Workers spend their entire careers saving for retirement, but when it’s time to transition from saving to spending, many retirees struggle to know where to start.
“The biggest mistake I often see when working with retirees is to treat their retirement savings as one big checking account and every dollar as equal value,” says Evan Mills, associate financial advisor at Scholar Financial Advising in Winston-Salem, NC “A 401(k) withdrawal plan, or any retirement account withdrawal plan, should be planned for withdrawal, not built before retirement.
Mills says retirees should have a clear plan of which account to tap first, how much they can withdraw without hurting their savings, and how taxes will be handled on each account.
Read more: What are the retirement ages for Social Security, 401(k), and IRA withdrawals?
The changing mindset of retirement savings
A recent study by Nuveen and the TIAA Institute found that only 19 percent of late-time 401(k) participants have given much thought to how they will take retirement money out of their 401(k) savings. Even among late participants who expect 401(k) savings to be their most important source of income for retirement, only 23% say they have given much thought to withdrawals.
Part of the challenge may be the lack of fluency during retirement and a long life of learning.
The same survey assessed retirement smoothness among 401(k) participants using 15 questions covering five topics, including Social Security benefits, Medicare benefits, and long-term care.
On average, 401(k) participants answered only 32% of retirement questions correctly. More than half (52%) of the participants answered less than one-third (five) of the questions correctly, and only 7% answered 10 or more questions correctly.
“Retirees need to prepare for a big mindset shift. You’re going from saving to spending, and replacing your check means generating income out of a bucket of potentially volatile assets,” says Margie Glenn, CFP®, CPA, and Moneta advisor.
“Without a formal distribution system, you don’t see very well,” Glenn said. “You risk spending too early and jeopardizing your long-term security, or for fear of spending too little and failing to enjoy the retirement you spent a lifetime building. Accumulating wealth is the first part of the plan; a strong distribution strategy is how you win the second part.”
Read more: How much does a financial advisor cost?
How 401(k) withdrawals work
A traditional 401(k) is funded with pre-tax money, which means that contributions reduce the taxable income of an employee for the year. However, any withdrawals are treated as taxable, ordinary income. An early withdrawal penalty of 10% will apply in most cases if the withdrawal is made before age 59 ½.
The rules for withdrawing money from a 401(k) vary across account types. A traditional 401(k), funded with pre-tax dollars, is also subject to mandatory withdrawals called required minimum distributions (RMDs) once you reach age 73, although the RMD age will increase to 75 in 2033 under the Secure Act 2.0 rules.
A Roth 401(k), funded with after-tax dollars, offers tax-free withdrawals in retirement. Although account holders generally need to be at least 59 ½ AND have held the account for at least five years to do so.
Unlike traditional 401(k)s, Roth 401(k)s are no longer subject to RMDs. Account holders can let money grow indefinitely.
Read more: How much should I contribute to my 401(k)?
How much money you should withdraw from your 401(k), according to experts
One general guideline is the 4% rule, which encourages retirees to pool all their investments and withdraw 4% of that total within the first year of retirement.
In subsequent years, the withdrawal amount must be adjusted to account for inflation. The goal is to try to stretch that retirement account balance to last as long as possible.
“The number that most people should rely on is the 4% rule, but that should be taken as a guideline and not a driving plan,” Mills said. “Some households may be less than that, and some may be more than that, depending on their equity value, fixed income, retirement timeline, and how flexible they want to spend during bull markets or bear markets.”
Although the law was first published in the 1990s, it has been updated to cover retirees with a wide variety of assets.
The new 4.7% rule states that retirees can effectively withdraw 4.7% in the first year of retirement while maintaining a high probability that their savings will last at least 30 years.
While guidelines like the 4% or 4.7% rule can give retirees a head start on their retirement plan, experts caution that this is only a baseline, and it’s important to consider factors such as tax implications, retirement timelines, other income streams, lifestyle, and inheritance goals.
“The risk is not just withdrawing too much. It’s withdrawing from the wrong account, at the wrong time, in the wrong market, and doing it in the wrong way,” Mills said. “You can still get the same amount of money, but there may be a more efficient way to do it.”
