Retirement plans like 401(k)s and individual retirement arrangements offer a variety of tax benefits, but they are also subject to government regulations that place limitations on withdrawals. Most retirement account withdrawals are subject to federal income tax in the year of withdrawal. Retirement funds may also be subject to penalties if funds withdrawn before retirement or if account holders fail to make required withdrawals.
Defined Contribution Plans
Defined contribution plans are retirement plans provided by employers to employees. The most common type of defined benefit plan is the 401(k) plan, which lets employees save money for retirement on a pretax basis. Other defined contribution plans include 403(b) plans, which are available to employees of public schools and certain tax-exempt organizations and 457 plans, which provide benefits local and state government workers. Withdrawals from defined contribution plans are subject to federal income tax in the year with withdrawal.
Individual Retirement Arrangements
Individual retirement arrangements are plans with tax benefits that individuals can open privately with financial institutions like bank. There are two basic types of IRAs: traditional IRAs and Roth IRAs. Traditional IRAs are similar to 401(k) plans in that funds are subject to income tax at the time of withdrawal. On the other hand, withdrawals from Roth IRAs are usually not subject income taxes upon withdrawal as long as an account holder waits 5 years to withdraw funds after opening an account.
Retirement account withdrawals made before the age of 59 1/2 are considered early withdrawals. Early withdrawals from 401(k) plans, traditional IRAs and 403(b)s are subject a 10 percent early withdrawal penalty in addition to applicable income taxes. Contributions can be taken out of a Roth IRA at any time tax free, but early withdrawals of investment gains are subject to income tax and the 10 percent penalty. Section 457 plans are not subject to early withdrawal penalties. Withdrawals made in certain special circumstances, such as due to disability or death, are exempt from the penalty.
All employer sponsored retirement plans and traditional IRAs are subject to required minimum distributions. Required minimum distributions force account holders to begin withdrawing funds starting at age 70 1/2. Failure to make a required withdrawal results in tax penalty of 50 percent of the amount the account holder did not withdraw. Roth IRAs are not subject to required minimum distributions.
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