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401(k) withdrawal tips

Everyone tells you to put money in a 401(k), but no one tells you the best way to take money out of it. Here are some tips that will mean more cash for you and less for Uncle Sam.

Just as there are many ways to leave your lover, there are lots of ways to withdraw from your 401(k) plan. You could hop on the retirement bus, Gus. You can roll into a new plan, Stan. You can take a loan for a house, Lee -- or claim hardship, and set your credit card bills free.

Dos and Don'ts of 401(k) withdrawal
Do ... Don't ...
  • Consult a trusted financial adviser.
  • Talk to your company's plan administrator.
  • Roll your 401(k) into an IRA upon retirement.
  • Plan ahead for level-load distributions.
  • Keep your money in a company 401(k) after you leave the firm.
  • Borrow against your 401(k).
  • But be aware of the tax consequences and penalties of your actions. There are specific circumstances where you can avoid a huge tax bite.

    Before you do anything with your retirement plan, consult a trusted financial and tax adviser as well as your company's 401(k) plan administrator to understand the consequences.

    Whatever is stated in your company's plan documents dictates what the rules are for withdrawing from your plan. "Not all 401(k) plans are created equal," cautions Brenda Newman, a San Francisco-based managing editor for mPower, publisher of 401(k)afe, a retirement planning Web site.

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    Riding off into the retirement sunset

    For those who are older than age 59 , the IRS' magic number for penalty-free distributions, you're in an ideal 401(k)-withdrawal situation. Your company hands you a check, and you're free to do with the money as you please.

    However, since the money that you stashed away was tax-deferred, if you cash in that mongo-sized lump sum, you're subject to ordinary income taxes on the amount withdrawn, warns Steph Chalk, owner of Chalk 401(k) Advisory Board in Cincinnati.

    Chalk recommends that retirees take out a portion for their retirement income and fulfill their dreams, but he advises rolling the remaining money into an IRA to continue tax-deferred growth. The Internal Revenue Service requires withdrawals from a 401(k) by age 71.

    "When you pull your money out of a 'k,' you're not required to spend it," Chalk says. "If you roll to an IRA, you preserve the [tax-deferred] status, as opposed to putting it into a taxable investment [outside of an IRA] where it immediately becomes taxable income."

    Financial experts also point out that you're better off having control of your money in an IRA after leaving a company for any reason. There's less corporate bureaucracy to deal with, and you control your life savings.

    What if I'm under 59 1/2?

    The IRS makes one special provision for both early retirees and anyone else below the age of 59 . You can roll your 401(k) into an IRA and take a level amount of money out each month for either five years or until 59 , whichever comes later, explains Peter Crane, chartered retirement planning counselor for First Allied Securities Inc., in Newport Beach, Calif.

    So if you're 58 and you start to withdraw a level monthly lump sum, you have to wait another five years to change the distribution. There are no exceptions for cost of living increases, lifestyle changes or greed.

    Crane says the ideal age to roll into an IRA and withdraw is 54 , because the five-year level-load period expires at the exact time when you're eligible for penalty-free distributions.

    The key is that the money must come from an IRA, and the monthly payment stays level. In doing so, you're avoiding the nasty IRS penalty that requires companies to withhold 20 percent of the money withdrawn before the luckiest half-birthday of our lives (59 ), a 10 percent penalty for early withdrawal plus adding to your taxable income.

    Even if you're considering dipping into a 401(k) through an IRA rollover, the experts recommend avoiding a withdrawal at all costs, except for extreme hardship emergencies, such as a severe disability or death -- which are excluded from tax penalties but still subject to income tax.

    "Sabotaging your retirement"

    It's true you can borrow from yourself through a 401(k). You can use the cash to make the down payment on the home of your dreams or to pay for Johnny's and Jane's ridiculously expensive education, then pay yourself back with interest.

    "You're sabotaging your retirement," cautions Dee Lee, a Boston-based author of The Complete Idiot's Guide to 401(k) Plans. "It's great to have a home now and lessen the cost of the mortgage, but this is costing you in retirement dollars."

    Should you leave your current job, you're stuck. The loan is due within 60 days. If you don't pay it back, guess what? You're slapped with the good ol' IRS early withdrawal penalties, as well as ordinary income tax on the money withdrawn.

    Bye-bye, money

    Even if you pay back the loan, you've sacrificed the growth of that money tax-deferred. In addition, the money is paid as taxable income on your paycheck. This means, you'll windup with a double tax -- at pay-back time and at retirement. Ugh.

    "That can really add up," Lee says.

    When money gets tight and that 401(k) nest egg looks tempting, Lee suggests you consider other possibilities, such as seeking help from a credit counselor or negotiating down debt with credit card companies.

    "A young person may think that retirement is a long time away," she says. "But ask any 60-year-old where the last 35 years went, and they'll say that it blew by."

    So can your retirement, if you dip into the 401(k) cookie jar too early.

    -- Posted: Feb. 15, 2000

     

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