Personal Finance

I have a large 401k balance and when I retire I want to take the entire balance and pay taxes on it - is this a smart idea?

Rich Duprey

Published: December 21, 2024 10:15 am

After a lifetime of work and saving, you finally made it to retirement and managed to squirrel away a significant nest egg to live off of. Now comes the challenge of making your money last. Do you pull it out all at once or withdraw funds slowly over time?

That’s the situation a Redditor on r/fatFIRE finds himself in. He has made it to the finish line and built up a sizable 401(k) account. He wants to know whether he should do a one-and-done withdrawal, albeit paying a significant tax bill, and then have the balance tax-free. Alternatively, he could roll some of the funds annually into a Roth IRA and then withdraw funds every year for his living expenses.

While many consider the latter option the best, this is an intriguing question because there are actually benefits to the one-time withdrawal.

24/7 Wall St. Key Points:

• Accessing your 401(k) plan at retirement opens up options for when and how to withdraw the money.
• A one-time withdrawal gives you full access to your funds, but hands you a substantial tax bill as well.
• There are better ways to withdraw funds that don’t penalize you and open you up to other problems.
• Also: Take this quiz to see if you’re on track to retire

Benefits of withdrawing the full amount

Taking your money out of your 401(k) retirement plan in a lump sum gives you immediate access to your money. You gain full control over your savings and can allocate it as needed without restriction. You would also be able to invest the proceeds in other assets as you saw fit.

For example, you could buy alternative assets such as real estate or rental properties, or even put it into mutual funds or brokerage accounts that could potentially offer better returns or provide greater diversity in your investments.

You would also simplify the estate planning process by bypassing any specific beneficiaries or rules a 401(k) plan might require.

To that last point, moving funds out of the 401(k) allows you to avoid any of the potential fees, administrative rules, or potential limited investment options of the plan.

Disadvantages of withdrawing the full amount

Unfortunately, there are substantial disadvantages to withdrawing your money from your 401(k) plan all at once that outweigh the benefits.

First is the heavy tax burden you incur. While the Redditor acknowledged he would have to pay taxes on the money, he thought the freedom to use the money tax-free afterward outweighed the cost.

Because 401(k) withdrawals are taxed as ordinary income, taking out the full amount can push you into a higher tax bracket, significantly increasing your tax liability. You’ve worked hard to save that money and at the end you are just turning it over to the government. You also lose a significant chunk of your money that you are counting on to live out your years in retirement.

Additionally, you lose the benefit of tax-deferred growth in your account. By withdrawing the entire balance, you lose the advantage of compounding without taxes until you need the money.

One of the biggest disadvantages, though, is the impact a withdrawal could have on Medicare and Social Security benefits. A large withdrawal increases your taxable income, potentially raising your Medicare premiums and causing up to 85% of your Social Security benefits to become taxable.

Last, there is also the very real possibility you will overspend when you get this windfall as it increases the temptation to spend the money quickly. You could potentially depleting your savings prematurely.

Alternative strategies for withdrawing your money

I’m not a financial planner and these are just my opinions,  so talk to a tax and financial professional first. However, the following seems like a better course of action for someone in a similar circumstance.

As the Redditor suggested, there is the option of rolling over a portion of the funds at regular intervals to a Roth IRA. By moving your 401(k) to such an account, it gives you flexibility in managing any withdrawals and investments without being penalized or heavily taxed.

Alternatively, you might pursue gradual withdrawals, and draw down the balance in smaller increments. That would help you manage your tax bracket while allowing you to retain some tax-deferred growth.

Last, consider waiting until you have to make required minimum distributions (RMD) at age 73. If you are able to postpone tapping into the money, it will help spread out your tax liability.