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401(k) Withdrawals

5 Things you need to know

Older woman at her computer

The 401(k) is a very common type of retirement savings account in the United States. Many people invest in their 401(k) plans monthly for years, watching their funds grow. Then eventually, the time comes to withdraw from their 401(k), and these lifelong investors are not sure what to do. The important thing is that the money is there for you to retire on. Withdrawing from a 401(k) is simpler than it initially seems once you know these key points.

If you withdraw before 59 1/2, you pay a penalty.

Unfortunately, 401(k) funds assign what's known as an early withdrawal penalty to any funds you withdraw before you reach the age of 59 1/2. This penalty is equal to 10% of the amount you are withdrawing. Because of this, financial experts almost always recommend against withdrawing from your 401(k) early, unless you have no other choice.

Once you do reach the age of 59 1/2, you can make 401(k) withdrawals penalty-free. The only real exception to this is if you are between the ages of 55 and 59 1/2 and have left the company that contributed to the 401(k). However, you need to have left after your 55th birthday in order to avoid the penalty.

You have to pay taxes on the money you withdraw.

A 401(k) is what's known as a tax-deferred investment. You do not pay tax on the money you invest when you invest it. However, you do have to pay tax later on when you withdraw that money. The amount of tax you pay will depend on the income bracket you fall into at the time of the withdrawals. For instance, if your 401(k) is your only source of income and you withdraw $30,000 a year from it, then you will pay tax on that $30,000 as the current tax brackets designate.

You're required to begin withdrawing at age 72.

When you reach the age of 72, the IRS requires that you begin withdrawing from your 401(k) if you have not already. The withdraws are known as required minimum distributions. How much do you need to withdraw? That depends on your life expectancy, which the IRS calculates using several different factors. Usually, though, your fund will let you know what your required minimum distribution is.

If you do not take your required minimum distribution, the IRS will take a penalty of 50% of that distribution, so this is really something to pay attention to. 

You can withdraw more than your required minimum distribution.

Sometimes people see the required minimum distribution amount and become worried because they know they can't live on that amount. The good news is that you can withdraw more than this, and most people do. You do need to carefully plan to ensure you will have enough money to live on in future years, however. 

You do not have to immediately spend your withdrawals.

If you have multiple retirement accounts with required minimum distributions, you may actually find yourself having to withdraw more than you spend in a year. This is not actually a problem. You do not have to spend all the money you withdraw immediately, and many people do not. You can put it in a savings account or even invest it in an individual, taxable brokerage account. 

Hopefully, these points have cleared up your uncertainties about 401(k) withdrawals. At first, making 401(k) withdrawals can seem strange after you've spent the past years focusing on contributing to the account. However, the purpose of this fund is to enable you to live comfortably in retirement—and making withdrawals is key.

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