A 401(k) plan lets you contribute money on a before-tax basis, giving you more money to invest and, hopefully, have grow. However, when you start taking money out of your 401(k), you'll have to pay regular income tax on every penny of it. Furthermore, because distributions become mandatory once you turn 70 1/2 years old, it's challenging to avoid paying at least some taxes.
The tax rate that you pay isn't just based on your income. It's also dependent on how you file your taxes. Generally, married couples that file separate returns have the narrowest brackets and pay the highest rates while married couples that file a joint return have the broadest brackets and pay the lowest rates. In between the two types of married returns, single tax payers pay higher rates than heads of households, which are single people that are taking care of and providing a home for at least one dependent.
For the 2013 tax year, the Internal Revenue Service has seven tax brackets ranging from 10 percent to 39.6 percent. For a married couple filing jointly, the first $17,850 in income gets taxed at 10 percent, while anything between $17,851 and $72,500 is taxed at 15 percent. The 25 percent bracket applies to income between $72,501 and $146,400, and income above that level is taxed at 28 percent until you reach $223,050 of income. At that point, the 33 percent bracket applies up to $398,350, the 35 percent bracket applies on income up to $450,000 and 39.6 percent tax applies on incomes more than $450,001.
Marginal Tax Rates
The money that you take out of your 401(k) will be taxed at your marginal tax rate. The marginal tax rate is the rate that you pay on your first dollar of additional income. For example, if you have $65,000 of consulting income per year and an additional $50,000 of taxable investment income, your first dollar of 401(k) withdrawals will be taxed at the tax rate applicable to incomes of at least $115,001, and the rate will continue to increase as you go up through the tax brackets. If you don't have any income other than 401(k) withdrawals, your marginal tax rate calculation works the same way, but you start from zero instead of starting from your first dollar after your other income. If you're married and pull out $45,000 in 2013, for example, your first $17,850 is subject to the 10 percent rate and the remaining $27,150 is taxed at the 15 percent rate.
The IRS requires you to start taking required minimum distributions on April 1 of the year after you reach 70 1/2, although you can begin withdrawing from your 401(k) without penalty once you turn 59 1/2. The amount that you have to withdraw varies depending on your age and life expectancy and is outlined in tables published by the IRS in Publication 590. There are two ways to avoid tax on required minimum distributions. The first is to continue working for the company that sponsors your 401(k), as long as you aren't an owner of the company. The second is to donate your minimum distribution to charity.
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