Saving money today for tomorrow’s expenses is the best way to ensure long-term financial security. With the future of the nation’s supplemental retirement income program up in the air, consumers are urged to save as much money as possible during their working years in order to grow retirement funds.
One of the most popular methods of saving earned income for retirement is through employer-sponsored retirement programs that offer tax benefits. Here we look at the 401(k) program and how it is taxed:
Tax-Deferred Retirement Plans
The passage of the Tax Reform Act afforded taxpayers new opportunities to save for retirement while also enjoying certain tax benefits. Tax-deferred retirement plans, such as a 401(k), make it possible to deposit regular contributions into a retirement fund through employer-sponsored programs. Annual contributions (within IRS guidelines) are not taxed like regular income, making it possible to save money while at the same time reducing taxable earned income for the year. Employer-sponsored 401(k) retirement plans also provide the additional bonus of receiving free money from your employer, who may choose to match all or part of your contribution amount.
Contributions and Distribution Rules
Employees who participate in an employer-sponsored 401(k) plan determine a set percentage of their pay to contribute to their retirement account each year. The amount of money set aside by yourself and your employee reduces your annual taxable income. Tax-deferred growth of contributions and investment earnings are the main draw for individuals to participate in this type of plan. No distribution of funds may occur before the account owner reaches the age of 59½, barring few exceptions. If money is withdrawn from the account prior to this age without qualifying conditions being met, a 10% early withdrawal penalty, plus payment of all applicable taxes, will apply. Although all distributions from a 401(k) are subject to regular tax rates at the time of distribution, the following exclusions may allow for distributions without the additional 10% penalty prior to age 59½:
- Disability or death
- Court-ordered distributions as part of a divorce or separation agreement
- Payment of medical expenses in excess of 7.5% of AGI
- Purchase of home (must not own home at the time or within the previous two years – maximum $10,000 distribution qualifies for tax penalty exemption)
- Immediate and extreme financial hardship
In the event that the distribution prior to age 59½ qualifies you for an exemption, early withdrawal penalties may be avoided.
Minimum required distributions are necessary beginning at age 70½. Just as early withdrawal of distributions trigger a tax penalty, so does the failure to take required minimum distributions. Account owners who do not take the minimum required distribution as specified by the IRS will be subject to a penalty of 50% of the required amount. Additionally, state and local taxes will be owed on that amount. Minimum required distributions may not be rolled over to another retirement plan, as this money is intended to provide for expenses in your retirement years, and not to be passed on to beneficiaries at the time of your death.