YOU ASK:

What are the tax benefits of 401k?

WE ANSWER:

Since the 401k retirement plan is a cash and deferred arrangement (CODA), participants can decide whether to receive their funds as cash, or invest the money they receive into the plan. Either way, any employee contributions made to the 401k plan are not currently subject to tax - a fact that makes 401k plans very attractive to the average American taxpayer.

Although federal income taxes are deferred now, they are not eliminated altogether. Federal income tax is payable upon distribution, whenever it takes place. If 401k participants make early withdrawals (before age 59.5), a 10 percent penalty is typically imposed on the distributed amount. However, individuals can be exempt from the premature withdrawal tax.

401k Early Withdrawal Tax Exceptions

  • If the plan participant passes away or becomes disabled;
  • If the 401k plan participant separates from service before retirement but after attaining age 55;
  • If the distributions are made to a payee under a qualified domestic relations order;
  • Medical expenses that are deductible, according to the Internal Revenue Service (IRS), are paid out with the distributions;
  • When timely 401k distributions are made to reduce an employee's elective deferral contributions and an employer's matching contributions, which are in excess.

The 10 percent early withdrawal tax applies even to hardship withdrawals. However, there is a provision in the 401k, which allows participants to take out money under a loan without being penalized.

Tax on 401k required distributions

Under current federal law, 401k plan participants have to start paying federal income tax on their distributions once they reach age 70.5 or upon retirement, whichever is earlier. This rule acts as a put-off for some people, especially for those who expect to be in a higher tax bracket when they retire.

Yet another 401k drawback is that 401k participants have to receive a required minimum distribution (RMD) amount on a regular basis when they retire but no later than the year in which they reach age 70 ½, regardless of whether they wish to, or not. Failure to do is harshly penalized - a 50 percent excess accumulation tax is imposed on the amount that is not distributed.

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