Tax Implications of a 401k
A 401k is a tax-deferred retirement plan. Tax-deferred means that a participant can put pre-tax dollars into this account directly from their paychecks, and defer the payment of income tax on these amounts until they take them as a distribution at the later date. While one is working, their marginal tax bracket is generally going to be higher than when they are not working or in retirement. This means the actual dollar amount of taxes paid on these funds should be less than would have been paid had the participant taken the income at the time it was earned.
Rules of the 401k require the participant to wait until age 59.5 to take withdrawals.
If they take a withdrawal before the age of 59.5, they may be subject to an IRS
excise tax, often referred to as a penalty, of 10% of the total distribution, in
addition to the federal and state income taxes already assessed.
Exceptions to this rule
within a 401K are as follows:
- Distributions due to the death or disability of the plan participant.
- You retired or left your job after reaching the age of 55.
- You received the distribution as part of "substantially equal payments"
over your lifetime.
- You paid for medical expenses in the tax year which exceeded 7.5% of your
adjusted gross income.
- The distributions were required through qualified domestic relations court
order by a divorce decree or separation agreement.