Most retirees know that at some point they’re going to start moving money out of their 401(k) plans. But not everybody thinks about how that happens, or how many ways there are to do it. Or which ones could hurt their portfolios.

In fact, these plans often have specific redemption structures—and the withdrawals must automatically follow strict procedures. The bad news is that the way it’s done can thwart a retiree’s intentions or even throw asset allocations out of whack.

For example, some 401(k)s may take the requested money from low-risk assets in the accounts, inadvertently increasing a retiree’s risk exposure. Other 401(k) plans don’t allow partial withdrawals at all, according to Tamiko Toland, founder of 401(k) Annuity Hub in Santa Fe, N.M. While some plans allow participants to specify which fund or funds they want redeemed, other plans require the investors to take their money out “pro rata”—which means certain percentages of various holdings must come out.

Still other plans use a “hierarchy” approach—automatically taking money first from the lowest-risk and/or most easily traded funds, such as money-market investments, ostensibly to preserve the account’s growth potential, Toland said.

That means anybody who has more than one mutual fund or exchange-traded fund in their account could find themselves facing less than desirable distribution methods, Toland said.

Many clients don’t even discover these restrictions until too late. “This is something that an individual should find out during the retirement-planning process … before the need to take actual withdrawals comes up,” she said.

According to IRS regulations, clients cannot take distributions from retirement accounts before they turn age 59½ without incurring a 10% penalty—unless there are extenuating circumstances such as medical emergencies. In addition, Rule 72(t) allows for penalty-free early withdrawals if they are taken in periodic equal payments over a period of at least five years. (The amount of the payments depends on the account owner’s remaining life expectancy.) Some clients might feel desperate enough to take this route, but experts caution that it’s a last resort for reducing financial stress, and clients should first look into such measures as debt consolidation and bankruptcy before turning to these kinds of withdrawals if they are in bad financial straits.

Retirees should only take cash out of a 401(k) in concert with their overall retirement plan, Toland cautioned.

Plan Record-Keepers
The restrictions on clients’ withdrawals are often imposed by the plans’ record-keepers, she said, not the plan sponsors themselves. An employer might not even be aware of them. “Employers are increasingly working to create distribution options that support retirement income planning,” she said.

Take Fidelity Investments, which administers many of the nation’s 401(k) holdings. A company statement explains that most plans—though not all—have the distribution rules outlined in documents such as the summary plan description. But even within Fidelity-run plans, every plan sponsor’s terms are different. There is no universal protocol.

To some advisors, such disclosures aren’t adequate.

“While the procedures may technically be disclosed somewhere in the plan documents, they’re rarely highlighted or explained in a way that’s clear to participants,” said Amber Kendrick, a retirement plan consultant at Procyon in Shelton, Conn. The protocol is often buried in the record-keeper’s operating procedures or custodial agreements, she said, not clearly disclosed in participant-facing materials. “This lack of transparency can lead to confusion or unintended investment outcomes.”

To maintain a desired asset allocation, some clients might want to reallocate the funds in their portfolios before taking money out of their 401(k)s. Such a pre-emptive move “can be a smart strategy,” Kendrick said, “but only if it aligns with the participant’s goals and time horizon.” This sort of proactive approach could help the clients avoid an unintentional overweight in equities or an underweight in safer assets, she said, though it’s best to first try ascertaining the 401(k)’s exact default protocol before shifting assets.

“As a 401(k) advisor, I recommend that participants understand whether their plan has a set withdrawal protocol before taking any distributions. Not all plans do,” she said.

To know for sure, she recommends asking the plan administrator or record-keeper directly for specific guidance. “As advisors, we make it a point to review these operational details with our clients so they’re not surprised later. Understanding how the plan handles withdrawals is a crucial part of retirement planning—it’s not just about how you save, but how you spend that matters.”

By the same token, clients shouldn’t make rash withdrawals from their retirement plans. “We do not allow [clients] to blindly rebalance,” said David Demming, president of Demming Financial Services in Aurora, Ohio. “We oversee it.”

Other advisors recommend that when clients want to take money out of their 401(k) plans, they should request specific funds to be sold rather than a dollar amount.

“I don’t believe a company can force a distribution on certain funds versus an employee’s stated desire for specific funds to be sold,” said Charles Weeks Jr., a certified financial planner at Barrister in Philadelphia.

He acknowledged, however, that some companies’ rules may say that if the client does not specify what funds to sell, the companies themselves may start by selling off the funds with the lowest expense ratio. “This is likely on a custodian-by-custodian basis,” Weeks said. “But yes, clients should be aware that if they don’t give specific instructions to the custodian, the custodian may just choose what they sell to make the distribution.”

The most important lesson, Weeks said, is to stay vigilant and aware of “the overall allocation of the portfolio.” If rebalancing is necessary to maintain the desired mix, the timing shouldn’t matter. “Given that rebalances in 401(k)s are tax-free events, I don’t think it is impactful whether it occurs before or after the distribution,” he said.