When it comes time to retire, what should you do with your 401k? For most investors, it’s time to turn that money into a paycheck.
Many people spend their working years focused on building up a nest egg in the form of a retirement plan like a 401k (or an IRA, or both). But by the time retirement actually draws near, many are left scratching their heads about how to turn that nest egg into livable income.
Unfortunately, the process of turning a 401k into a paycheck isn’t as straightforward as it seems. According to a Government Accountability Office (GAO) report, only a third of 401ks have retirement withdrawal options and only a quarter offer an immediate annuity (though you can always buy one separately).
While it’s possible to turn your 401k into income, those seeking to retire comfortably will need to come up with a comprehensive retirement strategy that generates income from different sources, including Social Security, other investments, and – yes – a 401k.
If you’re close to retirement and you’re not sure what to do with your nest egg, here’s what you need to know.
Man sitting at table counting money.
Rollover Your 401k
Most investors have limited investment choices when investing within their 401k. There is a good chance those investments aren’t ideal for you after retirement. Beyond limited investments, you are also still tied to your former employer along with the specific rules of your company’s plan.
When you make a 401k rollover, you are selling the investments in your 401k in order to move the money to a different broker in an IRA rollover. Once you have the funds in an IRA rollover, your investment choices are nearly unlimited. Most brokers allow you to invest in any stock, bond, ETF, or mutual fund. Cash flow investing is a great option for those that want to rollover and maximize their portfolio paycheck. A strategy like the Snider Investment Method can generate income with a combination of stock, options, and cash using covered calls.
As long as you roll the money directly into an IRA, it is a tax-free event. Once complete, it gives you way more control over your investments. Also, you can spend the money as needed to cover expenses. Keep in mind, any withdrawals from an IRA will be taxed as regular income. Most of our clients set up a regular monthly distribution to replace some or all of the money they received from their employer while still working. This portfolio paycheck becomes a primary source of income along with their Social Security check.
If you are concerned about the risk of an investment and require a certain amount of money each and every month, then buying an annuity might be an option for you. Unfortunately, you may end up with a smaller portfolio paycheck throughout your life to compensate for the reduced risk.
Buying an Annuity
An annuity is a contract with an insurance company that guarantees a certain amount of income for the remainder of your life. You essentially hand over a lump sum and, in return, you receive monthly payments, which are determined by your intended lifespan (also called fixed annuities).
A 65-year-old man investing $100,000 in an immediate annuity, for example, would receive around $545 a month, while a 65-year-old woman would receive about $505 (you can use an annuity payment calculator to determine what you might receive).
Though this seems like the easiest solution for generating monthly income, using an annuity comes with its own set of risks.
With annuities, you risk losing money if you die earlier than planned. Since the money is calculated based on your total years spent in retirement, you won’t receive the full amount of your annuity if you pass on prematurely. Also, since the payment is fixed, any inflation reduces your purchasing power every year.
There are also other fees associated with annuities. Variable annuities – annuities that pay you based on the performance of investments rather than on age – tend to have higher fees than fixed annuities because they require more active management.
There’s also the issue of competition. You may have the choice to buy an annuity within your 401k or by rolling out the funds and using a different annuity provider. While some 401k plans offer an immediate annuity, your payment may actually be cheaper if you buy from an outside insurer. Settling for your current plan’s annuity without shopping around can cost you if you’re not careful. (If your plan doesn’t offer an annuity at all, you can always buy one within a rollover IRA.)
Of course, if you shop around and find an annuity plan that works for you, and you don’t mind paying the associated fees, you can use the money to supplement your Social Security to generate monthly income. Keep in mind, payments from the annuity will be taxed as regular income.
You can also buy a longevity annuity, which is an annuity where the payout doesn’t start until 80 or 85. This may be a good option for those who want to generate income from other sources first and want a backup in case their nest egg is depleted sooner than expected.
stacks of money in a metal briefcase
401k Withdrawal
Potentially the worst decision would be to simply withdrawal all the money. First, you will have to pay income tax for all of it at once. Depending on the size of your 401k, it could move you to a much higher tax bracket. If you withdraw before age 59 ½ you will also have to pay an additional 10% penalty.
Even if you plan on investing most or all of it right away, you should still keep roll the money into an IRA. This way any of the investment gains will also be deferred until withdrawing the money. You also run the risk of burning through the money faster than expected, leaving little in way of a backup should your Social Security or other sources of income not cover all of your bills.
On the other hand, there are some instances where withdrawing money makes the most sense. Some use their 401k to pay off debt that would hinder them in retirement, or they split the money between investing and covering larger bills while relying on other sources of income for primary bill paying.
You also have the option to cash out a part of your 401k, roll over a portion, and leave the rest in either a variable or fixed annuity to generate additional income. After retirement, you don’t have to do the same things with the entire account.
Final Thoughts
When it comes time to decide what to do with your 401k, you want to make sure that you’ve taken a financial inventory of your needs first. You should know how much money you should expect to make in retirement from other sources, like Social Security, part-time work, or from any other investments you may have.
You should then check to see if your 401k already has an annuity option and, if so, compare it against other insurers to make sure it will be a viable source of income for you. You may then need to decide whether or not to choose a fixed annuity – which will generate a set amount of income per month depending on how long you live – or a variable annuity, which is an investment option using stocks and bonds.
If you’re not sure you want to buy an annuity, or you want to buy an annuity but generate income in other ways, you can also weigh the option to withdraw some (or all) of your 401k to invest elsewhere. (Cash flow investing is a great solution for generating income without buying an annuity.) Just be careful not to withdraw all your money and spend it frivolously.
If you’re not sure what you want to do with your 401k, or you want to take a combination of the above options and are not sure what to do next, consider consulting with a financial expert that can help you make the decision before it comes time to retire.
