Personal Finance

My mother is 71 and wants to withdraw her entire 401(k) by January 2025 — is this advisable?

Rich Duprey

Published: December 19, 2024 1:11 pm

The 401(k) retirement program has been a massive benefit for workers since its creation in 1978. According to Fidelity Investments, of the more than 31,000 plans it serves as administrators for, there were 544,000 millionaires. 

Unfortunately, these people seem to be outliers. Earlier this year, investment manager Vanguard released its annual How America Saves report that looks at the saving behaviors of nearly 5 million Vanguard 401(k) participants. It found that the average account balance was just $134,128. Of course, that was dependent on the age of the participant. Where 25 to 34 year olds naturally had less in their accounts ($37,577) because they have been saving for less time, those aged 65 and older had $272,588 in their 401(k)s.

Yet those are the average. The media account balance, which takes into account extremes on both end of the spectrum, was only $88,488 for senior citizens. What that means is that half of all 401(k) holders aged 65 and up have saved less than that.

This sounds reminiscent of the situation the mother of a Redditor on the r/personalfinance situation finds herself in. She is 71 years old and her 401(k) has a balance of just $47,000. She is looking to withdraw all the funds at once and simply live off her monthly Social Security check. The Redditor wants to know if this is a smart decision, considering the taxes she will pay.

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Plan for a worst-case scenario

Wherever we are in our life’s journey, we should always be putting a little something away towards our retirement. And the sooner we start the better as time and the magic of compound interest can turn even small contributions into large nest eggs over time.

While life’s circumstances can upset our plans, such as the Redditor’s father getting cancer, deploying the early-and-often contribution strategy can minimize the impact such unfortunate circumstances can play with our finances.

Yet in this case, the mother doesn’t plan on using the 401(k) money to live off of, which wouldn’t go very far in today’s elevated inflation period. Rather, she is using the proceeds to build an addition onto the Redditor’s house where she will live out her days. She will not have expenses like housing, heating, or the myriad other day-to-day costs and she will be able to live well with the $1,100 in survivor’s benefits she gets from Social Security.

But is a lump sum 401(k) withdrawal the best way to go about accessing the money? Probably not.

Plan for tax avoidance

As the Redditor understands, she is going to have to pay taxes on the money. While his mother works a full-time job, she will be retiring from the position. In the new year she wants to withdraw the money, so that means it will be her entire income amount for the year, placing her in the 12% tax bracket. That suggests she will be liable for about $7,500 in federal taxes.

Of course, the state tax man needs his cut too. As she lives in North Carolina, the state imposes a flat 4.75% tax rate on retirement income (Social Security income is exempt), indicating another $2,200 in taxes due. She will net around $37,000.

Yet there is also the impact on her Social Security benefits, which would become taxable with her withdrawing all the 401(k) money at once.

But there are potentially better ways to handle it. For example, the Redditor could take out a home equity line of credit (HELOC) to finance the construction of the addition and his mother could then withdraw just the amount needed to make the monthly payment. Even taking out lump sum amounts of $12,000 annually could potentially eliminate her tax burden. Splitting the withdrawals over a two or three year period could also help lower the tax burden.

Key takeaway

While the purpose of the withdrawal is understandable, and admirable on the part of the Redditor, there are workarounds to limit the tax impact and still accomplish the same goal. It is in situations like these where meeting with a financial planner and a tax professional could pay dividends in the savings realized based on the individual’s particular situation.