Do you daydream about giving up the grind and trading it for an active retirement? Once you reach age 59 ½, you can start taking distributions from your Solo 401k with NO early withdrawal penalties. If that is your daydream, here are some key dates to keep in mind:
Important Distribution Ages to Remember
- Age 50 – Tax-advantage of “catch-up” contributions to your Solo 401k that can begin at this age. This could be part of your path to early retirement. (IRS catch-up provisions).
- Age 55 – Want to Retire early? Find out how it’s possible with rule 55! You may be eligible to take an income distribution from your Solo 401k retirement plan without paying an additional 10% tax for early withdrawal.
- Age 59 1/2 – This is the subject of this blog. Withdrawals from your Solo 401k are no longer subject to the 10% early withdrawal tax once you reach age 59 1/2. A Roth Solo 401k will not owe any taxes but a traditional Solo 401k will likely owe regular income tax on distributions. Read below for details and options.
- Age 62 – You can choose to begin receiving Social Security income at this age. But if you defer Social Security, the size of your monthly check will increase until your reach age 70.
- Age 65 – Eligibility for Medicare begins. This is the government’s retirement health insurance program. It’s a time when you may also want to purchase a private “Medigap” insurance policy to help with copayments and deductibles not covered by Medicare.
- Age 66 – is the Social Security ‘full retirement age’ if you were born between 1943 and 1953. For those born after 1953, there is a prorated scale for full retirement age that reaches 67 for those born in 1960 and later.
- Age 70 – This is the age for the largest possible monthly Social Security benefit if you’ve waited to begin receiving payments. Your benefit could be as much as 76% larger than if you had started receiving payments at age 62.
- Age 72 – Required minimum distributions from traditional Solo 401k and Roth Solo 401k plans must begin at this age, regardless if you’re retired or not (unless you turned 70-1/2 before January 1, 2020; then you must start taking your RMD at age 70-1/2). The minimum that must be distributed is different for everyone based on IRS worksheets. If you don’t begin these distributions within the required time frame, you’ll incur a significant tax penalty. (There is a COVID-19 Exception to minimum distributions for 2020).
If you retire at or after 59½, you can start taking withdrawals without paying the IRS early withdrawal penalty.
Big Life Changes at Age 59 ½
Age 59 1/2 can be a time for making a lot of important decisions in your life. If you’re nearing the big 6-0, don’t fret too much about getting old. After all, 60 is the new 40. There are many 60-year-olds who are in prime health and feel like they are just hitting their stride.
If you want to, this could be the time that you begin full retirement. It could be when you start reducing your work hours. It could be when you take more control of your retirement funds. Or it could be a time when you both reduce your work hours and take full control of your retirement funds. A good way for you to do both is by getting out of the rat race to start your own business based on a hobby. You can do this by rolling over 401k funds from an employer-controlled account into a Solo 401k account that you have full control over. With more time on your hands, you can use full control to manage investments any way you want to.
Difference Between Solo 401k and Roth Solo 401k Distributions After 59 1/2
Roth contributions are made with after-tax dollars. Once the account has been open for 5 years, all withdrawals made after age 59 1/2 are tax-free. Because you paid taxes before investing the money, the income tax has already been paid. You did not get a tax break at the time the contributions were made. The big advantage to a Roth solo 401k is that you don’t have to pay taxes on the earnings once you reach age 59 1/2.
With a traditional Solo 401k, you received a tax break at the time the contributions were made. It reduced your taxable income in the years that contributions were made. Earnings also grew tax-deferred until distributions begin. After decades of tax-deferred growth, the distributions become taxable as regular income — like income from a job — in the year you take the distribution.
Regardless if yours is a traditional or Roth account, there are many ways to take distributions. But with good planning and investments, you can be well situated to retire beginning at age 59 1/2!
The primary purpose of a 401k begins at age 59 1/2 with early retirement.
401k Withdrawal Rules and Strategies After Age 59 ½
Now that you’re 59½ and the withdrawal penalty is gone, you can easily use your Solo 401k for an accessible, tax-deferred retirement. There are almost no rules. You could withdraw it all at one time, but for IRS tax-deferral purposes it makes sense to take periodic payments. Leaving most of the money invested also means you can continue investing for growth or a steady income. You do want to protect plenty of funds for your golden years. You may want to consider aggressive growth if you don’t need the money and plan to postpone distributions until they become required at age 72. Remember, if you don’t take the required minimum distribution when you’re supposed to, the IRS can assess a penalty of 50% of the amount not distributed. But you can also withdraw more than the minimum.
If you haven’t already, age 59 1/2 is the time to research and decide on a withdrawal strategy that provides the income needed to fund your retirement. Before you choose a retirement withdrawal strategy, you should first consider other crucial factors that affect your retirement income.
- Your Social Security benefits depending on the age you choose to begin receiving these. You may need to draw a little heavier on your Solo 401k until Social Security begins with early benefits at age 62, full retirement at 67, maximum benefits at 70, or something in between.
- Other investments that you may have outside of your Solo 401k. This may be the time to further diversify your portfolio so that you are not financially hurt if there is a drop in the market or the value of other assets.
- Your life expectancy. The Social Security Administration says that the average life expectancy for a woman who is 65 years old today is 86.5 years and 84 years for a man. If you are only 59 1/2, you should anticipate needing retirement funds for at least another 25 to 35 years. You should also expect your health care costs to increase as you age.
- Calculate taxes you will owe in retirement. Many retirees owe taxes on Social Security benefits, pensions, annuity payments, and/or 401k withdrawals.
Here are five common withdrawal strategies to consider for your Solo 401k:
- 4% rule withdrawal strategy. This strategy is quite common and intended to keep pace with inflation. The first year, you simply withdraw 4% of the value of your Solo 401k. In the following years, you withdraw the same amount and add in the amount needed to keep pace with inflation (typically an additional 2%). With an example $1 million account, you begin the first year by withdrawing $40,000. In the second year you withdraw $40,800 and in the third year $41,616 (the previous year’s amount, plus 2%). This is simple to follow and gives you a predictable amount of income each year. However, if your remaining investments don’t keep up with inflation, you could run the risk of running out of money during your lifetime.
- Fixed-dollar withdrawal strategy. This is also simple where you first determine how much you need each year and then reassess that amount every few years. You might withdraw $40,000 for each of the next five years and then reassess both your needs going forward and the performance of your remaining investments. You can adjust the amount withdrawn each year but doing it only every several years adds stability to your budgeting. However, it doesn’t adjust for annual inflation.
- Fixed-percentage withdrawal strategy. This is similar to the 4% withdrawal strategy but there are important differences. You can use a different annual percentage and there is not a built-in inflation adjustment. Also, the percentage is based on the annual value of your portfolio rather than the beginning value. Using a fixed percentage, the dollar amount of your distribution will vary based on the underlying value/performance of your portfolio. This method is best for adjusting your withdrawals in response to investment value fluctuations.
- Systematic withdrawal strategy. For some retirees, this method might provide too low of a payout because it preserves all the investment capital. You only withdraw the income (dividends, profits, interest, etc.) earned by the investments in your portfolio. The big advantage is that you will never run out of money in your retirement account. However, your income will vary each year. Also, depending on market performance, if your investments don’t grow at the rate of inflation, your buying power can drop drastically. But it will leave the capital for your heirs.
- Buckets withdrawal strategy. This requires you to be the most active at managing your assets and investments during retirement but does bring stability to your retirement income. Using this method, you maintain your funds in at least three different accounts (buckets). The first bucket holds some percentage of your savings in cash. Typically, this is three to five years of living expenses. Fixed-income investments is the second bucket. This should provide a dependable income for the longer term. The third bucket contains a portion in higher-risk growth investments. The purpose is to give you more control over your assets with the potential to grow over time.
You should always be in full control of your retirement finances.
You can always mix and match the above approaches to arrive at the optimal income plan for your circumstances. As you think through your major expenses during retirement, you can combine investment strategies to fund your various income needs as you see fit.
Consult your financial advisor or tax professional.