401k Withdrawal
Making a 401k withdrawal after the age of 59 1/2 provides Americans with an important source of retirement income. As fewer employers offer pensions and Social Security begins to look more and more in jeopardy, Americans may find themselves dependent on this important resource to support themselves during their retirement years. As the retirement instrument turns 30 years old, many Americans facing difficult economic times have stopped contributing to their accounts or have considered withdrawing from their accounts. However, 401k withdrawal has some consequences that employees should take into consideration.
Ted Benna invented the 401k in 1981. Benna gained IRS approval for allowing his employees to contribute pretax dollars to a retirement account. Within their retirement account, employees had a choice of investments, and Benna’s firm offered matching contributions. Thirty years later, 60 percent of Americans have one of these accounts, and the average balance carried by the first adopters back in the 1980s is approximately $140,000.
Employees of American businesses contribute money into their accounts pretax. This has the effect of not only increasing retirement savings but also lowering taxable income. Then, employers offer matching funds up to a certain percentage of the employee’s paycheck. Some employers match contributions fully, while others match a percentage of contributions. Different employers offer different investment opportunities for their employees’ retirement accounts. Some employers, for instance, match an employee’s contribution with company stock.
By law, employees have a cap on their annual contributions. In 2012, employees may make a maximum contribution of $17,000 to their retirement account. This maximum contribution does not include employee matching funds. People over 50 may contribute an extra $5,500 in catch-up contributions.
Employees can initiate 401k withdrawal when they turn 59 1/2. Withdrawals may also be allowed without penalty under several special circumstances. Employees may withdraw without penalty from their retirement account to pay qualified medical expenses for themselves, their spouse or their dependents. A 401k withdrawal may also be made for the purchase of a primary residence or for payments of post-secondary education expenses for themselves, their spouse or their dependents. If employees are facing eviction or foreclosure on their primary residence, then they may withdraw money without penalty.
When employees at least 59 1/2 years of age withdraw, they have several disbursement options. Retirees can take a lump-sum 401k withdrawal, but they will pay taxes on their disbursement at their marginal tax rate and may even be subject to the alternative minimum tax. For this reason, retirees should never take lump-sum disbursements without discussing the tax consequences with an accountant. By law, employers must withhold 20 percent of the amount that retirees withdraw, and that amount will be credited toward income tax payable or refunds due in the appropriate tax year.
Retirees may choose to roll their holdings over to an IRA instead of taking a lump-sum withdrawal. With IRAs, employees can choose which funds they want to invest in with their retirement savings. Regular IRA withdrawals will be taxed at the marginal tax rate, while Roth IRA withdrawals will be tax-free if the account has been open for at least five years. After the employee turns 70 1/2, he or she has to take mandatory withdrawals from the IRA.
Workers may choose to withdraw from their account before they turn 59 1/2. However, they will be hit not only with the 20 percent required withholding but also with a 10 percent early 401k withdrawal penalty. Again, the tax consequences for early disbursement should be discussed with an accountant, and workers should set aside the money for the penalty so that they do not have a huge bill at tax time.
Another consequence of early 401k withdrawal is the loss of compound interest. Even a small amount of money invested in a retirement account will grow substantially over time. When people withdraw early, they lose not only the amount of cash that they withdrew but also the future savings that they could have earned if they had left the money alone or rolled it over into an IRA.
Instead of withdrawing from a retirement account, employees may borrow against their holdings. Generally, employees may borrow the lesser of 50 percent of their savings or $50,000. Interest rates for borrowing are generally quite low. Employees should contact their plan representative to find out more information about the procedures and financial ramifications of this type of borrowing.
The 401k is a crucial source of retirement income for more than half of all Americans. Workers may withdraw their money when they retire or choose to withdraw the money early. When workers withdraw early, they should educate themselves about the tax consequences and the loss of compounding interest. In the end, borrowing may be a better choice than the 401k withdrawal.