Retirement is an exciting time to plan for. It’s an incredible achievement that many work for years toward. As the date nears your final day at work, it’s time to start thinking about how to manage your finances in retirement. You’ve saved for years, but you will want to continue to plan into your retirement to limit tax exposure so your money lasts.
401ks and pensions are the two most common ways to finance retirement outside of Social Security benefits. Most workers know they should save for retirement, but they don’t know a whole lot about how taxes will affect them down the road.
401k plans are offered by employers as a benefit to their employees. Wages are deducted from each paycheck and go toward your 401k contributions. In many cases, organizations match employee contributions up to a certain limit.
Contributions that you make into a 401k reduce your adjusted gross income, which helps lower your overall tax liability each year.
Some workplaces also offer Roth 401k plans. Roth 401k plans allow you to determine what portion of your contributions are made pre-tax or post-tax. They traditionally follow the same rules as contributions made to a traditional or Roth IRA. However, the contribution limits on 401k plans is much higher.
Employers don’t have to match employee contributions. However, most established companies will offer matchings as part of a larger benefit package. Employees want to know their employer has a vested interested in helping them prepare for retirement.
When it’s time to make withdrawals from a traditional 401k account, you will have to pay taxes on not only the original contributions, but also on the earnings of the account.
Also, anyone who withdraws funds before the age of 59 ½-years-old from a 401k account is subject to a 10 percent penalty on the amount withdrawn, plus taxes.
The biggest difference between a pension and a 401k plan is that a pension is funded by the employer, while a 401k is funded by the employee.
Pension plans also do not grant you the ability to control the contributions you make to the account, unlike in a 401k. Some people like 401k plans because they can choose what investments to make with the money.
However, on the flip side, the one advantage of pensions over 401k plans is that you are guaranteed a monthly check during retirement. The same is not true of a 401k.
Distributions of a 401k and Pension
You have the right to withdraw money, or take distributions from a 401k account or pension at any time. It is your money and the federal government cannot control when and how you choose to spend it.
However, they can control what types of penalties and taxes the government assesses for early withdrawal. Early withdrawal for a 401k is defined as any time before you are the age of 59 ½-years-old.
The problem with early distributions is you face a stiff tax penalty. The IRS not only taxes you on the income but also places a 10 percent penalty on the amount withdrawn. The larger the amount, the higher the penalty.
Taxes on Traditional 401k Plans
Taxes for a 401k plan depend on whether you have a traditional account or a Roth 401k. Distributions from a traditional 401k are fairly straightforward.
Your contributions to the account are paid with pre-tax dollars which helps reduce your taxable earned income, ultimately reducing your tax liability. Since taxes on the contributions are deferred, you have to make up for it once you start taking distributions.
Distributions are taxed at the ordinary income rate of whatever your current tax bracket is. The situation is the same for a traditional IRA.
Taxes on Roth 401k Plans
Taxes are different on a Roth 401k. Roth 401ks require you to make contributions to the account with after-tax dollars. Therefore, you do not reap the benefits immediately by lowering your tax liability on annual income tax returns.
However, since you have already been taxed on the contributions, it is unlikely that you will also get taxed once you go to take a distribution. The major exception to the rule is if you have distributions that do not qualify.
Qualified distributions must “age” at least five years, and you must also meet the 59 ½ -year-old withdrawal age requirement. Withdrawing funds early will make you subject to the same penalties as a traditional 401k account.
Help for Unfair Tax Consequences of a 401k and Pension
Unfortunately, the IRS tends to penalize individuals who take their money out early from a traditional or Roth 401k. Thankfully, Levy & Associates is here to help.
We have years of industry experience and can help you sort through your 401k or pension issues. If you are facing stiff consequences for taking early distributions from a 401k or pension, please visit us at www.levytaxhelp.com or call 800-TAX-LEVY.