Retirees face a new challenge: How to spend their 401(k) savings

Workers spend their entire careers saving for retirement, but when it’s time to shift from saving to spending, many retirees struggle to know where to begin. 

“The biggest mistake I usually see when working with retirees is their treating their retirement savings like one big checking account and every dollar as equally valuable,” said Evan Mills, an associate financial advisor at Scholar Financial Advising in Winston-Salem, N.C. “A 401(k) withdrawal plan, or any withdrawal plan from retirement accounts, should be planned for and built before retirement, not improvised as paychecks stop.”  

Mills says retirees should have a clear plan for which account they’ll tap first, how much they can withdraw without hurting their savings, and how taxes will be managed in each account. 

Read more: What is the retirement age for Social Security, 401(k), and IRA withdrawals?

The retirement savings mindset shift 

A recent study by the Nuveen and TIAA Institute found that only 19% of late-career 401(k) participants have thought a lot about how they will withdraw retirement income from their 401(k) savings. Even among late-career participants who expect 401(k) savings to be their most important retirement income source, only 23% said they have thought a lot about withdrawals.

Part of the challenge could be a lack of retirement fluency and longevity literacy. 

The same survey assessed retirement fluency among 401(k) participants using 15 questions covering five topics, including Social Security benefits, Medicare benefits, and long-term care. 

On average, 401(k) participants answered only 32% of the retirement fluency questions correctly. More than half (52%) of participants answered fewer than one-third (five) of the questions correctly, and only 7% answered 10 or more questions correctly. 

“Retirees need to prepare for a major mindset shift. You are moving from saving to spending, and replacing your paycheck means manufacturing steady income out of a potentially volatile bucket of assets,” said Margie Glenn, a CFP®, CPA, and advisor with Moneta. 

“Without a formal distribution plan, you are flying blind,” Glenn said. “You risk either overspending early and jeopardizing your long-term security, or fearfully underspending and failing to enjoy the retirement you sacrificed a lifetime to build. Accumulating the wealth is only the first half of the plan; a dynamic distribution strategy is how you win the second half.” 

Read more: How much does a financial advisor cost?

How 401(k) withdrawals work

A traditional 401(k) is funded with pre-tax money, which means contributions reduce a worker’s taxable income for the year. However, any withdrawals are classed as taxable, ordinary income. A 10% early withdrawal penalty will also apply in most circumstances if a withdrawal is made before age 59 ½.

The rules for withdrawing money from a 401(k) vary across account types. A traditional 401(k), which is funded with pre-tax dollars, is also subject to mandatory withdrawals called required minimum distributions (RMDs) once you reach age 73, though the RMD age will increase to 75 in 2033 under Secure Act 2.0 rules.

A Roth 401(k), which is funded with after-tax dollars, offers the potential for tax-free withdrawals in retirement. Though account holders generally need to be at least 59 ½ AND hold the account for at least five years to do so. 

Unlike traditional 401(k)s, Roth 401(k)s are no longer subject to RMDs. Account holders can let the money grow indefinitely. 

Read more: How much should I contribute to my 401(k)?

How much to withdraw from a 401(k), according to experts

One common guideline is the 4% rule, which encourages retirees to add up all of their investments and withdraw 4% of that total during the first year of retirement. 

In subsequent years, the withdrawal amount should be adjusted to account for inflation. The goal is to try to stretch that retirement account balance to last as long as possible. 

“The go-to number most people rely on is the 4% rule, but that should be treated more like a guideline and not an autopilot system,” Mills said. “Some households might be below that, and some might be above that, depending on their stock concentration, fixed income, retirement timeline, and how flexible they want to be with spending during up markets or down markets.”

Although since this rule was first published in the 1990s, it has been revised to account for retirees having a more diverse range of assets. 

The newer 4.7% rule holds that retirees can comfortably withdraw 4.7% in the first year of retirement while maintaining a high probability that their savings will last at least 30 years. 

While guidelines such as the 4% or 4.7% rule can give retirees a starting point for their withdrawal plan, experts warn that this is just a baseline, and it’s important to consider factors such as tax implications, retirement timelines, other streams of income, lifestyle, and legacy goals. 

“The danger is not just withdrawing too much. It’s withdrawing from the wrong account, at the wrong time, in the wrong market, and doing so inefficiently,” said Mills. “You can still get the same amount of money, but there may be a more efficient way to do it.”