This is a pretty popular question, if only because a 401k is still a very popular option for those who want to save for retirement. A 401k gives you the ability to take a portion of your monthly pre-tax income, match it with contributions from your employer (up to certain limits), and have it placed into an investment account.
You control the allocation of your money into various investment assets, like stocks, bonds, mutual funds, and money market accounts, and the money grows over time until you retire.
Because it allows you to use your pre-tax dollars to invest – which gives you additional firepower for your investment strategy and helps you grow your wealth faster using a larger base for compound interest – a 401k is a nice way to invest and build up your nest egg. It also, however, comes with several constraints and a slew of guidelines, rules, and procedures that must be followed.
The main law that most people know of is the age requirement. In short, you have to wait until a certain age to withdraw your 401k funds without penalty. Here, I’ll explain what that age is, what penalties await if you have to withdraw money early, and why it makes sense to wait that long before you touch the funds.
What is the Minimum Age for Withdrawal?
If you have a 401k and think you can access the funds the moment you retire – whenever that is – you might be surprised. It’s a retirement account, after all; shouldn’t the funds be disbursed when you actually retire?
While it is a retirement plan, it’s also not intended as a depository for short-term cash so people can take advantage of the momentary tax break and profit. The intent is to give you a way to save for your retirement, use investment as a way to grow your nest egg, and leave you with enough money to retire when you reach a certain age.
Before you withdraw money from your 401k, you have to be 59 ½ years old. When you withdraw your funds at this time, you have to pay taxes on the entire amount. But, that should be significantly larger than what you started with – which is the point.
If you want to avoid taxes altogether, you can wait another decade and withdraw once you turn 70 ½. Most people, though, make the distribution at 59 ½ because they are generally in a lower tax bracket at that point anyway and prefer to have the money to help purchase a retirement home, create college savings funds for the grandchildren, or travel.
Now, there are two ways you can withdraw money before the age of 59 ½ (as with anything related to the IRS, there are exceptions to everything). The first is to begin distributions after you separate from your employer and turn 55.
The second is to receive equal distributions once per year for a period of five years or until you turn 59 ½, whichever is longer. So, if you are 54, you can withdraw your money in five equal installments, once per year, until the age of 59 ½.
Can you withdraw money from your 401k while you’re actually still with the company? Yes and no. You can withdraw from an old 401k plan, but you may not be able to withdraw funds that were contributed by your current employer.
Check with your company’s 401k plan administrator; he or she will be able to tell you if you can make what is called an in-service withdrawal if you’re still working there after the age of 59 ½ and want your money.
Having to withdraw your money before the age of 59 ½, without meeting any exceptions, calls for a 10% penalty. See more about penalties here.
Why Leave It In That Long?
The reason you want to keep your money in a 401k is to take advantage of the power of compound interest.
Let’s say you are paid an annual salary of $50,000. You contribute 100% of your maximum, and your employer matches it as much as they can (up to $50,000 each year combined between you and them).
If you are 25 now, assume an annual rate of return of just 5%, and expect your salary to increase by 2% each year, you will have $6,276,284 at the age of 60.
That’s not bad at all. If you take it out 10 years before, at the age of 50? You’ll have $3,116,161 – and you’ll lose 10% of that right away because of early withdrawal fees.
As you can see, there’s a good reason why the age is what it is. If you really need the money, it can be accessed – but unless it’s a financial hardship, I recommend making full use of your 401k.