How do IRA and 401(k) Withdrawals Work?

Written by , March 20, 2013

How do IRA and 401k Withdrawals WorkChances are you’ll spend a significant portion of your working years saving for retirement by building up the balances in your traditional IRA or 401(k) account. Perhaps you’ll even save in both types of accounts. Over the course of your career (or careers) you may even accumulate several 401(k) or IRA accounts.

When you reach your retirement age, whatever that age may be, you’ll start withdrawing these funds. It’s important to understand all of the rules and restrictions relating to IRA and 401(k) withdrawals; you do have flexibility in the timing and amounts of your withdrawals, but not complete freedom.

Here is some retirement advice and a summary of the most significant rules effecting withdrawing money from your retirement accounts.

  • Standard Withdrawals. The minimum age to begin penalty-free withdrawals from either a traditional IRA or a 401(k) is 59½. Any withdrawals before age 59½ will incur a 10% penalty. Withdrawals from a traditional IRA or 401(k) will be taxable regardless of when they are made (both with respect to your original contributions as well as your investment earnings within the account).
  • Required Minimum Distributions (RMDs). Perhaps the biggest advantage of 401(k)s and traditional IRAs is that they delay the point at which you need to pay taxes on the account funds (both contributions and earnings). Any funds you contribute in your 20s, for example, will be able to grow and compound on a tax-free basis until you withdraw them, and this could be 40 or 50 years later or more. But the government won’t wait forever to tax these funds, so once you reach a certain age you’ll be forced to start taking certain minimum withdrawals from your account. This obligation begins the year in which you turn 70½ years old. To find the required minimum withdrawal amount, you calculate your life expectancy (or joint life expectancy with the beneficiary of your account) using a standardized table and divide the balance in your retirement account by that number. The result will be the amount you need to withdraw from your account that year.
  • Recalculating RMDs. The RMD is simply a minimum, so you are free to withdraw more than the RMD amount each year. In addition, the balance of your IRA or 401(k) account will change (perhaps significantly) based on your investment selections. You therefore need to perform the RMD calculation every year, using the updated balance of your account and your updated life expectancy figure.
  • Penalty-Free Early Withdrawals. Despite the general rule in which withdrawals before age 59½ incur a penalty (in addition to taxes coming due) there are a few situations where an early withdrawal will not be penalized. For example, if you become disabled or require the funds to pay certain medical expenses then no penalties will apply. You may also withdraw funds penalty free to pay for a “first home” purchase (up to $10,000 withdrawal) or for certain educational expenses.
  • When planning how and when you want to access your IRA and 401(k) retirement funds, it’s important to have a clear understanding of the rules governing withdrawals. Having a withdrawal strategy that meets your needs (and avoids any unnecessary penalties) might be as important as choosing the investments in your accounts.

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