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10 401(k) Modifications to Make When You're Near Retirement

By Chuck Saletta - Jun 1, 2021 at 7:00AM
Clock with Time to Retired written on its face.

10 401(k) Modifications to Make When You're Near Retirement

It's time to make your money work for you

Once you retire, your paychecks stop coming in. That fundamentally changes your relationship with your money and your 401(k). To the extent you will be relying on it to cover your costs of living, you will need to make sure your 401(k) is set up to enable your success, even when the market isn’t cooperating.

With that in mind, here are 10 changes to make to your 401(k) when you’re near retirement to improve your chances of your money lasting at least as long as your retirement does. With a solid plan in place before your call it quits, you can spend more of your retirement on family, friends, and the things that matter, and less of it worrying about the mechanics of your money.

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Slip of paper saying 401k Contribution being slipped into piggy bank.

1. Take advantage of catch-up contributions

One of the best parts of 401(k) investing is that it continues automatically once you start it. The challenge with that, however, is that if you leave your plan entirely on autopilot, you could miss out on the ability to invest more of your money once you reach age 50.

Employees age 50 and up are typically eligible to contribute $6,500 more to their 401(k)s than their younger counterparts are, up to a total of $26,000 per year in 2021. Most 401(k) contributions are based on a certain dollar amount or a certain percentage of your salary every paycheck. As a result, you will likely have to increase the amount you’re socking away to take advantage of that catch-up contribution.

ALSO READ: Planning to Retire in 2021: A Complete Guide

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Person smiles behind row of growing stacks of coins.

2. Top off your savings in your final (partial) year of work

401(k) contribution limits are generally set by year, not by paycheck. If you expect to retire in the middle of a calendar (or your plan’s fiscal) year, you may be able to increase your contribution rate during that last year of work to get closer to the total limit.

For instance, assume you plan to retire at the end of August of next year and your plan follows the calendar year conventions. You may be able to contribute $3,250 per month to your 401(k) from January through August of that year. Eight months of contributions at that rate will get you to the $26,000 limit for age 50-plus employees just in time for your retirement. That final boost just might be enough to top off your savings and make your retirement that much more comfortable.

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Notebook open to Roth 401k and Traditional 401k on facing pages.

3. Consider switching to traditional-style contributions

401(k) contributions come in two types: traditional and Roth. The key difference is that with traditional-style contributions, you get an immediate tax deduction, though withdrawals are taxed as ordinary income. With Roth-style contributions, you get no immediate tax deduction but your withdrawals can potentially be taken tax-free.

Near the end of your career, you may be close to your peak earnings (and taxes), and thus could benefit from the immediate tax deduction from making a traditional contribution. Especially if you don’t have much saved in traditional-style plans, you could then take your withdrawals from that plan after you retire and pay less in total taxes.

Do note, though, that this may not be the best idea if you already have a substantial balance in your traditional-style retirement plans. This is because you have to start taking taxable mandatory withdrawals at age 72 from your traditional-style plans. If those account balances are high enough, it could increase the taxes on your Social Security benefits and raise your Medicare premiums due to the income level you’ll be reporting from those withdrawals.

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A Roth IRA road sign.

4. Consider switching to Roth-style contributions

On the flip side, if you already have a substantial amount of money in your traditional-style retirement accounts, it may make sense to switch your contributions to Roth-style ones instead. Even though you’ll pay more in taxes up front since you can’t deduct your contributions, money inside a Roth-style 401(k) can grow completely tax-free.

Indeed, once you separate from service, you can roll your Roth 401(k) money -- including the growth on it -- to your Roth IRA with no tax consequences. Once it’s there, you can even let it grow tax-free for the rest of your life, as there’s never a requirement for the original account owner to take mandatory distributions from a Roth IRA. If you’re planning for a long retirement or to leave an inheritance, those benefits can outweigh the up-front tax costs of not being able to deduct your contributions.

ALSO READ: Is Your 401(k) Enough for Retirement?

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Cartoon of people climbing a ladder to make a deposit in a giant piggy bank.

5. Increase the certainty of some of the money in your 401(k)

Once you reach retirement, chances are that you’re going to expect to have to spend some of that money you’ve spent a good part of your career accumulating inside your 401(k). As a general rule, money you expect to spend within the next five years does not belong in stocks. Because of this, you should plan to start moving money out of stocks beginning around five years before you retire.

No, you don’t need to move everything out of stocks, just the money you expect to spend from your account within the next five years. Say, for instance, that you expect to have to spend $5,000 a month covering your retirement costs, with around $1,500 of that coming from Social Security. That leaves $3,500 each month (or $42,000 each year) that you need to cover from your savings.

As a result, in this example, by the time you’d retire, you’d want somewhere in the neighborhood of $210,000 -- maybe a bit more if you want to plan for inflation -- in safer investments than stocks. Think things like cash, CDs, duration-matched U.S. Treasuries, or investment-grade bonds. The rest of your money can certainly stay invested in stocks to try to grow over time.

In today’s low interest rate environment, you certainly won’t earn much in the way of returns on that safer money. The point of it, though, is to give you much higher confidence that the money you need will be there when you need it, even if the market is down.

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Two people looking at laptop in kitchen.

6. Make sure your 401(k) has good information about you and your wishes

Once you start taking money out of your 401(k), your withdrawals start getting reported to the government and potentially taxed. In order to make sure those withdrawals are processed and taxed correctly (which can save time, headaches, and potentially money later), your 401(k) needs to have your personal information correct. In addition, all retirements end at some point, and that processing flows smoother if your beneficiaries are set up correctly. Key details your plan should have correct include:

  • Name
  • Birthdate
  • Social Security number
  • Marital status
  • Address
  • Special tax withholding instructions for withdrawals
  • Receiving accounts (such as a bank, brokerage, or IRA) for any withdrawals or transfers
  • Your beneficiaries and their relationships to you

You should be able to update that information at any time, but it might be easier to do so before you retire, while you’re still able to interact with your employer’s human resources department or plan administrator from the inside.

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A bank in an urban setting.

7. Have your receiving accounts set up in advance of withdrawals

After you retire, chances are that you will need to take money out of your 401(k) to cover your living expenses. Even if you don’t strictly need the money, once you reach age 72, you are generally required to take withdrawals from your 401(k) account.

That money has to go somewhere. You’re better off having the receiving accounts set up and ready to take the money before you make those withdrawals than scrambling at the last minute to find a way to get your assets handled properly. Key account types to consider include:

  • Traditional IRA
  • Roth IRA
  • Standard brokerage account
  • Checking account

While your required minimum distributions (RMDs) cannot be rolled into another retirement account, it might make sense to roll other money into either a traditional or Roth IRA depending on your plans. And just because you have to withdraw the money from your retirement account doesn’t mean you have to spend it. You can transfer that money into a standard brokerage account and keep it invested.

ALSO READ: Eager to Retire Early? Here's 1 Mistake You Can't Afford to Make

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Tax forms and calculator with Post-it note reading Tax Time!

8. Set your tax plan for tax withholdings on withdrawals

When you withdraw money out of your traditional 401(k) or roll it into a Roth IRA, that movement is a taxable event. While you don’t have to get your taxes perfect before the filing deadline, you do need to pay enough before that deadline to be covered by a "safe harbor" test.

All withdrawals you directly receive from a traditional 401(k) face a mandatory 20% withholding. Above and beyond that, you can pay your taxes due from any source of money you have, but having them withheld directly from your 401(k) might be the most convenient way to make sure they get paid.

Whatever process you use, make sure you have a plan to both hit a safe harbor test and cover your total taxes due by the appropriate deadlines. Retirement is expensive enough without having to pay penalties on top of taxes just to access your own money.

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Person using ATM.

9. Plan for any early withdrawals if you're retiring early

There are several key ages to be aware of when it comes to retiring from a company. Two of the most important if you’re looking to retire early are ages 55 and 59 1/2. If you retire from your employer at age 55 or later, you can withdraw money from your 401(k) plan sponsored by that employer without facing any early withdrawal penalties.

Once you reach age 59 1/2, all early withdrawal penalties are gone, no matter when you actually separated from service. In addition, if you have a Roth 401(k), you need to be at least 59 1/2 to take tax-free withdrawals of your earnings from that account.

Even with those rules in place, there are ways to get your money out of your retirement plans earlier than that without penalties. One of the most common ways is through something known as a substantially equal periodic payment. In a nutshell, the IRS will let you start withdrawing money before you reach 59 1/2 without facing a penalty, as long as you set up an approved withdrawal plan in advance.

In addition, if you are withdrawing from a Roth 401(k) early, you can withdraw your contributions tax-free. Unfortunately, your early withdrawals will be prorated between earnings and contributions. As a result, you will pay taxes -- and potentially penalties -- on the portion of your early withdrawal that’s considered earnings.

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Person hugs a piggy bank.

10. Plan for mandatory distributions well before you reach age 72

Even if you have many years before you reach 72 and are forced to take money out of your 401(k), you should start thinking about those mandatory distributions well before you reach that age. This is because those distributions can raise your income taxes and the portion of your Social Security benefit that gets subject to taxes. In addition, if your income is high enough -- even if it all comes from RMDs and Social Security, that income will raise your Medicare Part B premiums.

One key strategy people follow to mitigate those potential costs is to convert money from a traditional 401(k) to their Roth IRAs once they retire. You can convert any amount you want, as long as you’ve satisfied any required minimum distributions you may face for the year. Yes, a conversion from a traditional 401(k) to a Roth IRA does create taxable income, but it’s a one-time hit for each conversion. Once the money is in your Roth IRA, it can potentially grow tax-free for the rest of your life.

Making those conversions early in your retirement can reduce your required distributions later in retirement, thus potentially sparing you higher costs and taxes down the road. That’s why it’s so important to plan for those distributions well before you face them. The benefits you get for planning ahead can be well worth the costs.

5 Winning Stocks Under $49
We hear it over and over from investors, “I wish I had bought Amazon or Netflix when they were first recommended by the Motley Fool. I’d be sitting on a gold mine!” And it’s true. And while Amazon and Netflix have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $49 a share! Simply click here to learn how to get your copy of “5 Growth Stocks Under $49” for FREE for a limited time only.

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Two people hold hands on the beach.

It's time to put your money to work for you

Once you retire, the money you’ve spent your career accumulating in your 401(k) becomes a key source of income to cover your costs for the next chapter of your life. As you approach retirement, putting these 10 modifications to work for you can help you improve the chances that your money will be able to help support the lifestyle you’ve been planning for. So start today, and get yourself financially ready for the next great adventure of your life.

The Motley Fool has a disclosure policy.

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