Update Dec. 23, 2019 — A new law, the SECURE Act of 2019, changes at least one part of this article. Effective in 2020, anyone who had not already reached 70 and 1/2 is not required to take their Required Minimum Distribution until they reach the age of 72. If you are 70 and 1/2 prior to Dec. 31, 2019, you still must take your RMDs. See “SECURE Act Signed into Law”.
October 27, 2013 — Through all those years of faithful contributions to your 401k or IRA, you probably never really thought too much about the day those savings would be used. But either now or soon in the future, that money has to come out of your account, most likely as a key component of your retirement financial picture. This article will review some of the issues you are likely to face with your 401k, IRA, or similar retirement account. Tax laws are tricky and we have attempted to paint a broad picture, there will always be exceptions to some of the general principles discussed here. We are not tax or investment experts – check with a qualified professional from this ira vs 401k article for an expert opinion.
401ks – A Review
First, a few facts. 401ks are a relatively new part of the retirement picture. They are defined contribution plans (a promise of how much will be contributed to the plan), and they were largely designed to replace defined benefit pension plans (the old days, a promise of how you much you would get in retirement). There are some variants of 401k plans, such as 403b and 457b plans. IRAs are treated somewhat similarly for tax purposes, and their variants include SEP and SARSEP plans.
With a 401k plan you contributed a certain percentage of your gross pay, and your employer probably matched a portion of that. The amount from both sources that went into your plan was not counted as part of your taxable income for that year, which was one of the key incentives to help people save. Smart workers contributed as much as they could for multiple reasons: for the employer match, to keep their tax bill down, and to help insure a comfortable retirement.
The tax part of the equation comes into play when you retire. Although your contributions were not counted as part of your income when they went in, they will, along with all accrued earnings, be taxed as ordinary income when they come out of your plan.
The Investment Company Institute (ICI) reported recently that the average American 401(k) account with consistent participation had $94,482 at the end of 2011. That’s way up from just a few years before; the average balance was $50,000 in 2008. The average 401k contribution was 6% of salary. Older Americans have saved even more: Fidelity Investments reported that the average 401k balance for its customers over 55 years of age who had worked for their current employer for a while was $255,000.
Issues to consider
How to invest your 401k
Once you retire you might have the option to keep your 401k managed by your previous employer. That is often the easiest and best idea, since your employer is required to offer a variety of investment options. You should investigate, however, to make sure the fees are reasonable.
If you have to roll the money to another provider and start managing it yourself you might consider hiring a financial advisor. The best way to do that is probably worth several articles by itself. But for general principles: Check out several advisors, get references and performance history, verify certifications, get all fees clearly established. Or, if you are committed to learning about financial matters and being a disciplined investor, you can manage the money yourself through mutual funds like those from Vanguard and Fidelity.
Be aware of how much different funds charge. There are very big differences among them, and those can mean thousands of dollars over time. Try to stay away from funds that charge entrance or exit fees. If you hire a financial adviser, find out if he or she charges a fee for service or a fee based on % of assets (either approach might be best for your situation). Find out if your adviser charges commissions, which are usually considered a conflict of interest.
When to take the money
This is one of most important areas you need to be on top of. If you take the money out of your 401k or IRA before age 59.5 you will usually have to pay a penalty – avoid that if you possibly can. (See IRS regulations on early withdrawals. There is also an exception for substantially equal periodic payments). The year you turn 70.5 you must start taking required minimum distributions (RMDs), although you can delay that first withdrawal until April 1 of the following year (in all other years they must be taken by Dec. 31). The distribution amount is based on your remaining life expectancy – the required distribution percentage starts at 3.65% at age 70 and goes to 15.87% at age 100. The IRS has tables telling you how much to take, depending on your age.
If you are like most people, you probably have IRAs and a 401k, which makes the withdrawal requirement a little trickier.You can calculate how much you have to withdraw from all your IRAs and then take it out of one or more of them. But for multiple 401ks, you have to take the required amount from each account. See the IRS FAQs on Required Minimum Distributions for details.
The annuity option
The usual route is to take the required distributions every year. However, many financial experts recommend that you explore converting your 401k to an annuity. That way you are guaranteed a fixed amount of money for the rest of your life (or some fixed period). An annuity removes the investment risk. If you and/or your spouse are not interested in managing money, it simplifies things for you. Some people don’t like the idea of an annuity because they can affect your plans to leave an inheritance, or you might feel you could get a better return on your own. If you do buy an annuity, do your homework, they are not all the same.
When your heirs inherit your IRA, 401k, or Roth account, a number of complex rules apply. We do not have the space or expertise to adequately discuss all of those here. For example, your spouse usually has the option to roll your IRA or 401k into his own account, which is fairly simple. Other heirs usually have fewer options, especially if you were 70.5 and already taking mandatory distributions. Check with your tax advisor for detailed advice. How your beneficiaries are listed on these accounts is very important, so it is worth checking on this with your advisor.
Withdrawal Strategy: Social Security vs. 410k
Lets say you are retired at 65, which is old enough to qualify for Social Security and take a penalty-free withdrawal from your IRA or 401k. Assuming you don’t have any other savings to use to live on, which money would be better to live on until age 70.5 – taking Social Security or withdrawing from your 401k or IRA? The answer is a personal decision, but here are some factors to consider. Finding your best answer might involve running what-ifs for your situation in the state in which you reside.
– If you wait to claim Social Security until you are age 70, your payout will be 8% higher for each year you wait beyond 66.
– You won’t have to pay a penalty for withdrawing 401k money (the penalty goes away after age 59.5). But, the money you take out is gone forever, and stops growing tax free.
– Depending on your income, you will probably have to pay federal tax on either the Social Security income or 401k/IRA distribution (and possibly state income tax too).
– What do you think your life expectancy is? If short, Social Security might be the better option.
401k withdrawal vs. Social Security vs. General Savings
Once again assuming you are 65 and that you have the option to live on one source of income (401k, Social Security, or your general savings) – which is the best one to choose until age 70.5? Although the choice is personal, we think most advisors would recommend living off of general savings. That option allows your Social Security payments to increase to the maximum at age 70. It also permits your IRA and 401k to continue to grow tax free – and to delay paying ordinary income taxes on what you take out of those accounts.
401k and IRA distributions are treated as ordinary income for federal purposes, but their treatment can vary by state. If you are going to receive significant distributions, and you thinking about moving anyway, you might consider choosing a low tax state or one that doesn’t tax these distributions. People who are planning significant gifts to charities might investigate giving some of these distributions directly to charity, rather than taking it as ordinary income and giving with after tax dollars. A professional is needed on this issue to do it correctly.
What not to do
The worst possible thing to do is take out all of your 401k and/or IRA money at once. If you blow it on a new kitchen or trip around the world, the money is gone. This is the money you have to live on for the rest of your life. Don’t be afraid to spend it, just make sure it is there for when you might need it.
Don’t make big money decisions without knowing the consequences. One thing to do is get good advice from a professional, or carefully research it yourself.
Think twice about so called Self Directed Investment Accounts. Many of these turn out to be scams (see end of article).
Never, ever, put all your eggs in one basket. Your retirement is too important to put it at risk.
Don’t stop working before you have to. Most people won’t have enough money for a happy retirement. The longer you can contribute to your retirement plans (and delay taking it out), the more you’ll have to enjoy.
A note about Roth plans
You generally have the option to convert your IRA into a Roth IRA, which has some advantages. But you will have to pay taxes at the time of the conversion. See Further Reading below for more about Roth plans.
What are your plans for your 401k? Do you plan to tap it before you have to take RMDs at age 70.5? What is your strategy before age 70.5 – will you take Social Security, tap your retirement accounts, work, or try to live on your general savings? Have you had experience with a financial adviser? Please share your thoughts in the Comments section below.
For further reading
Guide to Inheriting a 401k
5 Reasons to Convert to a Roth IRA
How to Buy an Annuity from Social Security
Not So Much: $1 Million for Retirement
Scammers Targeting IRA’s
Disclaimer: This website is definitely not giving any financial advice. This article is meant as a discussion of some of the issues involved with IRAs. Before you make any important financial decision we recommend getting professional advice.