There isn’t a magic or standard 401k withdrawal age. You can withdraw from your 401k at any time. Of course, you’ll likely owe taxes and possibly penalties if you do. Beyond a certain age you may be required to withdraw.
However, the consequences of a 401k withdrawal are very different depending on your age. Most notable is the 10% early withdrawal penalty. The real question isn’t just what you can do, but what you should do.
What you should do depends on what you hope to achieve and what you need. Your first step in figuring out when you should start taking withdrawals from your 401k should be to define your ideal outcome. Once you have an idea of what you would consider to be your ideal outcome you can incorporate the 401k withdrawal rules into a distribution plan to achieve it.
In this article I’ll address the tax rules that govern 401k withdrawals at different ages, as well as the factors that will affect you as a practical matter.
10% Early Withdrawal Penalty – Rule of 55
If you take withdrawals too soon you’ll be faced with a 10% early withdrawal penalty. This is on top of the income tax you would pay anyway.
For clarity, that penalty is a percentage of the withdrawn amount, not a 10% increase in your tax bill. Suppose you withdraw $75,000 from your 401k. The 10% penalty is $7,500 and you pay that in addition to your regular income tax.
So what is early? While the age for IRAs is 59 & 1/2, for 401ks the age is 55. Your employer may restrict these withdrawals until you separate from the company, but the IRS allows it and you won’t have to pay the 10% penalty.
If you plan to retire BEFORE you turn 59 & 1/2, but after you turn 55, this rule could help you significantly and is a good reason to hold off on a rollover.
Planning to retire before you turn 55? Then you may want to look at a Roth IRA. You can withdraw contributions from a Roth IRA at any point, for any reason, without incurring a tax liability or penalty.
If you have money in traditional IRAs or old 401ks from previous employers that you haven’t rolled over then you may could benefit from rolling these accounts into a Roth IRA.
Converted amounts rolled over from traditional tax-deferred accounts need to satisfy a five-year waiting period before you can get around the 10% early withdrawal penalty.
A Roth conversion ladder, in which rollovers are staggered to lower your overall tax bill on the total converted amount, can be a good way to get you to age 55. Once you’re there, you can just start withdrawing from your 401k without incurring the 10% penalty.
Substantially Equal Periodic Paymets
Another rule that lets you withdraw from your 401k at any age without incurring the 10% early withdrawal penalty is the 72(t) disribution.
You can use this rule to avoid the penalty if you take substantially equal periodic payments from your plan. The “substantially equal” part means you can’t change the amount you withdraw each year, and “periodic” means you have to continue to take the distributions.
Be careful with this one. If you start taking substantially equal periodic payments you have to continue them for AT LEAST five years, or until you turn 59 & 1/2, whichever is later. If you start taking payments and stop before you satisfy this rule you’ll have to pay the 10% penalty on the withdrawals you’ve made up to that point. You’ll also owe interest on the penalty since the time it was originally incurred.
The practical side to this is to realize that anything you withdraw from your 401k now isn’t there anymore to earn a return, and won’t be there later in retirement. If you use this rule to take distributions for 10 years, for example, you are really taking a bite out of your retirement savings. Make sure you have a solid plan in place for the money you’ll need later in life.
Required Minimum Distributions
You generally need to take minimum distributions from your account once you reach 70 & 1/2. If you are still working and have a 401k with your current employer then you aren’t required to take required minimum distributions from that employer.
Let’s go back to that idea of old 401k balances that you still have at previous employers.
Even if you are working you are still required to take RMDs from any other IRAs or 401ks that aren’t connected to your current employer. If your employers plan allows, you could roll over IRAs or other 401ks into your current plan. By doing this you can avoid the RMDs on those as well.
What are the consequences of not taking RMDs? The IRS hits you with a 50% penalty of the amount you should have taken. It’s not a one-time penalty either. You will owe 50% of the missed distribution until you take it out of the plan. It’s in your best interest to follow the RMD rules carefully. If you miss one, take the money out as soon as you realize it.
You also want to incorporate RMDs into your plan before you have to take them. If you plan ahead you can reduce the effect they have on your overall distribution strategy. If you don’t plan for them, you may need to make significant unplanned adjustments.
Safe Withdrawal Rates
The age at which you decide to begin withdrawing from your 401k will also inherently affect your safe withdrawal rate. The safe withdrawal rate is the maximum amount you can withdraw from your savings without running out of money. This is where the idea for the 4% rule comes from.
The point here is really pretty simple. The earlier you start withdrawing from your 401k, the lower your safe withdrawal rate will be. We can illustrate this point without any math. However you navigate the withdrawal rules, the sooner you start withdrawing from your 401k, the longer you need to withdraw from it. That means you need to adjust your annual spending downward to account for a longer time-frame.
