What to Do With Your 401(k) When You Retire

401k retirement

If you’re approaching retirement with a healthy 401(k) nest egg, you have a lot to be proud of. You’ve likely led a career of hard work at a job that--let’s face it--you probably didn’t love all the time.

Now what? Making the decision of how to take your hard-earned savings and live on them for 25 to 30 years is serious business. Among the many concerns of most families: What if I outlive what I saved up?

Here are four commonly considered approaches to handling your 401(k) retirement funds--along with some pros and cons for each.

1. Sell your 401(k) investments and withdraw the entire amount

Some investors look at their 401(k) as something that should be removed from investment risk as quickly as possible. This line of thinking suggests that once you are ready for retirement, the investments should be sold off and the entire portfolio moved into the safest asset possible--cash, preferably insured bank deposits--for safekeeping. But there are some big problems with this approach.

First, any withdrawal from your 401(k) account will result in a taxable event to you, since you were likely contributing to your 401(k) on a pre-tax basis. So if you withdraw $1,000 per month and your marginal tax rate is 25%, then you’ll owe $250 in taxes.

Withdrawing the entire balance of a 401(k) valued at $250,000 then would result in taxes owed of $62,500! Not only is this a steep tax bill (all within one year) but it will likely bump you into a higher marginal tax bracket as well, costing you even more.

Second, retirees must remember they will probably need to live off of their nest egg for 25 to 30 years, or even longer in some cases. A 401(k) portfolio moved entirely to cash will have a hard time standing up to the inflationary pressure that your all-cash portfolio will be under.

Simply put, cash is not an appreciating asset--money under a mattress doesn’t grow--and retirees, to a degree, need their money to continue to do so.

A combination of bond and stock investments will give your money a much greater likelihood of one, keeping up with inflation, two, providing additional income for future needs, and three, allowing for greater overall growth through future capital gains.

2. Buy an annuity for predictable, lifetime income

A big concern among many retirees is having sufficient income, especially if they end up living longer than expected. One way to deal with this “longevity risk” is to purchase an annuity.

An annuity is a type of insurance instrument that can be used to produce a guaranteed stream of income over one’s entire life. Annuities can serve as an excellent solution to retirees who are concerned with outliving their wealth. I’m looking at you, ultra-healthy old folks in televised drug commercials.

How annuities work in context of a 401(k) is fairly straightforward. As an example, some or all of your 401(k) wealth could be moved into a single-premium immediate annuity. This generates a fixed stream of income over your life. For instance, someone investing $100,000 into this annuity might receive $500-$600 per month, depending on the terms offered by the insurer and other factors such as current interest rates.

A few downsides to this option are that you would have no further access to the annuitized amount. Your money is locked away and you can only receive your monthly annuity payments. As with other annuity products, there is also the risk that you will die prematurely, at which point the annuity will stop making payments.

Certain types of annuities may not keep up with inflation either. Variable annuities, which invest a portion of your annuitized wealth, can possibly be used to protect against inflation risk.

3. Leave your 401(k) where it is

Some investors wonder if they can just leave their 401(k) where it is. The answer is--Yes! There may be a variety of reasons to not move your 401(k) at all, at least not for a while.

One benefit is that it’s simply less work. Moving your 401(k) elsewhere isn’t rocket science nor does it take a ton of time to accomplish, but it’s still simpler to just leave your 401(k) funds where they are. There are no problems with leaving your 401(k) where it is and taking your withdrawals starting at 59 ½.

Another unique advantage of keeping your 401(k) put isn’t commonly known. The typical age you must reach before making 401(k) withdrawals is 59 ½. But there’s a caveat. If you keep your 401(k) with your original company, withdrawals can actually begin early at age 55 (401(k) funds left at previous employers before you turned 55 don't qualify).

For those looking to retire early and not be penalized for early withdrawals (a 10% penalty typically follows any withdrawals before age 59 ½) this can be an excellent option and a great reason to leave your 401(k) where it is.

There can be problems with this option too, and they tend to center on your investment choices. Most 401(k)s I review for clients tend to be quite limited when it comes to the available investments. 401(k)s typically have 30-40 different investment options, whereas if your 401(k) were moved to a Rollover IRA a whole panacea of options will be opened to you. 401(k)s don’t have near the variety of investment options IRAs do.

To make matters worse, 401(k) investments often carry steep fees. These fees can significantly eat into your future investment returns. Remember, you’ll need your money to continue to build over 25 or 30 years. Lower cost investment choices can be found in IRAs without sacrificing investment performance.

4. Move your 401(k) to a Rollover IRA

Perhaps the most common approach to handling one’s 401(k) account is moving it into a Rollover IRA. This tends to provide the most options when it comes to keeping your money growing for the long-run.

Rollover IRAs work identically to a Traditional IRA, except they are specifically created as a tool for 401(k) transfers. This is important, because not moving your 401(k) funds into a tax-qualified account will be considered a distribution by the IRS. Not only will you owe taxes on this amount at your marginal tax rate, but you could also received a penalty if your distribution happens before age 59 ½.

Without a doubt the biggest benefit to moving your 401(k) wealth into a Rollover IRA is the greater flexibility of investment options. Your 401(k) investment choices are often limited and, frankly, quite poor.

Expensive mutual funds tend to run rampant in many 401(k) accounts costing savers--like you--a lot of money over time. IRAs have literally thousands of choices of mutual funds, stocks, bonds, and other investments. Comparable mutual funds to your 401(k) funds can be found in an IRA at a fraction of the cost.

The downsides of using a Rollover IRA are few, but still worth mentioning. For starters, transferring your old 401(k) to a Rollover IRA puts you at the mercy of your 401(k) plan administrator. Sometimes the process is quick, other times it can take several weeks. This shouldn’t dissuade you from taking advantage of the Rollover IRA, but just be prepared for it to take some time.

As mentioned earlier, the 55 year-old early withdrawal 401(k) rule can be a big benefit for early retirees who qualify. However, there’s a BUT and it’s big. 401(k) holders transferring their 401(k) to an IRA become ineligible to participate in this benefit. So before moving your 401(k) to a Rollover IRA, make sure you don’t have any plans to take advantage of this benefit. Once your funds are moved, you’ve missed out.

Make a plan for when your 401(k) withdrawals will begin

I hope reviewing these options has been helpful. From the clients and friends I’ve talked with, knowing which approach (or combination of approaches) to take with your 401(k) can be one of the most terrifying retirement decisions--and may even lead some to put it off.

A good place to start is to consider all your potential sources of income throughout retirement. Consider how social security, pensions, inherited assets, or part-time income can work together to form a picture of your future income. For most retirees, retirement isn’t just about living off your 401(k) wealth only.

Remember that a combination of the approaches I’ve presented can be taken. Plenty of retirees put a chunk of their assets into an annuity for guaranteed income, a portion in cash for their retirement “war chest” when/if things get tough financially, and another part left in financial markets for greater growth potential.

The key is to find a balance between the approaches you’re most comfortable with and make sure you don’t burn through your wealth too quickly.

What questions do you have about using your 401(k) wealth? Are you currently taking withdrawals from your 401(k)? What has your experience been? Please share your thoughts below!