A guaranteed minimum income benefit (GMIB) is an optional rider that can be included in an annuity contract to provide a minimum income amount to the annuity holder. An annuity is an insurance product in which you pay a premium to the insurance company, then receive payments back at a later date. There are a number of different types of annuities, with different annuity rates.
A GMIB annuity can ensure that you receive a consistent stream of guaranteed income. If you’re considering buying an annuity for your retirement, it’s helpful to understand what guaranteed minimum income means, and how it works.
Key Points
• A Guaranteed Minimum Income Benefit (GMIB) is an optional rider in an annuity contract ensuring a minimum income.
• GMIBs protect annuity payments from market volatility, offering stable income in retirement.
• These benefits are available in variable or indexed annuities, which tie earnings to market performance.
• The cost of GMIBs can be high, as adding riders increases the overall expense of the annuity.
• Evaluating the financial stability of the annuity provider is crucial, as the company’s health impacts the security of the guaranteed income.
GMIBs, Defined
A guaranteed minimum income benefit (GMIB) is a rider that the annuity holder can purchase, at an additional cost, and add it onto their annuity. The goal of a GMIB is to ensure that the annuitant will continue to receive payments from the contract — that’s the “guaranteed minimum income” part — without those payments being affected by market volatility.
Annuities are one option you might consider when starting a retirement fund. But what are annuities and how do they work? It’s important to answer this question first when discussing guaranteed minimum income benefits.
As noted, an annuity is a type of insurance contract. You purchase the contract, typically with a lump sum, on the condition that the annuity company pays money back to you now or starting at a later date, e.g. in retirement.
Depending on how the annuity is structured, your money may be invested in underlying securities or not. Depending on the terms and the annuity rates involved, you may receive a lump sum or regular monthly payments. The amount of the payment is determined by the amount of your initial deposit or premium, and the terms of the annuity contract.
A GMIB annuity is most often a variable annuity or indexed annuity product (though annuities for retirement can come in many different types).
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How GMIBs Work
Let’s look at two different types of annuities for retirement: variable and indexed.
• Variable annuities can offer a range of investment types, often in the form of mutual funds that hold a combination of stocks, bonds, and money market instruments.
• Indexed annuities offer returns that are indexed to an underlying benchmark, such as the S&P 500 index, Nasdaq, or Russell 2000. This is similar to other types of indexed investments.
With either one, the value of the annuity contract is determined by the performance of the underlying investments you choose.
When the market is strong, variable annuities or indexed annuities can deliver higher returns. When market volatility increases, however, that can reduce the value of your annuity. A GMIB annuity builds in some protection against market risk by specifying a guaranteed minimum income payment you’ll receive from the annuity, independent of the annuity’s underlying market-based performance.
Of course, what you can draw from an annuity to begin with will depend on how much you invest in the contract, stated annuity rates, and to some degree your investment performance. But having a GMIB rider on this type of retirement plan can help you to lock in a predetermined amount of future income.
Guaranteed minimum income benefit annuities can be appealing for investors who want to have a guaranteed income stream in retirement. Whether it makes sense to purchase one can depend on how much you have to invest, how much income you’re hoping to generate, your overall goals and risk tolerance.
Weighing the pros and cons can help you to decide if a GMIB annuity is a good fit for your retirement planning strategy.
Pros of GMIBs
The main benefit of a GMIB annuity is the ability to receive a guaranteed amount of income in retirement. This can make planning for retirement easier as you can estimate how much money you’re guaranteed to receive from the annuity, regardless of what happens in the market between now and the time you choose to retire.
If you’re concerned about your spouse or partner being on track for their own retirement, that income can also carry over to your spouse and help fund their retirement needs, if you should pass away first. You can structure the annuity to make payments to you beginning at a certain date, then continue those payments to your spouse for the remainder of their life. This can provide reassurance that your spouse won’t be left struggling financially after you’re gone.
Cons of GMIBs
A main disadvantage of guaranteed minimum income benefit annuities is the cost. The more riders you add on to an annuity contract, the more this can increase the cost. So that’s something to factor in if you have a limited amount of money to invest in a variable or indexed annuity with a GMIB rider. Annuities may also come with other types of investment fees, so you may want to consult with a professional who can help you decipher the fine print.
It’s also important to consider the quality of the annuity company. An annuity is only as good as the company that issues the contract. If the company were to go out of business, your guaranteed income stream could dry up. For that reason, it’s important to review annuity ratings to get a sense of how financially stable a particular company is.
Examples of GMIB Annuities
Variable or indexed annuities that include a guaranteed minimum income benefit can be structured in different ways. For example, you may be offered the opportunity to purchase a variable annuity for $250,000. The annuity contract includes a GMIB order that guarantees you the greater of:
• The annuity’s actual value
• 6% interest compounded annually
• The highest value reached in the account historically
The annuity has a 10-year accumulation period in which your investments can earn interest and grow in value. This is followed by the draw period, in which you can begin taking money from the annuity.
Now, assume that at the beginning of the draw period the annuity’s actual value is $300,000. But if you were to calculate the annuitized value based on the 6% interest compounded annually, the annuity would be worth closer to $450,000. Since you have this built into the contract, you can opt to receive the higher amount thanks to the guaranteed minimum income benefit.
This example also illustrates why it’s important to be selective when choosing annuity contracts with a guaranteed minimum income benefit. The higher the guaranteed compounding benefit the better, as this can return more interest to you even if the annuity loses value because of shifting market conditions.
It’s also important to consider how long the interest will compound. Again, the more years interest can compound the better, in terms of how that might translate to the size of your guaranteed income payout later.
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The Takeaway
As discussed, guaranteed minimum income benefits (GMIB) are optional riders that can be included in an annuity contract to provide a minimum income amount to the annuity holder. Annuities can help round out your financial strategy if you’re looking for ways to create guaranteed income in retirement.
Annuities may be a part of a larger investment and retirement planning strategy, along with other types of retirement accounts. To get a better sense of how they may fit in, if at all, it may be a good idea to speak with a financial professional.
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FAQ
What are guaranteed benefits?
When discussing annuities for retirement, guaranteed benefits are amounts that you are guaranteed to receive. Depending on how the annuity contract is structured, you may receive guaranteed benefits as a lump sum payment or annuitized payments.
What is the guaranteed minimum withdrawal benefit?
The guaranteed minimum withdrawal benefit is the amount you’re guaranteed to be able to withdraw from an annuity once the accumulation period ends. This can be the annuity’s actual value, an amount that reflects interest compounded annually or the annuity contract’s highest historical value.
What are the two types of guaranteed living benefits?
There are actually more than two types of guaranteed living benefits. For example, your annuity contract might include a guaranteed minimum income benefit, guaranteed minimum accumulation benefit or guaranteed lifetime withdrawal benefit.
About the author
Rebecca Lake
Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.
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To maintain the tax-advantages of a 401(k) or 403(b) retirement plan, employers must follow the rules established by the Employment Retirement Income Security Act (ERISA) of 1974, including nondiscrimination testing.
401(k) compliance testing ensures that companies administer their 401(k) plans in a fair and equal manner that benefits all employees, rather than just executives and owners. In other words, a 401(k) plan can’t favor one group of employees over another.
Companies must test their plans yearly and address any compliance flaws surfaced by the tests. Often a third-party plan administrator or recordkeeper helps plan sponsors carry out the tests.
Understanding nondiscrimination tests for retirement plans is important both as an employer and as an employee.
401(k) Compliance Testing Explained
Compliance testing is a process that determines whether a company is fairly administering its 401(k) plan under ERISA rules. ERISA mandates nondiscrimination testing for retirement plans to demonstrate that they don’t favor highly compensated employees or key employees, such as company owners. 401(k) compliance testing is the responsibility of the company that offers the plan.
How 401(k) Compliance Testing Works
Companies apply three different compliance tests to the plan each year. These tests look at how much income employees defer into the plan, how much the employer 401(k) match adds up to, and what percentage of assets in the plan belong to key employees and highly compensated employees versus what belongs to non-highly compensated employees.
• The Actual Deferral Percentage (ADP) Test: Analyzes how much income employees defer into the plan
• The Actual Contribution Percentage (ACP): Analyzes employers contributions to the plan on behalf of employees
• Top-Heavy Test: Anayzes how participation by key employees compares to participation by other employees
The Actual Deferral Percentage (ADP) Test
The Actual Deferral Percentage (ADP) test counts elective deferrals of highly compensated employees and non-highly compensated employees. This includes both pre-tax and Roth deferrals but not catch-up contributions made to the plan. This 401(k) compliance testing measures engagement in the plan based on how much of their salary each group defers into it on a yearly basis.
To run the test, employers average the deferral percentages of both highly compensated employees and non-highly compensated employees to determine the ADP for each group. Then the employer divides each plan participant’s elective deferrals by their compensation to get their Actual Deferral Ratio (ADR). The average ADR for all eligible employees of each group represents the ADP for that group.
A company passes the Actual Deferral Percentage test if the ADP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ADP for the group of non-highly compensated employees
OR
• The lesser of 200% of the ADP for the group of non-highly compensated employees or the ADP for those employees plus 2%
The Actual Contribution Percentage (ACP) Test
Plans that make matching contributions to their employees’ 401(k) must also administer the Actual Contribution Percentage (ACP) test. Companies calculate this the same way as the ADP test but they substitute each participant’s matching and after-tax contributions for elective deferrals when doing the math.
This test reveals how much the employer contributes to each participant’s plan as a percentage, based on their W-2 income. Companies pass the Actual Contribution Percentage test if the ACP for the eligible highly compensated employees doesn’t exceed the greater of:
• 125% of the ACP for the group of non-highly compensated employees
OR
• The lesser of 200% of the ACP for the group of non-highly compensated employees or the ACP for those employees plus 2%
Companies may run both the ADP and ACP tests using prior year or current-year contributions.
Top-Heavy Test
The Top-Heavy test targets key employees within an organization who contribute to qualified retirement plans. The IRS defines a key employee as any current, former or deceased employee who at any time during the plan year was:
• An officer making over $215,000 for 2023 and over $220,000 for 2024
• A 5% owner of the business OR
• An employee owning more than 1% of the business and making over $150,000 for the plan year
Anyone who doesn’t fit these standards is a non-key employee. Top-heavy ensures that lower-paid employees receive a minimum benefit if the plan is too top-heavy.
Under IRS rules, a plan is top heavy if on the last day of the prior plan year the total value of plan accounts for key employees is more than 60% of the total value of plan assets. If the plan is top heavy the employer must contribute up to 3% of compensation for all non-key employees still employed on the last day of the plan year. This is designed to bring plan assets back into a fair balance.
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Why 401(k) Compliance Testing Is Necessary
401(k) compliance testing ensures that investing for retirement is as fair as possible for all participants in the plan, and that the plan continues to receive favorable tax treatment from the IRS. The compliance testing rules prevent employers from favoring highly compensated employees or key employees over non-highly compensated employees and non-key employees.
If a company fails a 401(k) compliance test, then they have to remedy that under IRS rules or risk the plan losing its tax-advantaged status. This is a strong incentive to fix any issues with non-compliant plans as it can cost employers valuable tax benefits.
Nondiscrimination testing can help employers determine participation across different groups of their workers. It can also shed light on what employees are deferring each year, in accordance with annual 401k plan contribution limits.
Highly Compensated Employees
The IRS defines highly compensated employees for the purposes of ADP and ACP nondiscrimination tests. Someone is a highly compensated employee if they:
• Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation they earned or received,
OR
• Received compensation from the business of more than $150,000 in 2023 and $155,000 in 2024 or $135,000 (if the preceding is 2022) and was in the top 20% of employees when ranked by compensation
If an employee doesn’t meet at least one of these conditions, they’re considered non-highly compensated. This distinction is important when compliance testing 401(k) plans, as the categorization into can impact ADP and ACP testing outcomes.
Non-Highly Compensated Employees
Non-highly compensated employees are any employees who don’t meet the compensation or ownership tests, as established by the IRS for designated highly compensated employees. So in other words, a non-highly compensated employee would own less than 5% of the interest in the company or have compensation below the guidelines outlined above.
Again, it’s important to understand who is a non-highly compensated employee when applying nondiscrimination tests. Employers who misidentify their employees run the risk of falling out of 401(k) compliance. Likewise, as an employee, it’s important to understand which category you fall into and how that might affect the amount you’re able to contribute and/or receive in matching contributions each year.
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How to Fix a Non-Compliant 401(k)
The IRS offers solutions for employers who determine that their 401(k) is not compliant, based on the results of the ADP, ACP or Top-Heavy tests. When a plan fails the ADP or ACP test, the IRS recommends the following:
• Refunding contributions made by highly compensated employees in order to bring average contribution rates in alignment with testing standards
• Making qualified nonelective contributions on behalf of non-highly compensated employees in order to bring their average contributions up in order to pass test
Employers can also choose to do a combination of both to pass both the ADP and ACP tests. In the case of the Top-Heavy test, the employer must make qualified nonelective contributions of up to 3% of compensation for non-highly compensated employees.
Companies can also avoid future noncompliance issues by opting to make safe harbor contributions. Safe harbor plans do not have to conduct ADP and ACP testing, and they can also be exempt from the Top-Heavy test if they’re not profit sharing plans. Under safe harbor rules, employers can do one of the following:
• Match each eligible employee’s contribution on a dollar-for-dollar basis up to 3% of the employee’s compensation and 50 cents on the dollar for contributions that exceed 3% but not 5% of their compensation.
• Make a nonelective contribution equal to 3% of compensation to each eligible employee’s account.
Safe harbor rules can relieve some of the burden of yearly 401(k) testing while offering tax benefits to both employers and employees.
The Takeaway
A 401(k) is a key way for employees to help save for retirement and reach their retirement goals. It’s important for employers to conduct IRS-mandated 401(k) compliance testing in order to ensure that their 401(k) plans are administered in a fair and equal manner that benefits all employees.
If you don’t have a 401(k) at work, however, or you’re hoping to supplement your 401(k) savings, you may want to consider opening an Individual Retirement Account (IRA) to help save for retirement. Since IRAs are not employer-sponsored, they’re not subject to 401(k) compliance testing, though they do have to follow IRS rules regarding annual contribution limits and distributions.
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FAQ
What is top-heavy testing for 401(k)?
Top-heavy testing for 401(k) plans determine what percentage of plan assets are held by key employees versus non-key employees. If an employer’s plan fails the top-heavy test, they must make qualified, nonelective contributions on behalf of non-key employees in order to bring the plan into compliance.
What happens if you fail 401(k) testing?
If an employer-sponsored plan fails 401(k) compliance testing, the IRS requires the plan to make adjustments in order to become compliant. This can involve refunding contributions made by highly-compensated employees, making qualified nonelective contributions on behalf of non-highly compensated employees or a combination of the two.
What is a highly compensated employee for 401(k) purposes?
The IRS defines a highly compensated employee using two tests based on compensation and company ownership. An employee is highly compensated if they have a 5% or more ownership interest in the business or their income exceeds a specific limit for the year. Income limits are set by the IRS and updated periodically.
About the author
Rebecca Lake
Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.
Photo credit: iStock/tumsasedgars
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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Mutual funds are one option investors may consider when building a retirement portfolio. A mutual fund represents a pooled investment that can hold a variety of different securities, including stocks and bonds. There are different types of mutual funds investors may choose from, including index funds, target date funds, and income funds.
But how do mutual funds work? Are mutual funds good for retirement or are there drawbacks to investing in them? What should be considered when choosing retirement mutual funds?
Those are important questions to ask when determining the best ways to build wealth for the long term. Here’s what you need to know about mutual funds and retirement.
Key Points
• Mutual funds offer exposure to a wide range of asset classes, and thus may fit well in a retirement portfolio.
• Approximately 53.7% of U.S. households owned mutual funds in 2024, according to industry research.
• Target-date funds adjust their asset allocation as retirement approaches, offering a tailored solution.
• Income funds focus on generating steady income, and may be suitable for retirement needs.
• Potential drawbacks of mutual funds include high fees, portfolio overweighting, and tax inefficiency.
Understanding Mutual Funds
A mutual fund pools money from multiple investors, then uses those funds to invest in a number of different securities. Mutual funds can hold stocks, bonds, and other types of securities.
How a mutual fund is categorized depends largely on what the fund invests in and what type of investment strategy it follows. For example, index funds follow a passive investment strategy, as these funds mirror the performance of a stock market benchmark. So a fund that tracks the S&P 500 index would attempt to replicate the returns of the companies included in that index.
Target-date funds utilize a different strategy. These funds automatically adjust their asset allocation based on a target retirement date. So a 2050 target-date fund, for example, is designed to shift more of its asset allocation toward bonds or fixed-income and away from stocks as the year 2050 approaches.
How Mutual Funds Work
Mutual funds allow investors to purchase shares in the fund. Buying shares makes them part-owner of the fund and its underlying assets. As such, investors have the right to share in the profits of the fund. So if a mutual fund owns dividend-paying stocks, for example, any dividends received would be passed along to the fund’s investors.
• Understanding dividend payments. Depending on how the fund is structured or what the brokerage selling the fund offers, investors may be able to receive any dividends or interest as cash payments or they may be able to reinvest them. With a dividend reinvestment plan or DRIP, investors can use dividends to purchase additional shares of stock, often bypassing brokerage commission fees in the process.
• Understanding fund fees. Investors pay an expense ratio to invest in mutual funds. This reflects the annual cost of owning the fund, expressed as a percentage. Passively managed mutual funds tend to have lower expense ratios.
Actively managed funds, on the other hand, tend to be more expensive, but the idea is that higher fees may seem justified if the fund produces above-average returns.
It’s also important to know that mutual funds are priced and traded just once a day, after the market closes. This is different from exchange-traded funds, or ETFs, for example, which are similar to mutual funds in many ways, but trade on an exchange just like stocks, and typically require a lower initial investment than a mutual fund.
Investors interested in opening an investment account can learn more about how a particular mutual fund works, what it invests in, and the fees involved by reading the fund’s prospectus.
Types of Mutual Funds for Retirement
There are some mutual funds designed for people who are saving for retirement. These funds typically combine portfolio diversification, often with a greater emphasis on bonds and fixed income, and the potential for moderate gains.
For instance, retirement income funds (RIFs) are intended to be more conservative with moderate growth. RIFs may be mutual funds, ETFs, or annuities, among other products.
Target-rate funds, as mentioned, adjust their asset allocation based on an investor’s intended retirement date, and get more conservative as that date approaches. This automated strategy may help some retirement savers who are less experienced at managing their portfolios over time.
Mutual funds are arguably one of the most popular investment options for retirement planning. According to the Investment Company Institute, 53.7% of U.S. households totaling approximately 121.6 million individual investors owned mutual funds in 2024. Fifty-three percent of individuals who own mutual funds are ages 35 to 64 — in other words, those who may be planning for retirement — the research found.
There are also many investors living in retirement who own mutual funds. According to the Investment Company Institute, 58% of households aged 65 or older owned mutual funds in 2024.
So are mutual funds good for retirement? Here are some of the pros and cons to consider.
Pros of Using Mutual Funds for Retirement
Investing in mutual funds for retirement planning could be attractive for investors who want:
• Convenience
• Basic diversification
• Professional management
• Reinvestment of dividends
Investing in a mutual fund can offer exposure to a wide range of securities, which could help with diversifying a portfolio. And it may be easier and less costly to purchase a single fund that holds hundreds of stocks than to purchase individual shares in each of those companies.
The majority of mutual funds are actively managed (and sometimes called active funds). Actively managed mutual funds are professionally managed, so investors can rely on the fund manager’s expertise and knowledge. And if the fund includes dividend reinvestment, investors can increase their holdings automatically which can potentially add to the portfolio’s growth.
Cons of Using Mutual Funds for Retirement
While there are some advantages to using mutual funds for retirement planning, there are also some possible disadvantages, including:
• Potential for high fees
• Overweighting risk
• Under-performance
• Tax inefficiency
As mentioned, mutual funds carry expense ratios. While some index funds may charge as little as 0.05% in fees, there are some actively managed funds with expense ratios well above 1%. If those higher fees are not being offset by higher than expected returns (which is never a guarantee), the fund may not be worth it. Likewise, buying and selling mutual fund shares could get expensive if your brokerage charges steep trading fees.
While mutual funds generally make it easier to diversify, there’s the risk of overweighting one’s portfolio — owning the same holdings across different funds. For example, if you’re invested in five mutual funds that hold the same stock and the stock tanks, that could drag down your portfolio.
Something else to keep in mind is that an actively managed mutual fund is typically only as good as the fund manager behind it. Even the best fund managers don’t always get it right. So it’s possible that a fund’s returns may not live up to your expectations.
You may also have to contend with unexpected tax liability at the end of the year if the fund sells securities at a gain. Just like other investments, mutual funds are subject to capital gains tax. Whether you pay short- or long-term capital gains tax rates depends on how long you held a fund before selling it.
If you hold mutual funds in a tax-advantaged retirement account, then capital gains tax doesn’t enter the picture for qualified withdrawals
Pros of Mutual Funds
Cons of Mutual Funds
• Mutual funds offer convenience for investors
• It may be easier and more cost-effective to diversify using mutual funds vs. individual securities
• Investors benefit from the fund manager’s experience and knowledge
• Dividend reinvestment may make it easier to build wealth
• Some mutual funds may carry higher expense ratios than others
• Overweighting can occur if investors own multiple funds with the same underlying assets
• Fund performance may not always live up to the investor’s expectations
• Income distributions may result in unexpected tax liability for investors
Investing in Mutual Funds for Retirement Planning
The steps to invest in mutual funds for retirement are simple and straightforward.
1. Start with an online brokerage account, individual retirement account (IRA) such as a traditional IRA, or a 401(k). You can also buy a mutual fund directly from the company that created it, but a brokerage account or retirement account is usually the easier way to go.
2. Set your budget. Decide how much money you can afford to invest in mutual funds. Keep in mind that the minimum investment can vary for different funds. One fund may allow you to invest with as little as $100 while another might require $1,000 to $3,000 or even more to get started. In some cases, setting up automatic contributions may lower the required minimum.
3. Choose funds. If you already have a brokerage account or an IRA like a SEP IRA, this may simply mean logging in, navigating to the section designated for buying funds, selecting the fund or funds and entering in the amount you want to invest.
4. Submit your order. You may be asked to consent to electronic delivery of the fund’s prospectus when you place your order. If your brokerage charges a fee to purchase mutual funds, that amount will likely be added to the order total. Once you submit your order to purchase mutual funds, it may take a few business days to process.
Tips for Selecting Retirement-Ready Mutual Funds
If you’re considering investing in mutual funds for retirement, here are some strategies to keep in mind.
• Determine your risk tolerance and retirement goals. As discussed previously, the closer you are to retirement, the more conservative you may want to be. For example, you might want to consider target-date or bond funds.
• Analyze the fund’s performance. You can look for funds that have a history of consistent returns for the past three, five, and 10 years.
• Check out expense ratios. If a mutual fund’s fees are high, you may want to consider other funds instead.
• Evaluate the possible tax implications. Mutual funds are subject to capital gains tax, as mentioned. Index funds may be more tax efficient. You can read more about this below.
Determining If Mutual Funds Are Right for You
Whether it makes sense to invest in mutual funds for retirement can depend on your time horizon, risk tolerance, and overall investment goals. If you’re leaning toward mutual funds for retirement planning, here are a few things to consider.
Investment Strategy
When comparing mutual funds, it’s important to understand the overall strategy the fund follows. Whether a fund is actively or passively managed may influence the level of returns generated. The fund’s investment strategy may also determine what level of risk investors are exposed to.
For example, index funds are designed to mirror the market. Growth funds, on the other hand, typically have a goal of beating the market. Between the two, growth funds may produce higher returns — but they may also entail more risk for the investor and carry higher expense ratios.
Choosing funds that align with your preferred strategy, risk tolerance, and goals matters. Otherwise, you may be disappointed by your returns or be exposed to more risk than you’re comfortable with.
Cost
Cost is an important consideration when choosing mutual funds for one reason: Higher expense ratios can eat away more of your returns.
When comparing mutual fund expense ratios, it’s important to look at the amount you’ll pay to own the fund each year. But it’s also important to consider what kind of returns the fund has produced historically. A low-fee fund may look like a bargain, but if it generates low returns then the cost savings may not be worth much.
It’s possible, however, to find plenty of low-cost index funds that produce solid returns year over year. Likewise, you shouldn’t assume that a fund with a higher expense ratio is guaranteed to outperform a less expensive one.
Fund Holdings
It’s critical to look under the hood, so to speak, to understand what a particular mutual fund owns and how often those assets turn over. This can help you to avoid overweighting your portfolio toward any one stock or sector.
Reading through the prospectus or looking up a stock’s profile online can help you to understand:
• What individual securities a mutual fund owns
• Asset allocation for each security in the fund
• How often securities are bought and sold
If you’re interested in tech stocks, for example, you may want to avoid buying two funds that each have 10% of assets tied up in the same company. Or you may want to choose a fund that has a lower turnover rate to minimize your capital gains tax liability for the year.
Tax Efficiency of Mutual Funds in Retirement
As mentioned, when held in a taxable account mutual funds are subject to capital gains tax. Dividend income from mutual funds is also taxed. When mutual funds are held in a tax-advantaged retirement account, investors need to consider the tax treatment of those accounts rather than capital gains.
With actively managed mutual funds, fund managers typically need to constantly rebalance the fund by
selling securities to reallocate assets, among other things. Those sales may create capital gains for investors. While mutual fund managers usually use tax mitigation strategies to help diminish annual capital gains, this is a factor for investors to consider.
Index funds tend to have less turnover of assets than actively managed funds and thus may generally be more tax efficient.
Managing Risk with Mutual Funds in a Retirement Portfolio
Generally speaking, mutual funds offer diversification and less risk compared to some other investments. That’s why they are often part of a retirement portfolio. However, it’s important to remember risk is inherent in investing whether you’re investing in mutual funds or another asset class.
Investors can select mutual funds that align with their risk tolerance, financial goals, and the amount of time they have before retirement (the time horizon). A younger investor may choose funds that potentially offer higher growth but also have higher risk like stock funds. Those closer to retirement age may opt for more conservative options, such as bond funds, and they might want to consider target rate funds that automatically adjust their asset allocation to be in sync with an investor’s retirement date.
Performance of Mutual Funds Compared to Other Retirement Investments
When considering mutual funds, it’s important to look at a fund’s performance over time. Not all funds hit their benchmarks or deliver consistent returns over the long term.
In 2024, according to Morningstar, of the nearly 3,900 actively managed equity funds tracked, only 13.2% beat the S&P 500 SPX index. The average gain was 13.5% compared to the 25% return of the S&P 500.
Historically, index funds have generally performed better overall than actively managed funds.
Other Types of Funds for Retirement
Mutual funds, and target date funds in particular, are one of the ways to save for retirement. But there are other options you might consider. Here’s a brief rundown of other types of funds that can be used for retirement planning.
Real Estate Investment Trusts (REITs)
A real estate investment trust isn’t a mutual fund. But it is a pooled investment that allows multiple investors to own a share in real estate. REITs pay out 90% of their income to investors as dividends.
An investor might consider a REIT, which is considered a type of alternative investment, if they’d like to reap the potential benefits of real estate investing without actually owning property.
Exchange-Traded Funds (ETFs)
Exchange-traded funds are another retirement savings option. Investing in ETFs — for instance, through a Roth or traditional IRA — may offer more flexibility compared to mutual funds. They may carry lower expense ratios than traditional funds and be more tax-efficient if they follow a passive investment strategy.
Income Funds
An income fund is a specific type of mutual fund that focuses on generating income for investors. This income can take the form of interest or dividend payments. Income funds could be an attractive option for retirement planning if an individual is interested in creating multiple income streams or reinvesting dividends until they’re ready to retire.
Bond Funds
Bond funds focus exclusively on bond holdings. The type of bonds the fund holds can depend on its objective or strategy. For example, you may find bond funds or bond ETFs that only hold corporate bonds or municipal bonds, while others offer a mix of different bond types. Bond funds could potentially help round out the fixed-income portion of your retirement portfolio.
IPO ETFs
An initial public offering or IPO represents the first time a company makes its shares available for trade on a public exchange. Investors can invest in multiple IPOs through an ETF. IPO ETFs invest in companies that have recently gone public so they offer an opportunity to get in on the ground floor. However, IPO ETFs are relatively risky and are generally more suitable for experienced investors.
The Takeaway
Mutual funds can be part of a diversified retirement planning strategy. Regardless of whether you choose to invest in mutual funds, ETFs or something else, the key is to start saving for your pos-work years sooner rather than later. Time can be one of your most valuable resources when investing for retirement.
Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
Invest with as little as $5 with a SoFi Active Investing account.
FAQ
Are mutual funds safer than individual stocks for retirement?
Generally speaking, mutual funds tend to carry less risk than individual stocks for retirement. Mutual funds provide diversification by investing in a mix of stocks, bonds, and other assets, which may help reduce overall risk. Individual stocks, on the other hand, depend on the performance of one company, which makes them riskier.
What percentage of my retirement portfolio should be in mutual funds?
There is no one single approach to asset allocation. The percentage of your portfolio that’s in mutual funds depends on your individual goals, risk tolerance, and time horizon. Younger investors with retirement far in the future may want to consider a more aggressive strategy that’s heavier on stocks, with more possibility for growth, but also involves more risk. Conversely, an investor near retirement age will likely want to be more conservative, and they might choose less risky options such as fixed income and bond funds.
How often should I review my mutual fund holdings?
There is no fixed rule for how often to review mutual fund holdings. Some investors may prefer biannual or annual reviews, while others might feel more comfortable with quarterly reviews. Reviewing a portfolio can help you monitor mutual fund performance, track your returns, and manage risk, so choose the schedule you are most comfortable with.
Can mutual funds provide steady income in retirement?
Certain types of mutual funds, such as retirement income funds (RIFs), are designed to provide a steady source of income in retirement. Ideally, an investor may want to have a mix of stocks, bonds, and cash investments that provide streams of income and growth in retirement and help preserve their money.
What are the tax implications of mutual fund investments in retirement?
Mutual funds are subject to capital gains tax when held in a taxable account. Actively managed funds must report capital gains every time a share is sold or purchased and may result in more capital gains tax. Index funds tend to have less turnover of assets and are generally more tax efficient. However, you may wish to consult a tax professional about your specific situation.
Photo credit: iStock/kali9
About the author
Rebecca Lake
Rebecca Lake has been a finance writer for nearly a decade, specializing in personal finance, investing, and small business. She is a contributor at Forbes Advisor, SmartAsset, Investopedia, The Balance, MyBankTracker, MoneyRates and CreditCards.com. Read full bio.
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Mutual Funds (MFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or clicking the prospectus link on the fund's respective page at sofi.com. You may also contact customer service at: 1.855.456.7634. Please read the prospectus carefully prior to investing.Mutual Funds must be bought and sold at NAV (Net Asset Value); unless otherwise noted in the prospectus, trades are only done once per day after the markets close. Investment returns are subject to risk, include the risk of loss. Shares may be worth more or less their original value when redeemed. The diversification of a mutual fund will not protect against loss. A mutual fund may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
The purpose of an Individual Retirement Account (IRA) is to save for retirement. Ideally, you sock away money consistently in an IRA and your investment grows over time.
However, IRAs have strict withdrawal rules both before and after retirement. It’s very important to understand the IRA rules for withdrawals to avoid incurring penalties.
Here’s what you need to know about IRA withdrawal rules.
Key Points
• Traditional and Roth IRAs have specific withdrawal rules and penalties.
• Roth IRA withdrawal rules include the five-year rule for penalty-free withdrawals, and required minimum distributions (RMDs) for inherited IRAs.
• Traditional IRA withdrawals before age 59 ½ incur regular income taxes and a 10% penalty.
• There are exceptions to the penalty, such as using funds for medical expenses, health insurance, disability, education, and first-time home purchases.
• Generally speaking, early IRA withdrawals might be thought of as a last resort due to the potential impact on retirement savings and tax implications.
Roth IRA Withdrawal Rules
So when can you withdraw from a Roth IRA? The IRA withdrawal rules are different for Roth IRAs vs traditional IRAs. For instance, qualified withdrawals from a Roth IRA are tax-free, since you make contributions to the account with after-tax funds.
There are some other Roth IRA withdrawal rules to keep in mind as well.
The Five-year Rule
The date you open a Roth IRA and how long the account has been open is a factor in taking your withdrawals.
According to the five-year rule, you can generally withdraw your earnings tax- and penalty-free if you’re at least 59 ½ years old and it’s been at least five years since you opened the Roth IRA. You can withdraw contributions to a Roth IRA anytime without taxes or penalties. (The annual IRA contribution limits for 2024 and 2025 are $7,000, or $8,000 for those age 50 and up.)
Even if you’re 59 ½ or older, you may face a Roth IRA early withdrawal penalty if the retirement account has been open for less than five years when you withdraw earnings from it.
These Roth IRA withdrawal rules also apply to the earnings in a Roth that was a rollover IRA. If you roll over money from a traditional IRA to a Roth and you then make a withdrawal of earnings from the Roth IRA before you’ve owned it for at least five years, you’ll owe a 10% penalty on the earnings.
For inherited Roth IRAs, the five-year rule applies to the age of the account. If your benefactor opened the account more than five years ago, you can withdraw earnings penalty-free. If you tap into the money before that, though, you’ll owe taxes on the earnings.
Required Minimum Distributions (RMDs) on Inherited Roth IRAs
In most cases, you do not have to pay required minimum distributions (RMDs) on money in a Roth IRA account.
However, according to the SECURE Act, if your loved one passed away in 2020 or later, you don’t have to take RMDs, but you do need to withdraw the entire amount in the Roth IRA within 10 years.
There are two ways to do that without penalty:
• Withdraw funds by December 31 of the fifth year after the original holder died. You can do this in either partial distributions or a lump sum. If the account is not emptied by that date, you could owe a 50% penalty on whatever is left.
• Take withdrawals each year, based on your life expectancy.
Get a 1% IRA match on rollovers and contributions.
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1Terms and conditions apply. Roll over a minimum of $20K to receive the 1% match offer. Matches on contributions are made up to the annual limits.
Tax Implications of Roth IRA Withdrawals
Contributions to a Roth IRA can be withdrawn any time without taxes or penalties. However, let’s say an individual did active investing through their account, which generated earnings. Any earnings withdrawn from a Roth before age 59 ½ are subject to a 10% penalty and income taxes.
If you take funds out of a traditional IRA before you turn 59 ½, you’ll owe regular income taxes on the contributions and the earnings, per IRA tax deduction rules, plus a 10% penalty. Brian Walsh, CFP® at SoFi specifies, “When you make contributions to a traditional retirement account, that money is going to grow without paying any taxes. But when you take that money out — say 30 or 40 years from now — you’re going to pay taxes on all of the money you take out.”
RMDs on a Traditional IRA
The rules for withdrawing from an IRA mean that required minimum distributions kick in the year you turn 73 (as long as you turned 72 after December 31, 2022). After that, you have to take distributions each year, based on your life expectancy. If you don’t take the RMD, you’ll owe a 25% penalty on the amount that you did not withdraw. The penalty may be lowered to 10% if you correct the mistake and take the RMD within two years.
Early Withdrawal Penalties for Traditional IRAs
In general, an early withdrawal from a traditional IRA before the account holder is at least age 59 ½ is subject to a 10% penalty and ordinary income taxes. However, there are some exceptions to this rule.
When Can You Withdraw from an IRA Without Penalties?
As noted, you can make withdrawals from an IRA once you reach age 59 ½ without penalties.
In addition, there are other situations in which you may be able to make withdrawals without having to pay a penalty. These include having medical expenses that aren’t covered by health insurance (as long as you meet certain qualifications), having a permanent disability that means you can no longer work, and paying for qualified education expenses for a child, spouse, or yourself.
Read more about these and other penalty-free exceptions below.
💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
9 Exceptions to the 10% Early-Withdrawal Penalty on IRAs
Whether you’re withdrawing from a Roth within the first five years or you want to take money out of an IRA before you turn 59 ½, there are some exceptions to the 10% penalty on IRA withdrawals.
1. Medical Expenses
You can avoid the early withdrawal penalty if you use the funds to pay for unreimbursed medical expenses that total more than 7.5% of your adjusted gross income (AGI).
2. Health Insurance
If you’re unemployed for at least 12 weeks, IRA withdrawal rules allow you to use funds from an IRA penalty-free to pay health insurance premiums for yourself, your spouse, or your dependents.
3. Disability
If you’re totally and permanently disabled, you can withdraw IRA funds without penalty. In this case, your plan administrator may require you to provide proof of the disability before signing off on a penalty-free withdrawal.
4. Higher Education
IRA withdrawal rules allow you to use IRA funds to pay for qualified education expenses, such as tuition and books for yourself, your spouse, or your child without penalty.
5. Inherited IRAs
IRA withdrawal rules for inherited IRAs state that you don’t have to pay the 10% penalty on withdrawals from an IRA, unless you’re the sole beneficiary of a spouse’s account and roll it into your own, non-inherited IRA. In that case, the IRS treats the IRA as if it were yours from the start, meaning that early withdrawal penalties apply.
6. IRS Levy
If you owe taxes to the IRS, and the IRS levies your account for the money, you will typically not be assessed the 10% penalty.
7. Active Duty
If you’re a qualified reservist, you can take distributions without owing the 10% penalty. This goes for a military reservist or National Guard member called to active duty for at least 180 days.
8. Buying a House
While you can’t take out IRA loans, you can use up to $10,000 from your traditional IRA toward the purchase of your first home — and if you’re purchasing with a spouse, that’s up to $10,000 for each of you. The IRS defines first-time homebuyers as someone who hasn’t owned a principal residence in the last two years. You can also withdraw money to help with a first home purchase for a child or your spouse’s child, grandchild, or parent.
In order to qualify for the penalty-free withdrawals, you’ll need to use the money within 120 days of the distribution.
9. Substantially Equal Periodic Payments
Another way to avoid penalties under IRA withdrawal rules is by starting a series of distributions from your IRA spread equally over your life expectancy. To make this work, you must take at least one distribution each year and you can’t alter the distribution schedule until five years have passed or you’ve reached age 59 ½, whichever is later.
The amount of the distributions must use an IRS-approved calculation that involves your life expectancy, your account balance, and interest rates.
Understanding How Exceptions Are Applied
If you believe that any of the exceptions to early IRA withdrawal penalties apply to your situation, you may need to file IRS form 5329 to claim them. However, it’s wise to consult a tax professional about your specific circumstances.
💡 Quick Tip: For investors who want a diversified portfolio without having to manage it themselves, automated investing could be a solution (although robo advisors typically have more limited options and higher costs). The algorithmic design helps minimize human errors, to keep your investments allocated correctly.
Is Early IRA Withdrawal Worth It?
While there may be cases where it makes sense to take an early withdrawal, many financial professionals agree that it should be a last resort. These are disadvantages and advantages to consider.
Pros of IRA Early Withdrawal
• If you have a major expense and there are no other options, taking an early withdrawal from an IRA could help you cover the cost.
• An early withdrawal may help you avoid taking out a loan you would then have to repay with interest.
Cons of IRA Early Withdrawal
• By taking money out of an IRA account early, you’re robbing your own nest egg not only of the current value of the money but also the chance for future years of compound growth.
• Money taken out of a retirement account now can have a big impact on your financial security in the future when you retire.
• You may owe taxes and penalties, depending on the specific situation.
Alternatives to Early IRA Withdrawal
Rather than taking an early IRA withdrawal and incurring taxes and possible penalties, as well as impacting your long-term financial goals, you may want to explore other options first, such as:
• Using emergency savings:Building an emergency fund that you can draw from is one way to cover unplanned expenses, whether it’s car repairs or a medical bill, or to tide you over if you lose your job. Financial professionals often recommend having at least three to six months’ worth of expenses in your emergency fund.
To create your fund, start contributing to it weekly or bi-weekly, or set up automatic transfers for a certain amount to go from your checking account into the fund every time your paycheck is direct-deposited.
• Taking out a loan: You could consider asking a family member or friend for a loan, or even taking out a personal loan, if you can get a good interest rate and/or favorable loan terms. While you’ll need to repay a loan, you won’t be taking funds from your retirement savings. Instead, they can remain in your IRA where they can potentially continue to earn compound returns.
Opening an IRA With SoFi
IRAs are tax-advantaged accounts you can use to save for retirement. However, it is possible to take money out of an IRA if you need it before retirement age. Just remember, even if you’re able to do so without paying a penalty, the withdrawals could leave you with less money for retirement later.
Ready to invest for your retirement? It’s easy to get started when you open a traditional or Roth IRA with SoFi. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).
Help build your nest egg with a SoFi IRA.
FAQ
Can you withdraw money from a Roth IRA without penalty?
You can withdraw your contributions to a Roth IRA without penalty no matter what your age. However, you generally cannot withdraw the earnings on your contributions before age 59 ½, or before the account has been open for at least five years, without incurring a penalty.
What are the rules for withdrawing from a Roth IRA?
You can withdraw your own contributions to a Roth IRA at any time penalty-free. But to avoid taxes and penalties on your earnings, withdrawals from a Roth IRA must be taken after age 59 ½ and once the account has been open for at least five years.
However, there are a number of exceptions in which you typically don’t have to pay a penalty for an early withdrawal, including some medical expenses that aren’t covered by health insurance, being permanently disabled and unable to work, or if you’re on qualified active military duty.
What are the 5 year rules for Roth IRA withdrawal?
Under the 5-year rule, if you make a withdrawal from a Roth IRA that’s been open for less than five years, you’ll owe a 10% penalty on the account’s earnings. If your Roth IRA was inherited, the 5-year rule applies to the age of the account. So if you inherited the Roth IRA from a parent, for instance, and they opened the account more than five years ago, you can withdraw the funds penalty-free. If the account has been opened for less than five years, however, you’ll owe taxes on the gains.
How do inherited IRA withdrawal rules differ?
According to inherited IRA withdrawal rules, you don’t have to pay the 10% penalty on withdrawals from an IRA unless you’re the sole beneficiary of a spouse’s account and roll it into your own, non-inherited IRA. In that case, the IRS treats the IRA as if it were yours from the start, meaning that early withdrawal penalties apply.
In addition, for inherited IRAs, the five-year rule applies to the age of the account. If the person you inherited the IRA from opened the account more than five years ago, you can withdraw earnings penalty-free.
Are there penalties for missing RMDs?
Yes, there are penalties for missing RMDs. You are required to start taking RMDs when you turn 73, and then each year after that. If you miss or don’t take RMDs, you’ll typically owe a 25% penalty on the amount that you failed to withdraw. The penalty could be lowered to 10% if you correct the mistake and take the RMD within two years.
Photo credit: iStock/Fly View Productions
SoFi Invest®
INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below:
Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.
For a full listing of the fees associated with Sofi Invest please view our fee schedule.
Brokerage and Active investing products offered through SoFi Securities LLC, member FINRA(www.finra.org)/SIPC(www.sipc.org). For all full listing of the fees associated with Sofi Invest, please view our fee schedule.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
If you’re enrolled in a 401(k) plan and you need to get your hands on some money, you may have wondered, when can you withdraw from a 401(k)?
It’s a common question, and there are some important rules to be aware of, as well as tax implications and possible penalties. Read on to find out about the rules for withdrawing from a 401(k).
Key Points
• Withdrawals from a 401(k) can be made penalty-free starting at age 59 1/2.
• Aside from some possible exceptions, early withdrawals before 59 1/2 face a 10% penalty and are taxable.
• The rule of 55 permits penalty-free withdrawals at 55 or older for those who separate from their employer at 55 or older.
• Hardship withdrawals without penalty are available for urgent financial needs for those who qualify, but the withdrawals are subject to income taxes.
• Some 401(k) plans allow for 401(k) loans, which must be repaid in full with interest within five years.
What Are The Rules For Withdrawing From a 401(k)?
Because 401(k) plans are retirement savings plans, there are restrictions on when investors can make withdrawals. Typically, plan participants can withdraw money from their 401(k) without penalty when they reach the age of 59 ½. These are called qualified distributions. But if an individual takes out funds before that age, they may face penalties.
💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.
At What Age Can You Withdraw From a 401(k) Without Penalty?
There are certain circumstances in which people can take an early withdrawal from their 401(k) without penalty before age 59 ½.
Under the Age of 55
If a 401(k) plan participant is under the age of 55 and still employed at the company that sponsors their plan, they have two options for withdrawing from their 401(k) penalty-free:
If they’re no longer employed at the company that sponsors their 401(k), individuals might choose to roll their funds into a new employer’s 401(k) plan or do an IRA rollover.
Between Ages 55–59 1/2
The IRS provision known as the rule of 55 allows account holders to take withdrawals from their 401(k) without penalty if they’re age 55 or older and leave or lose their job at age 55 or older. However, they must still pay taxes on the money they withdraw.
There are a few guidelines to consider regarding the rule of 55:
• A 401(k) plan must permit early withdrawals before age 59 ½ for individuals to take advantage of the rule of 55.
• The withdrawals must be from the 401(k) the person was contributing to at the time they left their job, and not a previous employer’s 401(k).
• The rest of the funds must remain in the 401(k) until the individual reaches age 59 ½.
• If someone rolls their 401(k) plan into an individual retirement account (IRA) such as a traditional IRA, the rule of 55 no longer applies.
After Age 73
In addition to penalties for withdrawing funds too soon, you may also face penalties if you take money out of a retirement plan too late. When you turn 73 (as long as you turned 72 after December 31, 2022), you must withdraw a certain amount of money every year, known as a required minimum distribution (RMD). If you don’t, you’ll face a penalty of up to 25% of that distribution.
The RMD amount you need to take is based on a specific IRS calculation that generally involves dividing the account balance of your 401(k) at the end of the prior year with your “life expectancy factor,” which you can find more about on the IRS website.
Withdrawing 401(k) Funds When Already Retired
If a 401(k) plan holder is retired and still has funds in their 401(k) account, they can withdraw them penalty-free at age 59 ½. The same age rules apply to retirees who rolled their 401(k) funds into an IRA.
Withdrawing 401(k) Funds While Still Employed
If a 401(k) plan holder is still employed, they can access the funds from a 401(k) account with a previous employer once they turn 59 ½. However, they may not have access to their 401(k) funds at the company where they currently work.
401(k) Hardship Withdrawals
Under certain circumstances, some 401(k) plans allow for hardship distributions. If your plan does, the criteria for eligibility should appear in the plan documents.
Hardship distributions are typically offered penalty-free in the case of an “immediate and heavy financial need,” and the amount withdrawn cannot be more than what’s necessary to meet that need. The IRS has designated certain situations that can qualify for hardship distributions, including:
• Medical expenses for the employee or their spouse, children, or beneficiary
• Cost related to purchasing a principal residence (aside from mortgage payments)
• Tuition and related educational expenses
• Preventing eviction or foreclosure on a primary residence
• Funeral costs for the employee or their spouse, children, or beneficiary
• Certain repair expenses for damage to the employee’s principal residence
Hardship distributions are typically subject to income taxes.
Some retirement plans allow participants to take loans from their 401(k). The amount an individual can borrow from an eligible plan is capped at 50% of their vested account balance or $50,000 — whichever is less.
The borrower has to pay the money back plus interest, usually within five years. As long as they repay the money on time, they won’t have to pay taxes or penalties on a 401(k) loan. However, if a borrower can’t repay the loan, that’s considered a loan default and they will owe taxes and a 10% penalty on the outstanding balance if they are under age 59 ½.
IRA Rollover Bridge Loan
If you need money for a short period of time and you also happen to be doing an IRA rollover, you may be able to use that money as a loan — provided that you follow the 60-day rule. In short, the 60-day rollover rule requires that all funds withdrawn from a retirement plan be deposited into a new retirement plan within 60 days of distribution, Thus, within that 60-day window, you could potentially use the money you’re rolling over as a “bridge” loan.
401(k) Withdrawals vs Loans
While it’s generally wise to keep your retirement funds in your 401(k) for as long as possible to keep saving for your future, withdrawals and loans are possible if you need money. If you find yourself considering a 401(k) withdrawal vs. a loan, be sure to weigh the choices carefully. You’ll need to repay a loan plus interest within five years, and with an early withdrawal, you’ll either need to qualify for a hardship withdrawal and then pay income taxes on the withdrawal, or if you’re age 55, you may be able to take advantage of the rule of 55.
Cashing Out a 401(k)
Cashing out a 401(k) occurs when a participant liquidates their account. While it might sound appealing, particularly if an individual needs money right now and has no other options, cashing out a 401(k) has drawbacks. For example, if they are younger than 59 ½, the cashed-out funds will be subject to income taxes and an additional 10% penalty. That means a significant portion of their 401(k) withdrawal might be paid in taxes.
Rolling Over a 401(k)
If you’re leaving your job you may choose to roll over your 401(k) to continue saving for retirement.
This strategy allows you to roll the money into an IRA that you open and manage yourself by choosing investments — which may be things like stocks, mutual funds, and exchange-traded funds (ETFs) — and you won’t have to pay taxes or early withdrawal penalties.
With an IRA rollover, you might have a wider range of investment options than with an employer-sponsored plan (think of it as a kind of self-directed investing), and your money has a chance to potentially continue to grow tax-deferred.
The Takeaway
While it may be possible to withdraw money from a 401(k), certain factors like age and hardship distribution eligibility determine whether you can make a withdrawal without incurring taxes and penalties. You might also consider a 401(k) loan, but you’ll need to repay the money you borrow plus interest within five years.
If you are leaving or changing your job, you could opt to roll over your 401(k) into an IRA to continue saving for retirement. With a rollover, you won’t pay penalties or taxes.
Review your options carefully to decide the best course for your situation.
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FAQ
Can you take out 401(k) funds if you only need the money short term?
It’s possible to take out 401(k) funds if you only need the money short term. For example, you could take out a 401(k) loan if your plan allows it. There are limits on how much you can take out, however, and you need to repay the amount you borrow plus interest within five years. Just be sure you can repay the loan so it doesn’t go into default.
How long does it take to cash out a 401(k) after leaving a job?
The length of time it takes to cash out a 401(k) after leaving a job depends on your employer and the company that administers your 401(k) plan. The process generally takes anywhere from a few days to a few weeks.
What are other alternatives to taking an early 401(k) withdrawal?
One alternative to taking an early 401(k) withdrawal is to take out a 401(k) loan instead. You will need to repay the amount you borrow plus interest within five years. As long as you do that, you won’t owe taxes on the money you borrow with a 401(k) loan.
At what age can I withdraw from my 401(k) without penalty?
You can withdraw from your 401(k) without penalty at age 59 ½. However, if you are 55 or older, and you leave or lose your job in the same calendar year that you’re 55 or older, you may be able to take out money without taxes or penalties if your 401(k) plan allows it. This is thanks to a provision called the rule of 55.
When can I access my 401(k) funds if I’m already retired?
If you are already retired, you can access your 401(k) funds anytime you like as long as you are at least 59 ½ years old. Just remember that you will owe income tax on the money you withdraw, so plan accordingly.
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