Putting money in a tax-advantaged retirement plan such as a 401(k) typically saves money on taxes in the long run, but retirement plans don't avoid taxation completely. With plans such as 401(k)s where contributions come out of before-tax income, you have to pay taxes when you withdraw or distribute funds during retirement. You also may be subject to withdrawal penalties if you access funds too soon or fail to withdraw money later in life.
401(k) Distribution Basics
Contributions to a 401(k) are deducted from your pretax income, so you don't pay income tax on contributions in the year you make them. In addition, any investment gains in the form of capital gains, interest and dividends are tax-deferred, meaning such gains aren't taxable at the time you earn them. Instead, you include 401(k) distributions in your normal taxable income in the year of withdrawal. Some workers have lower annual incomes during retirement than they do during their working lives; delaying taxes with a 401(k) plan can be especially beneficial for such individuals.
If you take money out of a 401(k) before you reach 59 1/2, the withdrawal is considered an early distribution. Early distributions are subject to a 10 percent early withdrawal penalty in addition to normal income taxes. The government imposes early withdrawal penalties to discourage the use of retirement funds for reasons other than paying for expenses during retirement. The early withdrawal penalty also applies to traditional individual retirement accounts, so you can't avoid it by saving in an IRA instead of a 401(k).
The government makes exceptions to the early withdrawal penalty in a few special cases. According to the Internal Revenue Service, distributions made due to a permanent disability, inheriting a 401(k) or medical expenses that exceed 7.5 percent of your adjusted gross income are exempt from the penalty. If you are separated from service with an employer, distributions are not penalized if the separation occurred in or after the year you reached age 55.
Required Minimum Distributions
The governmental forces you to distribute 401(k) funds later in life to avoid tax penalties. Beginning at age 70 1/2, you have to start taking "required minimum distributions" from a 401(k) each year. If you fail to take a required minimum distribution, a 50 percent tax penalty applies the amount you don't withdraw. If you keep working past the age of 70 1/2 you can avoid required minimum distributions until the year you retire.
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.