Tax advantaged retirement accounts are one of the best ways to save for the future. 401K plans are retirement plans offered by many employers that allow employees to make contributions on a pretax basis and to defer taxes until money is withdrawn. Withdrawals from 401k plans are also called distributions. When taking distributions you will want to consider the rules regarding taxation.
401k Tax Rate
401k plans and traditional individual retirement accounts (IRAs) both offer the benefit of deducting contributions from your gross income. In other words, every dollar you save in a 401k plan reduces the pool of income that is subject to tax each year. In addition, investment gains within the plan are not taxed. Since taxes are not charged on 401k plan contributions and growth, they are applied at the time of withdrawal. 401k distributions are considered income and are taxed at the recipient's normal rate.
401k plans are designed to help workers save for retirement, but expenses may arise that tempt workers to tap into their plans before that. Early distributions from a 401k, which usually means withdrawals before age 59 1/2, are taxed as regular income, plus an a additional 10 percent penalty applies. You can also wait too long to take distributions. You must start taking required minimum distributions (RMDs) from your 401k plan when you reach the age of 70 ½. According to the IRS, if you do not take a RMD, the amount not withdrawn is taxed at 50 percent.
Early Distribution Exceptions
There are a variety of circumstances where the IRS allows for early withdrawals from a 401k account without penalty. The IRS states that distributions for medical expenses or those made to a beneficiary on or after the date of the account holder's death are not subject to a penalty. If you suffer from a disability or a federally declared disaster you may also be able to make penalty-free distributions.
401k plans can vary as to their exact rules and conditions. Some 401k plans allow participants to take loans from the plan. According to the IRS, loans taken from a 401k plan are not taxable if the loan is not in excess of $50,000 and is repaid within five years. Payments must be made at least once a quarter over the life of the loan. The IRS also states that participants can generally borrow up to 50 percent of their account balance up to the $50,000 maximum.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.