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The way your 401(k) works after you retire depends on what you do with it. Depending on your age at retirement (and the rules of your company), you may elect to start taking qualified distributions. Alternatively, you may choose to let your account continue to accumulate earnings until you are required to begin taking distributions by the terms of your plan.

Qualified Distributions

If you retire after age 59.5, the IRS allows you to begin taking distributions from your 401(k) without owing a 10% early withdrawal penalty. Depending on your company's rules, you may elect to take regular distributions in the form of an annuity, either for a fixed period or over your anticipated lifetime, or to take non-periodic or lump sum investments.

When you take distributions from your 401(k), the remainder of your account balance remains invested according to your previous allocations. This means that the length of time over which payments can be taken, or the amount of each payment, depends on the performance of your investment portfolio.

If you take qualified distributions from a traditional 401(k), all distributions are subject to your current ordinary income tax rate. If you have a designated Roth account, however, you have already paid income taxes on your contributions so they are not subject to taxation upon withdrawal. Roth accounts allow earnings to be distributed tax-free as well, if the account holder is over 59.5 and has held the account for at least five years (see 401(k) Plans: Roth or Regular? and Know the Rules for Roth 401(k) Rollovers).

Early Money: The "Age 55 Rule"

If you retire – or lose your job – when you are age 55 but not yet 59.5, you can avoid the 10% early withdrawal penalty for taking money out of your 401(k). However, this only applies to the 401(k) from the employer you just left; money that is still in an earlier employer's plan is not eligible for this exception (nor is money in an IRA).

Let It Lie

You are not required to take distributions from your account as soon as you retire. While you cannot continue to contribute to a 401(k) held by a previous employer, your plan administrator is required to maintain your plan if you have more than $5,000 invested. Anything less than $5,000 will trigger a lump-sum distribution, but most people nearing retirement have more substantial savings accrued.

If you have no need of your savings immediately after retirement, there's no reason not to let your savings continue to earn investment income. If you do not take any distributions from your 401(k), then you are not subject to any taxation.

Required Minimum Distributions

While you don't need to start taking distributions from your 401(k) the minute you stop working, you must begin taking required minimum distributions (RMDs) by April 1st, following the year you turn 70.5. Some plans may allow you to defer distributions until the year you retire, if you retire after age 70.5, but it is not common.

If you wait until you are required to take your RMDs, you must begin taking regular, periodic distributions calculated based on your life expectancy and account balance. While you may withdraw more in any given year, you cannot withdraw less than your RMD.

If You Want to Keep Building

If you want to keep contributing to your retirement savings, but cannot contribute to your 401(k) after retiring from your job at that company, you can elect to roll over your account into an IRA. While you can contribute to a Roth IRA for as long as you like, you cannot contribute to a traditional IRA after you reach age 70.5. Note that you can only contribute earnings to either type of IRA – so this strategy will only work if you have not retired completely and still earn "taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment," as the IRS puts it. You can't contribute money earned from investments or from your Social Security check, though certain types of alimony payments may qualify.

To execute a rollover of your 401 (k), you can elect to have your plan administrator distribute your savings directly to a new or existing IRA. Alternatively, you can elect to take the distribution yourself. However, you must deposit the funds into your IRA within 60 days to avoid paying taxes on the income. Traditional 401(k) accounts must be rolled over into traditional IRAs, while designated Roth accounts must be rolled into Roth IRAs.

Like 401(k) distributions, withdrawals from a traditional IRA are subject to your normal income tax rate the year in which you take the distribution. Withdrawals from Roth IRAs are completely tax-free if they are taken after you reach age 59.5 and if you have contributed to any Roth IRA for at least five years. IRAs are subject to the same RMD regulations as 401(k)s and other employer-sponsored retirement plans.

The Bottom Line

Rules controlling what you can do with your 401(k) after retirement are very complicated, shaped both by the IRS and by the company that set up the plan. Consult your company's plan administrator for details and try to talk to a financial advisor as well before making any final decisions.

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