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There always seem to be tons of articles about maximizing the amount money in your 401ks and your IRAs, but there doesn't seem to be much talk about what happens to those accounts when you get to 59.5.

I understand that the income tax on these accounts has been deferred, and when a person reaches retirement age they have to pay the income tax. How does that work? If you've saved 2 million dollars, do you take it all out and pay taxes as though you made 2 million dollars that year? Does the account have to be closed when you reach retirement, or can you leave the account open and take an "income" out of it every year?

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4 Answers

up vote 4 down vote accepted

For 401(k) and regular IRA, you pay income tax on withdrawals from the account.

At a certain age, there is a "required minimum distribution". This is an amount you must withdraw from the account or you face penalties.

I've also read about, but am not familiar with, mechanisms by which you can retire early and start taking withdrawals before the regular official retirement age. (These may or may not be legit, I didn't do any research on it.)

A Roth IRA, which is not "tax deferred" and thus not technically covered by your question, there is no tax on withdrawals (assuming you are at retirement age) and no required minimum distribution.

Something to watch out for on your accounts are fees that they charge for withdrawals. I was in a 401(k) once that had a $50 fee per-withdrawal. A monthly check from this account would eat your money! I paid the fee once, when I rolled it into an account at a brokerage after leaving the company.

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There are two different ages, one where you can start withdrawing from the account, and a higher age where you must start withdrawing (at a minimum rate). The withdrawals are treated like regular income, so they get taxed according to the same rates, and with the same deductions, as a salary.

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The phrase "tax deferred" in the question implies Traditional 401k's and IRA's, as opposed to the Roth variant of either. It helps to state explicitly that Roth IRA's do not require regular withdrawals after age 70.5 while the rest do. –  SpecKK Aug 30 '10 at 22:21
    
@SpecKK The question specifically asked about tax-deferred IRA's, which includes Traditional 401k's and IRAs. This answer pertains specifically to Traditional 401k's and IRA's. Why even mention anything about Roth IRA's? The person didn't ask about Roth IRAs i.e. non-tax deferred accounts. Although it is very helpful that you stated the age of 70.5 years as the date of mandatory minimum distribution requirement! –  Feral Oink Dec 19 '11 at 2:23
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You may withdraw penalty-free from a 401(k) if you separate from service at 55 or later. This may make the rolling to any IRA "not" a good idea. You can withdraw penalty free if you are disabled. You can withdraw penalty free if you take the withdrawal using a process called Section 72t which basically means a steady withdrawal for either 5 years or until age 59-1/2 whichever is second.

Aside from these exceptions, the concept is to be allowed to take withdrawals after 59-1/2, but you must start to take withdrawals starting at 70-1/2. These are called RMDs (required minimum distributions) and represent a small fraction of the account, 1/27.4 at 70, 1/18.7 at 80, 1/11.4 at 90. Each year, you take a minimum of this fraction of the account value and pay the tax. If you had a million dollars, your first withdrawal would be $36,496, you'd be in the 15% marginal rate with this income.

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You only have to pay income tax on a tax deferred account (like a 401k) when you withdraw money from it.

You might only need $3K to live on a month, or less, so you only have to pay the taxes at that time I believe.

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