by Gary Foreman

Not sure how to withdraw money from your 401k when you retire? Can you take a lump sum? Be sure to fully understand all of your options before deciding so you can hopefully avoid a big tax mistake.

Disclaimer: Before making decisions that could significantly affect your taxes, it’s wise to see a qualified tax professional. This is a big decision. Don’t risk making a big mistake.

What To Know About Taxes and Your 401k

The distribution options on your 401k are governed first by the tax laws and then by the plan’s rules. Some plans don’t offer every option that’s available by law.

If Owen really wants the money, he can get it now, either through a 401k loan or by taking a distribution. You can take money out of your 401k anytime you want. It’s just a matter of whether you want to pay the penalty.

If you withdraw money before age 59 1/2, you’ll pay a 10% early withdrawal penalty. There’s an exception if you leave your company after age 55. Then, a lump sum distribution is not subject to the penalty. But, it will still be taxed. (See How a 401k Loan Affects Future Wealth.)

Tax law also allows for ‘hardship’ withdrawals that would not trigger an early withdrawal penalty. “If a 401(k) plan provides for hardship distributions, it must provide the specific criteria used to make the determination of hardship. Thus, for example, a plan may provide that a distribution can be made only for medical or funeral expenses, but not for the purchase of a principal residence or for payment of tuition and education expenses. In determining the existence of a need and of the amount necessary to meet the need, the plan must specify and apply nondiscriminatory and objective standards.” (source: IRS.gov) Owen doesn’t appear to have a hardship reason. But, if you do, contact your plan administrator to find out what rules they have.

While Owen wants to get his money out soon, many prefer to leave money in their 401k to avoid adding to their taxable income. You cannot put it off forever. Tax law says that you must begin withdrawing part of the account in the year that you reach age 73. The amount will be determined by life expectancy.

5 Different 401k Retirement Options

Next, let’s look at what choices Owen will have when he retires. The decision will largely be his. The law allows for five different alternatives for a 401k account at retirement. The options include lump-sum distribution, continue within the plan, roll the money into an IRA, take periodic distributions, or use the money to purchase an annuity. Owen’s particular plan will allow for some or all of them.

The fastest way for Owen to get his “big wad” of money is to take a lump-sum distribution. He’ll get the money quickly. But there are two disadvantages. First, he’ll pay ordinary income taxes on the entire amount withdrawn. Second, the money will no longer be growing tax-free.

If Owen does take a lump-sum distribution, he’ll be subject to 20% withholding. That means the IRS will take 20% of the money distributed now and apply to his tax bill next April. Owen can thank the “Unemployment Compensation Amendments Act of 1992” for that idea.

Owen could decide to leave the money in the account. It will continue to grow tax-free. That can make a big difference in how much is available to him during retirement. Many retirees choose to live off of and spend taxable accounts first saving IRA’s and 401k’s until they need the money or are forced by law to begin distributions.

Another possibility would be to roll the 401k into an IRA. That would give Owen the largest number of investment options. He could still withdraw the money when he wants or choose to let it grow tax-free.

Owen may also choose to take a regular, scheduled distribution from the 401k. Scheduled withdrawals are not subject to the 20% withholding. Most plans allow for a monthly or quarterly distribution. The amount can be adjusted annually if you choose. That can be handy if inflation causes your expenses to increase.

The final option, an annuity, takes the investment work out of the equation. An annuity can be purchased with part or all of the 401k money. It would pay Owen a regular income for the rest of his life.

Expert Interview: How a Distribution Plan Can Maximize Retirement Plan Assets

Is a Lump-Sum the Best Option If Buying a Home?

Owen’s goal is to buy a home. Depending on how much he has in his 401k, he has a couple of possibilities. He mentioned the first option. Taking all the money, paying the taxes due and paying cash for his new home.

But he might want to consider withdrawing just enough from his 401k for the down payment. The balance of the account could be set up on regularly scheduled distributions. He could control the investments and distributions. Or Owen could choose to buy an annuity and let them do the investing and check-writing.

Those regular distributions would cover the mortgage payments. The advantage for Owen is that he won’t have a spike in taxable income. Also he might be able to take a tax deduction for the mortgage interest at the same time that he is earning money without taxes within the retirement account.

Owen should speak with his accountant to find our which choice is best for him. Hope he enjoys his retirement and his new home!

Related Articles

• Managing Your 401k In Your 50s
• A 401k Loan on the Road to Retirement
• What’s the Difference Between a Roth and a Traditional 401k?
• Choosing Beneficiaries for a 401k Plan
• 401k Retirement Distribution Rules and Options

Reviewed April 2023

About the Author

Gary Foreman is the former owner and editor of the After50Finances.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.