A common question I hear from people approaching retirement: 

What do I do with my 401(k) when I stop working?

It sounds like a straightforward question. But the answer matters more than expected, and the wrong move can mean a tax bill that catches you completely off guard or giving up a withdrawal benefit you didn’t even know you had.

In my latest video, I cover the four biggest 401(k) mistakes I see people make in retirement, including:

  • Why cashing out is almost always the wrong move
  • A little-known rule that shields early retirees from penalties
  • What scattered old 401(k)s from previous employers are quietly costing you
  • Why retiring without a withdrawal tax strategy could mean paying more to the IRS than you need to

If you’re within five years of retirement, or you’ve recently left a job, watch before you make any moves with that account.

 

 

Transcript

Many people spend 20 or 30 years building up their 401(k). Then they retire, make one decision without fully thinking it through, and hand a big chunk of that over to the IRS. I see this happen more than you’d expect, and in almost every case, it’s completely avoidable.

I’m Joe Dowdall, a CERTIFIED FINANCIAL PLANNER® professional in Dallas, Texas. I work with people who are nearing or in retirement, and one of the biggest questions that comes up is “What should I do with my 401(k)?” Well, today I want to talk about the biggest mistakes I’ve seen, so you know what to avoid. The first mistake I see is people cashing out their 401(k) when they retire.

Mistake #1: Cashing Out Your 401(k) When You Retire

It sounds straightforward, right? It’s my money. I earned it. I saved it. I want to have access to that. But here’s what many people don’t realize: that distribution is fully taxed in the year it’s taken.

Let me give you a hypothetical example to show how fast those taxes can add up. Let’s say someone has $400,000 in their 401(k) and they decide to cash it out all at once. That $400,000 gets added to any other income they had that year, which could easily push someone up into the 32 or 37% income tax bracket.

And that’s only federal income taxes. If your state also has income taxes, you have to add that as well. And also, if you’re under a certain age, you may also be exposed to an additional 10% penalty.

The tax bill on that distribution can easily add up to $50,000, $60,000, $70,000, easy. There are many options when it comes to what to do with your 401(k). The two most common? Roll that into an IRA or perhaps leave it in the plan.

Both of those choices are worth considering. The right answer depends on your specific situation. But cashing out your 401(k) when you depart from work is rarely the right choice.

Mistake #2: Rolling Your 401(k) Into an IRA Too Quickly

The next mistake I see is people rolling their 401(k) into an IRA too quickly without knowing about something called the Rule of 55. This one catches a lot of people off guard, especially those under 59½. If you leave your job in the year you turn 55 or older, you may be eligible to take a penalty-free withdrawal directly from your 401(k).

But here’s where the mistake might happen. Let’s say someone retires at 57 and they immediately roll their 401(k) over to an IRA because that’s what they thought they were supposed to do. But then they need money from that IRA for living expenses.

Well, if they take a distribution from their IRA before they’re 59½, they are going to be exposed to that 10% early withdrawal penalty because IRAs don’t have the same exception that 401(k) plans do. Rolling over right away might be the right choice. But it is something you have to think through.

Definitely talk to a financial advisor before you make that decision.

Mistake #3: Leaving Old 401(k) Plans at Previous Jobs

The next mistake I see is people leaving old 401(k) plans at every job they’ve ever had. A lot of people will work several jobs over their career.

And I’ve spoken with folks who’ve left 401(k)s at four or five different companies because they’ve never consolidated. Managing your money well is hard to do, especially when it’s in different places. And those different places may have different investment options, different fee structures, and maybe login credentials you haven’t touched for years.

And don’t forget about fees. A 1% difference in annual fees may not sound significant. But when that difference is compounded over time, it can take a real bite out of your savings.

Consolidating your accounts will give you a clearer picture of your overall financial situation and makes it a lot easier to manage your money in retirement.

Mistake #4: Retiring Without a 401(k) Withdrawal Strategy

The final mistake I want to cover is people retiring without a strategy for how they’ll take money out. A lot of people will reach retirement with a great 401(k) balance but no real plan for withdrawals.

They just start pulling what they need and figure the taxes will sort themselves out. But the timing and order of withdrawals matter more than most people realize. For example, in the years between your retirement and Social Security or required minimum distributions, your taxable income may be lower than it’s been in decades.

That window is a real planning opportunity. During those years, it may make sense to do a Roth conversion, moving money from a traditional IRA or 401(k) into a Roth IRA at a lower tax rate than you’d face later. Once required minimum distributions kick in or at 73 or 75, you’re no longer in control of the timing.

The IRS will tell you how much to take out and when to take it. Without a plan, that window closes and you miss the opportunity. These are the kinds of mistakes that are hard to undo once they’re made.

Review Your 401(k) Options Before Making a Retirement Decision

If you’re approaching retirement or recently retired, I suggest taking a close look at your 401(k) options before you make any moves. I offer a free, no-obligation 15-minute call. And if I can help you, I’ll tell you that.

And if I can’t help you, I’ll tell you that too. You can reach me at 469-423-1989 or email me at joe@worthassetmgmt.com. I look forward to talking with you.