This article was originally published on July 9, 2015, and was updated on Dec. 18, 2015.
It's important to understand 401k withdrawal rules so that you don't get socked with an unexpected penalty. Before you even think about that, though, be sure you understand what a 401k is and how to use it wisely.
A 401k account is a tax-advantaged, employer-sponsored retirement saving tool. With a traditional 401k, you get to contribute money on a pre-tax basis, diverting it from your paycheck straight into your account. For example, if you earn $60,000 per year before tax and contribute $10,000 to your 401k, then the income that you're taxed on drops to $50,000. If you're in the 25% tax bracket, then that $10,000 avoids a 25% haircut, giving you an upfront tax break of $2,500. However, when you eventually withdraw the funds, they will be taxed at your income tax rate.
There's a newer kind of 401k that's increasingly available to workers, and that's the Roth 401k. It works much like a Roth IRA, taking post-tax contributions, which eventually can be withdrawn tax-free. In other words, if you earn $60,000 and contribute $10,000 to a Roth 401k, your taxable income is not reduced. Your tax break comes later.
For 401k accounts, as well as 403(b) and 457 accounts, which are similar, the 2015 contribution limit is $18,000 (and it remains the same for 2016). Those aged 50 and older are allowed to make an additional "catch-up" contribution of up to $6,000, for a grand total of $24,000. (In contrast, IRA contribution limits for 2015 and 2016 are only $5,500 for most folks and $6,500 for those 50 and up.)
A 401k account can be a powerful way to build a retirement nest egg. If you save $10,000 annually in a 401k and it grows by the stock market's long-term annual average growth rate of close to 10%, you'll end up with more than $600,000 in 20 years.
The deadline for each year's contribution is the tax return filing deadline, usually April 15. So you can make your 2015 contribution until April 15, 2016.
401k withdrawal rules
For both traditional and Roth 401k accounts, you can start withdrawing funds at age 59-1/2. And for both of them, you must take distributions -- "required minimum distributions" (RMDs) -- each year beginning at age 70-1/2 (or when you leave the workforce, if that's later). You can't just withdraw any sum you want, either. The IRS has rules about these withdrawals.
Each year, you must withdraw at least your RMD, and you can always choose to withdraw more. The RMD is calculated based on life expectancies and the balance in your account at the end of the previous year. Your 401k custodian (often the financial institution where your account lives) will likely inform you of your RMD, while also reporting it to the IRS. That can make things easy. If you don't know what your RMD is, you can check with your plan's administrator or simply consult the IRS' helpful RMD table and figure it out on your own.
For every year in which you must take an RMD, it must be taken by Dec. 31 -- except for your first year. For the year in which you turn 70-1/2, you have until April 1 (not April 15) of the year following that year. In other words, if you turn 70-1/2 in 2015, then you have until April 1, 2016 to make your first RMD. For the year 2016, you have until Dec. 31. Note, though, that if you use the allowed delay in your first year, then you will be taking two distributions in the same year, which might boost your taxable income and bump you into a higher tax bracket. Proceed with caution -- and a calculator.
Be sure to stay on top of your RMDs, because if you withdraw less than you need to or make the withdrawal after the deadline, then you may have to pay an excise tax of 50% of the amount you failed to withdraw.
Distributions from 401k accounts will usually be taxable as ordinary income for the year in which they're taken, and they may be subject to state or local taxes, too. Exceptions include any sums that were taxed prior to being contributed to the account or qualified distributions from Roth 401k accounts.
The discussion above covers how most people will withdraw money from their 401k accounts, but there are also other ways to go about it. Here are a few examples:
- You can withdraw money before age 59-1/2, but unless you qualify for a hardship withdrawal, you'll likely be socked with a 10% early withdrawal penalty.
- If you leave an employer at or after age 55, you can start withdrawing from the 401k you have there. People leaving jobs as police officers, firefighters, or medics at age 50 or later can do so, too.
- If you're extremely and permanently disabled, then you may be able to withdraw funds early, without penalty.
You can amass a huge sum of money in a 401k account. Just be sure that you follow the rules when you make withdrawals.
Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.