (RMDs) from their designated Roth accounts.
Taking Money Before Age 59½ Can Get Expensive
If you withdraw taxable money from a 401(k) before age 59½, an additional 10% early-distribution tax generally applies unless you qualify for an exception.
So imagine withdrawing $100,000.
You could potentially owe ordinary federal income taxes, applicable state income taxes, and another $10,000 from the 10% additional federal tax if no exception applies.
That’s why we would look for another source of retirement income before automatically taking an early 401(k) withdrawal.
One clarification is important: standard 401(k) withdrawals do not have a special 25% early-withdrawal penalty. The 25% rule applies to certain SIMPLE IRA distributions made within the first two years of participation.
Option 1: Use the Rule of 55
One of the most valuable exceptions for someone retiring early is commonly called the Rule of 55.
If you separate from service during or after the calendar year in which you turn age 55, distributions from that employer’s qualified retirement plan can potentially avoid the additional 10% early-distribution tax.
The important part is that this rule is connected to separation from service and the employer’s plan.
For example, if you retire from your employer at 55 and leave the money in that employer’s 401(k), you may be able to take distributions without waiting until 59½.
However, don’t automatically roll the entire account into an IRA before determining whether you want to use this exception. The age-55 separation-from-service exception generally applies to qualified employer plans rather than IRAs.
Pros
- Can provide access to retirement savings before age 59½ without the normal 10% additional tax.
- Offers more flexibility than some other early-retirement withdrawal strategies.
- Can help bridge the income gap between retirement and age 59½.
Cons
- Traditional pre-tax distributions are still generally subject to ordinary income taxes.
- You must meet the separation-from-service requirements.
- The strategy generally applies to the qualifying employer plan, not an IRA you previously rolled the money into.
Who Could Benefit?
Someone leaving an employer during or after the calendar year they turn 55 who needs retirement income before age 59½ may benefit from the Rule of 55.
Who Might Not Benefit?
Someone who left the employer before the qualifying year, has already rolled the entire account into an IRA, or has enough non-retirement savings to cover early retirement may not need this strategy.
Option 2: Use a 72(t) Distribution
Another possibility is a 72(t) substantially equal periodic payment strategy, often called a SEPP.
This allows qualifying distributions before age 59½ without the normal 10% additional tax.
But this is not something you want to casually set up.
The IRS provides several methods for calculating substantially equal periodic payments. Once the strategy starts, strict rules apply. In general, the payment schedule must continue until the later of five years from the first payment or age 59½.
So if you start at age 50, you generally need to continue until age 59½.
If you start at 58, reaching 59½ doesn’t get you out of the arrangement immediately. Five years is longer, so the restrictions generally continue for five years.
Improperly modifying a SEPP can trigger the additional tax that would have applied to earlier distributions, plus interest.
Pros
- Creates a way to access retirement-account income before age 59½.
- Can avoid the normal 10% early-distribution tax when properly structured.
- Provides predictable retirement income.
Cons
- The strategy is rigid once it starts.
- You don’t have the same freedom to change withdrawals whenever you want.
- Breaking the rules can create retroactive penalties and interest.
Who Could Benefit?
Early retirees who need predictable income from qualified retirement savings and don’t have enough non-retirement assets to bridge the gap to age 59½ may benefit from a 72(t) strategy.
Who Might Not Benefit?
Someone who needs flexible withdrawals or expects their income needs to change substantially during the next several years may not be a good fit for a 72(t) strategy.
Option 3: Spend Non-Retirement Money First
If you’re retiring before age 59½, another strategy is using nonqualified, after-tax savings to bridge the gap.
That could include savings accounts, taxable brokerage accounts, CDs, or other assets that aren’t held inside your 401(k) or IRA.
“Nonqualified” does not mean “non-taxable.” It simply means the money isn’t held in a qualified retirement plan. Depending on the asset, interest, dividends, capital gains, or annuity earnings can still be taxable.
But strategically spending after-tax money can allow you to leave your 401(k) alone until you reach an age where the additional 10% early-distribution tax is no longer an issue.
Pros
- Provides more flexibility than many retirement-plan withdrawal strategies.
- Can help avoid taking premature distributions from a 401(k).
- Allows retirement accounts to potentially continue growing tax-deferred.
Cons
- You are spending liquid assets that could otherwise remain invested.
- It can reduce the amount of emergency savings you have available.
- Investment earnings or gains may still create taxes.
Who Could Benefit?
Early retirees with substantial savings outside their retirement accounts may benefit from using non-retirement assets to bridge the gap to age 59½.
Who Might Not Benefit?
Someone with limited cash savings or someone who would significantly reduce their emergency reserves by using this strategy may want to consider other options.
Option 4: Consider a Nonqualified Immediate Annuity for Early Retirement Income
Another strategy for someone retiring early is using after-tax money to purchase a nonqualified immediate annuity designed to generate income.
You give an insurance company a lump sum and, depending on the payout option selected, the company can provide a contractual income stream for a specified period or for life.
However, there’s an important distinction here: simply funding an annuity with after-tax cash does not automatically mean every payment is tax-free or exempt from an early-distribution tax.
Nonqualified annuity payments can contain both taxable income and a return of your original investment. The tax treatment depends on how the contract and distributions are structured.
Section 72(q) can also impose a 10% additional tax on taxable amounts distributed from a nonqualified annuity before age 59½, although exceptions exist, including certain substantially equal periodic payments.
So this strategy needs to be designed correctly.
Pros
- Can create predictable retirement income.
- Can provide income for a specific period or potentially for the rest of your life.
- Removes investment-performance decisions from part of your retirement paycheck.
Cons
- Traditional immediate annuities can have significantly less liquidity.
- Some payout options provide little or no remaining death benefit.
- Payments may be partially taxable.
- Early-distribution tax rules can still apply depending on how the contract is structured.
Who Could Benefit?
Someone who values guaranteed income more than liquidity and wants an income bridge during early retirement may benefit from a properly structured immediate annuity.
Who Might Not Benefit?
Someone who needs frequent access to the principal, wants significant investment flexibility, or is uncomfortable committing money to an insurance company may not be a good fit.
Option 5: After 59½, Consider Automating Your Retirement Income
Once you’ve reached age 59½, the normal 10% early-distribution tax is generally no longer the major concern.
At that point, our bigger concern becomes something else: How do you keep yourself from spending the account down too quickly?
You can certainly leave the money invested and take withdrawals manually.
But another option is rolling some of the 401(k) into an IRA annuity with a Guaranteed Lifetime Withdrawal Benefit (GLWB).
A direct rollover from an eligible employer retirement plan into an IRA is generally not currently taxable. If the money is paid directly to you instead, mandatory federal withholding can apply to an eligible rollover distribution.
The annuity doesn’t magically make traditional 401(k) money tax-free. The retirement money generally remains tax-deferred inside the IRA, and taxable distributions are still taxed when withdrawn.
What you’re adding is an insurance guarantee around the income.
Depending on the specific contract, a GLWB can provide 5-8% withdrawals for life, offering a more predictable stream than the traditional 4% rule, even if the underlying contract value eventually reaches zero through permitted lifetime-income withdrawals.
Guarantees depend on the terms of the contract and the claims-paying ability of the issuing insurance company.
This can essentially automate part of your retirement paycheck. Instead of asking yourself every year, “How much can I safely take out?” you can know how much contractual lifetime income the annuity is designed to provide. That can make retirement budgeting much easier.
Pros
- Creates predictable lifetime income.
- Can continue paying income even if the contract value is depleted through covered lifetime withdrawals.
- Helps automate retirement withdrawals.
- Can reduce the risk of spending retirement savings too quickly.
- Many contracts allow remaining account value to pass to beneficiaries.
Cons
- Annuities can include surrender periods and withdrawal restrictions.
- Income-rider features may come with an annual fee.
- Taking more than the permitted withdrawal amount can reduce future guarantees.
- Guarantees depend on the financial strength and claims-paying ability of the insurance company.
Who Could Benefit?
Someone who depends on their 401(k) or IRA to pay monthly retirement expenses and wants a predictable paycheck for life may benefit from a guaranteed lifetime withdrawal benefit.
Who Might Not Benefit?
Someone whose Social Security, pension, rental income, or other guaranteed income already covers their lifestyle may not need additional guaranteed lifetime income.
Retirement annuities organized by goal can be narrowed by the job the money must do in retirement—income, protection, growth, liquidity, or legacy—rather than by product name alone.
What About the Money When You Die?
This is another area where people misunderstand annuities.
With many deferred annuities using lifetime-withdrawal riders, you haven’t necessarily surrendered the entire account simply because you started income.
If there is remaining contract value when you die, it can generally be paid to your designated beneficiaries according to the contract’s death-benefit provisions.
That’s different from certain life-only immediate annuities, where payments can stop at death with no remaining benefit. You need to compare the actual contract instead of assuming every annuity works the same way.
After-Tax 401(k) Contributions Need Special Attention
Some 401(k) plans contain traditional pre-tax contributions, Roth contributions, and separate after-tax 401(k) contributions.
After-tax contributions have already been included in your taxable income, so you don’t pay income tax on that same principal again. However, earnings attributable to those after-tax contributions are generally considered pre-tax amounts.
This can create planning opportunities. For example, certain distributions can be structured so after-tax contributions go to a Roth IRA while associated pre-tax amounts are rolled into a traditional IRA, subject to IRS rollover rules.
If you have significant after-tax 401(k) money, don’t automatically cash it out without first looking at your rollover options.
Other Exceptions May Let You Avoid the 10% Additional Tax
Age 59½, the Rule of 55, and 72(t) aren’t the only possibilities.
Federal law provides additional exceptions to the 10% additional tax for certain circumstances, including some distributions involving disability, terminal illness, qualified birth or adoption expenses, domestic abuse, certain emergency expenses, qualified disasters, medical expenses, qualified public safety employees, and other situations.
Eligibility depends on the specific exception and account type. Before paying the 10% additional tax, determine whether an exception applies to you.
Our Advice on Taking 401(k) Withdrawals
If you are approaching retirement and need to plan 401(k) withdrawals efficiently, don’t start with the question: “How much can I withdraw?”
Start with: “Where should my retirement income come from, and what is the most tax-efficient way to create it?”
Your best strategy could involve a combination of:
- Traditional 401(k) withdrawals after age 59½
- Qualified Roth 401(k) withdrawals
- The Rule of 55
- 72(t) substantially equal periodic payments
- Spending taxable savings first
- A properly structured nonqualified immediate annuity for early retirement
- Rolling part of a 401(k) into an IRA
- Using an annuity with a guaranteed lifetime withdrawal benefit for lifetime income
- Coordinating withdrawals with Social Security and pension income
- Managing Roth conversions and traditional-account withdrawals over multiple tax years
- Preserving emergency savings instead of depending entirely on the 401(k)
There isn’t one correct withdrawal strategy for everyone. The biggest mistake is taking money first and figuring out the taxes and retirement-income consequences afterward.
Who Should Consider a Guaranteed Lifetime Income Strategy?
We think it deserves consideration if you’re approaching or already in retirement and:
- Need your retirement accounts to support your monthly lifestyle
- Don’t want to continually calculate withdrawal rates
- Are concerned about market downturns affecting retirement income
- Are worried about living long enough to exhaust your savings
- Want part of your retirement income to be predictable regardless of market performance
The goal isn’t necessarily to put every dollar into an annuity. The goal can simply be to create enough guaranteed income to cover the portion of your lifestyle that you don’t want dependent on investment performance.
Who Probably Doesn’t Need Guaranteed Lifetime Income?
You may not need additional lifetime-income insurance if Social Security, pensions, rental income, or other guaranteed income already covers your lifestyle.
You also may not need it if you have significantly more assets than you’ll realistically spend, prioritize maximum liquidity and investment flexibility, or are comfortable managing withdrawals and market risk yourself.
Other Insurance That Can Protect Your Retirement Withdrawal Plan
Generating retirement income is only one part of the problem. You also need to consider risks that could force you to spend retirement assets faster than expected.
Long-term care insurance or hybrid coverage protects retirement savings from healthcare costs and extended-care expenses.
Life insurance can help replace income for a surviving spouse or preserve assets for children and other beneficiaries.
Medicare and supplemental health coverage can help manage healthcare expenses, but they shouldn’t be confused with long-term care insurance.
Your withdrawal strategy works better when you aren’t forced to unexpectedly liquidate large portions of your retirement accounts to pay for risks that could have been insured.
Compare Your 401(k) Retirement Income Options
If you’re getting close to retirement—or already there—we can compare how much income your 401(k) could generate using different withdrawal and annuity strategies.
At The Annuity Expert, we’re an independent annuity broker and insurance agency. We can compare multiple insurance companies to determine how much contractual lifetime income your retirement savings could generate and whether an annuity makes sense for your situation.
Want to maximize your 401(k) withdrawals? Contact us for free quotes and comparisons to build a strategy for tax-efficient retirement income. There is no obligation to purchase coverage.
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