Mechanics of 401(k)s (Pt. 2)
How do you take money out of a retirement plan? This is tricky, because one wrong move can cost you in taxes and penalties. The process is complicated, to say the least.
For this second part in our series that looks under the hood of the 401(k) plan, we review its mechanics of distribution. As with the first article, we refer to all sorts of qualified retirement plans – including 401(k), 403(b), 457 and others – generically as 401(k) plans throughout. These are tax-deferred plans, meaning you put away pre-tax money and only pay the Internal Revenue Service when you withdraw it.
Several scenarios exist in which you take distributions from your 401(k) plan: 1) You withdraw the money before reaching retirement age. 2) You withdraw the money after retirement age, and 3) you take a loan from your 401(k), regardless of age.
Here, we review the first two scenarios and leave the third one to our next article.
But first, we need to define retirement age. Generally speaking, it is 59½ for a 401(k) plan, just the same as with an individual retirement account. If you leave employment at or after 55, you can make penalty-free withdrawals. Otherwise, you have to reach 59½ to have access to the funds in your account without the early distribution penalty.
For government jobs with a 457 plan, retirement age is whenever you leave employment – there is no set age. If you move your funds from the 457 plan to any other type of plan, such as an IRA or 401(k), you lose this provision and must abide by the retirement age for your new plan.
Distributions before retirement age. You owe ordinary income tax and a 10% penalty for early distribution if you take money from your 401(k) account before you reach retirement age.
The money you withdraw from your 401(k) plan is taxable income if you put it into a non-deferred account (or just spend it), instead of rolling it over into some other sort of tax-deferral vehicle, such as an IRA or another 401(k) account. Ordinary income tax applies to the pre-tax amounts you withdraw from your account.
All funds in your 401(k) account are taxable upon distribution, including any growth of the funds such as interest received, capital gains and dividends.
Two exceptions: If you have post-tax funds in your account – the funds you contributed were already taxed – there will be no additional tax on the distribution. If you take the money out as a rollover, there should be no tax on that one either.
Some situations may exempt you from the 10% penalty. These include (with limits): first-time home purchase, medical expenses and education expenses.
Distributions after retirement age. If you are older than 59½, then you are not subject to the 10% penalty on funds you withdraw from the account. Other tax rules regarding withdrawals are the same. So, pre-tax contributions and growth in the account are taxed as ordinary income, unless you roll them over into another tax-deferred account. Post-tax contributions to the account are tax-free upon distribution.
“Cream in the coffee” rule. If your account includes some after-tax money in addition to pre-tax money, the government taxes you on each distribution on a pro rata basis. For example, if your 401(k) account contains $100,000 in total, of which $10,000 is post-tax contributions, for every dollar you take out, 10 cents is tax-free, and 90 cents is taxable. We call it the “cream in the coffee” rule – as in, once you have cream (post-tax money) in your coffee (your account), every sip (distribution) contains some cream along with the coffee.
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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
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