Employer-sponsored 401(k) plans help millions of savers sock away money for retirement each year. The primary benefit of these plans is the tax savings they offer. Not only are contributions made with pre-tax dollars, but savers get to enjoy tax-deferred growth on their investments.
There is, however, one major drawback to the 401(k), and it's that you can't let your money sit in your account forever. Like traditional IRAs, 401(k) plans come with strict rules regarding required minimum distributions, or RMDs. Generally, you must take your first 401(k) withdrawal once you reach age 70 1/2, and if you don't take your mandatory distributions, you could face some pretty stiff penalties.
The problem with required minimum distributions
The purpose of a 401(k) is to provide income in retirement. Since many seniors are already retired and in need of extra income by the time they reach age 70 1/2, RMDs aren't always so problematic. But if you have another source of income and don't need to make a withdrawal from your 401(k) by the time your RMDs kick in, this rule could trip you up big time.
Though 401(k)s are funded with pre-tax dollars, and you won't pay taxes on your earnings during your working years, once you start taking distributions, your withdrawals will be taxed as ordinary income. If you don't need the money from your 401(k) but are required to make a withdrawal nonetheless, you'll be automatically subjected to taxes you otherwise could've avoided.
Furthermore, any time you take money out of a 401(k), you're limiting your portfolio's ability to grow. Granted, you probably won't be seeing too high a return on your 401(k) by the time you reach 70 1/2, as at that point in life you should, ideally, have a good portion of your assets in safer investments. But the more money you remove from your 401(k), the less growth opportunity you'll achieve.
Though calculating your RMD can be a little tricky, it's imperative that you get that number right, because if you don't take your RMD in full, you'll be assessed a whopping penalty. Your actual RMD will be based on your account balance and life expectancy, and you must take your initial RMD in full by April 1 of the year after the year you turn 70 1/2. Confused yet? No need to be. Basically, if you turn 70 in April 2017 and turn 70 1/2 in October 2017, your first RMD must be taken in full by April 1, 2018.
What happens if you don't take that RMD? Bad news -- you'll be slapped with a 50% penalty on whatever amount you fail to withdraw. So if you're looking at a $5,000 RMD and you don't remove any money from your 401(k), you'll lose $2,500. Yikes.
Exceptions to RMDs
Though there's generally no flexibility when it comes to 401(k) RMDs, there is one exception: If you're still working for the company sponsoring your plan by the time you turn 70 1/2 and you don't own 5% or more of that company, you can get out of the RMD requirement for as long as you remain employed. Once you leave that company, however, you'll need to start taking withdrawals. Also keep in mind that this exception applies to 401(k)s only; if you have an IRA in addition to your 401(k), you'll need to take your RMDs regardless of whether you're still working at the time.
The best way to avoid RMDs (and the taxes they trigger) is to switch your traditional 401(k) to a Roth IRA. Roth IRAs are funded with after-tax dollars, so there's no immediate tax savings when you contribute. Your money, however, gets to grow tax-free, and withdrawals in retirement aren't taxed at all. Furthermore, Roth IRAs don't impose RMDs, which means you can leave your money in your plan indefinitely and let it grow. Note that Roth 401(k)s, despite the fact they are also funded with after-tax money, are not exempt from RMDs.
If you have a 401(k), be sure to read up on the rules of required minimum distributions so you're not caught off-guard down the line. The last thing you want is to forgo some of your hard-earned savings because you failed to take your RMD in time.
The Motley Fool has a disclosure policy.