How to Turn a 401(k) into Retirement Income
By Russell W. Hall, CFP®
Here’s a bedtime story for retirees: Once upon a time, you worked for one company for a long time and then retired. In return the company gave you a nice watch or something, but also (and much more importantly) they gave you a stream of income called a pension that would continue until you passed away. In addition to this defined benefit plan, you had Social Security benefits, and you had some retirement savings of your own. This setup was often called the “three-legged stool” of retirement.
Today, that story is more of a fairy tale for most of us because we won’t have a pension at retirement. That’s like trying to sit on a stool that has only two legs (which can be a challenge at best), so we’re saving to our 401(k) plan or other retirement account to build up as much of a nest egg as we can.
If you’re reading this article, it’s likely that you find yourself in that situation. After years of saving, you’re approaching retirement and thinking about the best way to turn your 401(k) into income. Before you start withdrawing, here are two things to consider.
1. Stay or Go?
The first question you’ll probably be faced with: Should you leave your 401(k) in place with your former employer or roll it over to an IRA?
If you’re working with a financial advisor, they’ll likely suggest that you roll over the account. Access to more investment options and increased visibility are good reasons for this recommendation. In a 401(k), you have no control over which investment options are offered, and because of perceived liability, plans have been shrinking the number of options available.
We’ve also seen a number of employers pushing retirees to move out their 401(k), as changes in the law have increased the responsibility of retirement plan sponsors and they’d rather have fewer accounts to be accountable for.
Another reason to roll over is simplicity. We generally think that having fewer accounts is better because it’s less likely that something will be lost or overlooked (plus that’s less paper or fewer statement files to download!).
Also, we won’t cover all of the required minimum distribution rules here, but it’s good to know that when you’re required to start taking distributions, you’ll have to calculate the RMD and take a separate distribution from each 401(k) or similar retirement account.
2. Manage or Outsource?
So now let’s say that you’ve rolled over your 401(k) to an IRA. The next decision: Are you going to manage that lump sum to create your income stream (which may include having a financial advisor help you)? Or are you going to outsource and turn the money over to a third party, which usually means purchasing an annuity from an insurance company?
(Note that we are discussing an immediate fixed annuity here, where you exchange a lump sum for guaranteed payments. There are many annuity options available, and we don’t like most of them.)
There are pros and cons to both of these options, and they’re not mutually exclusive. For example, you might choose to utilize an annuity for part of your account and then invest the rest.
Managing your IRA allows you to be flexible with the timing of withdrawals. You can choose to take more or less risk with your investments to possibly get higher growth and keep up with inflation, and you have a chance to leave something to your heirs if you pass away early or don’t spend down your account in your lifetime. You are more in control of your retirement planning.
The main downside is that you are subject to the movements of the stock market and the returns from other investments. There’s timing risk, where if the market drops a lot at the beginning of your retirement, it can be difficult to come back. You also have to figure out withdrawal rates—how much can you spend each year so that your investments last throughout retirement? Will that be enough to cover your living expenses?
Outsourcing to an annuity simplifies some of these questions because you know upfront how much income you’re going to receive. The payments are guaranteed by the insurance company, so unless they go out of business (a possible risk, but unlikely in most cases), you have income for life.
On the downside, you’re stuck with that payment amount even when inflation makes your expenses increase during retirement. You lose flexibility, and you lose the ability to leave an inheritance. Some annuities offer a return of premium or giving some other amount to your heirs, but you’re charged higher fees to pay for that and it’s generally not worth it.
We hope this helps you as you move into retirement. One last note: If you’re hiring a financial advisor to help you with these decisions, make sure you know how they get paid and when. You want to know that if someone is recommending that you buy an annuity or roll over an account, they’re putting your interests ahead of their own.
If you’re facing these decisions, our Fullerton financial advisory firm is happy to talk through your situation. Schedule a 15-minute discovery call with a fee-only financial advisor.