How to Use Your 401(k) in Retirement

By Justin Pritchard, CFP®

When you stop working, you have full control over the funds in your retirement plan. During your working years, your employer chose where to put the 401(k), and in some cases, those 401(k) plans offer high-quality investment options at a reasonable price. But now that you’re in charge, you get to decide how to use your 401(k) assets.

So, what do you actually do with that pot of money? These are the options most clients have, and we work together to determine what course of action is best:

  • You can move the funds to an IRA, which is what most people do.
  • You might set up lifetime income directly from your (former) employer’s 401(k) plan.
  • You could buy an annuity from an insurance agent if you want to purchase guarantees.
  • You may want to explore Roth conversions to manage taxes.

We’ll discuss each of those options in detail below. But to start with the big picture, you can use your 401(k) in a variety of ways:

  1. Monthly pay: Supplement your income from Social Security and pensions.
  2. On-demand withdrawals: Have a pool of money to draw from as expenses arise.
  3. Reserve assets: Set aside money for an unknown future or to leave unused assets to loved ones.

Pros and Cons of Moving Funds Out of a 401(k)

Before you decide what to do, it’s critical to understand the pros and cons of taking money out of your workplace retirement plan. For example, if you leave your job after age 55 but before age 59.5, it may make sense to keep the money in your 401(k) to get early withdrawals with no tax penalty. But it’s also important to look at expenses, investment options, and other features as part of the big picture. Make sure you do that before making a decision.

Rolling Over to an IRA?

Most clients move their 401(k) to an IRA after they stop working. Doing so gives them more control over several things:

  • Investment choices: You can choose from a broad range of investments, including mutual funds, ETFs, CDs, stocks, and other vehicles.
  • Expenses: Instead of being stuck with whatever your employer arranged, you can choose an IRA that you think charges reasonable fees.
  • Withdraw money with ease: 401(k) plans might not allow for on-demand withdrawals, and withdrawal requests can take longer than you’d like. With an IRA, you often link your bank account from the beginning, and you can request money quickly and easily.
  • Simplify life: When you consolidate your retirement accounts, you have less to keep track of. That makes it easier to manage your investments while reducing clutter and confusion.

How to Take Income

Hands with a bounty of blueberries suggesting harvest of retirement savingsAfter moving your money to an IRA, you can take income in whatever way you want. Set up a system that provides the retirement cash flow you need. For example, you might choose to set up automatic monthly transfers into your bank account from your IRA. Or, you could just request funds whenever your bank account runs low and you need to replenish your cash holdings. It’s up to you.

How to raise cash: Logistically, you’ll probably need to sell something to generate cash for your withdrawals. That can be extremely easy—especially if you automate the process. But with some accounts, you may need to sell securities every month (or every several months) to provide funds for cash withdrawals.

Take income that lasts: If you go this route, it’s crucial to take funds out at a sustainable rate. You need that money to last for the rest of your life, and running out of money early can be problematic. The best way to figure out how much you can afford to pay yourself is by doing some detailed financial planning. But you can also get a ballpark idea with the 4% rule of thumb (which is far from perfect). There’s no way to predict the future, but you can improve your chances of success with smart planning.

Remember Taxes

If your money is in pre-tax accounts like a traditional IRA or a pre-tax 401(k), you will likely owe taxes on your withdrawals. It’s wise to budget for those taxes—you probably can’t spend every penny in your 401(k)—and you can even have taxes withheld from your withdrawals. For example, when your IRA custodian sends funds to your bank account, you can ask for 15% or so to go directly to the IRS. That amount is just an estimate, and you’ll determine if you paid enough after the end of each year. If you pay too much, you can often get a refund, but check with your CPA to avoid problems.

Lifetime Income From Your 401(k) Plan

Some 401(k) offer a benefit in the form of lifetime income. For example, the plan might provide annual or monthly payments that last for the rest of your life—no matter how long you live. Those payments often cover a spouse’s life as well.

When you choose lifetime income, you effectively use your 401(k) plan to buy an annuity for you. That’s not necessarily a bad thing, but there are many annuities available, and you might prefer to buy an annuity yourself. Doing so improves the chances of you getting the features that are most important to you, and you may have additional customization options. However, having your 401(k) provider handle everything is a way to keep things simple, so it’s not necessarily a bad idea.

No going back: With lifetime income annuities, you typically make an irrevocable decision. Put another way, you usually cannot change your mind. For example, you might prefer to stop the payments and take a lump sum payment of your remaining funds, but that’s probably not an option. The payments last for your life (and possibly a spouse’s life), and that’s it. 

Buying an Annuity Yourself

You can also buy an annuity directly from an insurance company. With that approach, you choose the features and expense structure that fits your needs, and you roll your 401(k) money into the annuity.

Annuities can be extremely complicated. Before going that route, it’s critical to understand why you’re buying an insurance product, and you need to evaluate the pros and cons carefully. Unfortunately, sometimes insurance agents don’t understand these products, and they may be motivated primarily by large commissions.

One of the most important things to know about an annuity is that you’re paying for guarantees, so the cost (whether it’s a clear dollar amount or not) needs to make sense. What’s more, your money may be locked up for many years, so take your time when evaluating these products.

When you buy an annuity, you have various options to choose from. You can categorize them into two basic groups:

  • Immediate annuities begin paying income more or less immediately. That might be a solution for converting your savings into lifetime income that you want right now.
  • Deferred annuities can hold your funds for an extended period, and you might or might not ever convert the money into a stream of payments.

Within those categories, there are several additional varieties. For example, you may see options like longevity annuities, indexed annuities, variable annuities, and more. Again, take your time until you understand exactly how the strategies work—and what you’re giving up in return for any benefits.

How to Use 401(k) Savings Wisely in Retirement

Manage Taxes

If savings from your 401(k) plan will result in sizable withdrawals each year, it’s smart to manage your taxes in retirement. Taking everything out in a big lump sum (to pay off the mortgage, for example) can result in a big tax bill. Consider drawing funds out at a rate that keeps you in relatively low tax brackets—and that doesn’t mess up your Social Security taxation, Medicare premiums, or other aspects of your tax return.

As you plan your income, it’s critical to strategize and pick the right accounts to withdraw from first.

It may make sense to use your 401(k) for partial Roth conversions in retirement. With that approach, you shift money from pre-tax accounts to Roth accounts. Ideally, if you follow all IRS rules, you can then take tax-free income during retirement. This strategy can work when you have low-income years, which are often at the beginning of your retirement journey.

Manage Investments

It’s challenging to get the best of both worlds: You may want to keep your money safe while at the same time pursuing enough growth to fend off inflation. Losing purchasing power over time is a significant risk—but market crashes can be problematic, too.

Decide how to invest your money in a way that fits with any market conditions that may arise. If you need help exploring your risk preferences, this questionnaire designed by financial psychologists may be helpful.

How Do You Get Your 401(k) When You Retire?

To get funds out of your 401(k), contact your employer’s benefits department or the investment company that handles your 401(k). You can provide instructions online, by phone, or with a paper form. After you stop working, you’re allowed to take funds out of your 401(k) plan. You can typically roll the money to an IRA, cash out your holdings and pay taxes, or leave the assets in your employer’s plan.

Each option has pros and cons, and it’s critical to weigh this decision carefully. If you’ve been working at your job for several years, you could have a substantial amount in your account.