401k Withdrawal Rules and Options

By Selena MaranjianFool.com

Source:TaxCredits.net.

It's important to understand 401kwithdrawal rules so that you don't get socked with an unexpected penalty. Before you even think about that, though, be sure that you understand what a 401kis and how well it can serve you.

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401kbasicsA 401k account is a valuable, tax-advantaged, employer-sponsored retirement saving tool. With a traditional one, you get to contribute money on a pre-tax basis, essentially diverting it from your paycheck into your account. For example, if you earn $60,000 and contribute $10,000, the income on which you can be taxed drops to $50,000. If you're in the 25% tax bracket, that's $10,000 that avoids a 25% haircut, giving you an upfront tax break of $2,500.

There's a newer kind of 401k that might be available to you now or soon, and that's the Roth 401k. It works much like a Roth IRA, taking post-tax contributions, which eventually can be withdrawn tax-free.

For 401k accounts, as well as 403(b) and 457 accounts, which are similar, the 2015 contribution limit is $18,000. Those aged 50 and older are allowed to make an additional "catch-up" contribution of up to $6,000, for a grand total of $24,000. (In contrast, IRA contribution limits for 2015 are only $5,500 for most folks and $6,500 for those 50 and up.) Clearly, a 401k account can be a powerful way to build a retirement nest egg. If you can sock away $10,000 annually in a 401k and it grows by the stock market's long-term annual average growth rate of close to 10%, you'll end up with more than $600,000 in 20 years.

The deadline for each year's contribution is the tax-return-filing deadline, usually April 15. So you can make your 2015 contribution until April 15, 2016.

You can accumulate alot of money with a 401k.

401k withdrawal rulesFor both traditional and Roth 401k accounts, you can start withdrawing funds at age 59 1/2. And for both of them, you must take distributions -- "required minimum distributions" (RMDs) -- annually beginning at age 70 1/2 (or when you retire, if that's later). You can't just withdraw any sum you want, either. The IRS has rules about these withdrawals.

Each year, you must withdraw at least your RMD, and you can always choose to withdraw more. The RMD is calculated based on life expectancies and the balance in your account at the end of the previous year. Your 401k custodian (often the financial institution where your account lives) will likely inform you of your RMD, while also reporting it to the IRS. That can make things easy. If you're not informed what your RMD is, you can check with your plan's administrator or simply consult the IRS' helpful RMD table and figure it out on your own.

For every year in which you must take an RMD, it must be taken by December 31 --except for your first year. For the year in which you turn 70 1/2, you have until April 1 (not April 15) of the year following that year. In other words, if you turn 70 1/2 in 2015, you have until April 1, 2016 to make your first RMD. For the year 2016, you have until December 31. Note, though, that if you use the allowed delay in your first year, you will be taking two distributions in the same year, which might boost your taxable income and bump you into a higher tax bracket. Proceed with caution -- and a calculator.

Be sure to stay on top of your RMDs, because if you withdraw less than you needed to or make the withdrawal later than the deadline, you might have to pay an excise tax of 50% of the amount you failed to withdraw.

Distributions from 401k accounts will usually be taxable as ordinary income for the year in which they're taken, and they may be subject to state or local taxes, too. Exceptions include any sums that were taxed prior to being contributed to the account or qualified distributions from Roth 401k accounts.

Non-standard withdrawalsThe discussion above covers how most people will withdraw money from their 401k accounts, but there are also other ways to go about it. Here are a few examples:

  • You can withdraw money before age 59 1/2, but unless you qualify for a hardship withdrawal, you'll likely be socked with a 10% early withdrawal penalty.
  • If you leave an employer at or after age 55, you can start withdrawing from the 401k you have there. People leaving jobs as police officers, firefighters, or medics at age 50 or later can do so, too.
  • If you're extremely and permanently disabled, you may be able to withdraw funds early, without penalty.

You can amass a huge sum of money in a 401k account. Just be sure that you follow the rules when you make withdrawals.

The article 401k Withdrawal Rules and Options originally appeared on Fool.com.

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