401K Withdrawal
Added: September 27, 2006
A 401K withdrawal can, and should be controlled. Assuming that the 401K account is being used for the intended purpose of retirement after age 59 and a half, then the holder of the 401K account can, by staying in close contact with an accountant or tax preparer or by simply keeping track of income and IRS rules, control 401K withdrawals in such a way as to minimize taxes paid.
For instance, if a person has $100,000 in a 401K account and has $10,000 a year in social security income, then a $401K withdrawal of $10,000 a year would give the retired person $20,000 a year in income to live on and taxes would only be paid on the $10,000 per year of 401K withdrawal funds, keeping the retiree in a lower income tax bracket than if that person were to withdraw $100,000 all at once. This is because 401K accounts are tax deferred, and taxes are only paid on the initially deposited funds and the interest or profits that they have accumulated when that money is withdrawn and actually used, allowing the person who owns the account to exercise a great deal of control over taxes paid and over the 401K withdrawal.
The benefit of this is, of course, obvious. The person who is withdrawing funds is retired and therefore probably has a lower income than was maintained when this person was a full time member of the workforce. The retiree may have been in a very high percentage tax bracket when working but it is natural to be in a lower tax bracket when a person retires. Most people are able to maintain their lifestyles properly when income is lowered because they no longer have many of the expenses they once had, provided they have properly planned for retirement.
As an example, most people have mortgages on their homes, ranging from fifteen to thirty years. Upon retirement the goal is to have the mortgage paid off and own the home free and clear. With no mortgage payment to make, which is often twenty five percent or more of a person’s income, then less money is needed in income to maintain the lifestyle the retireee is accustomed to.
What exactly is a 401K? A 401K is a retirement account maintained by an employer with funds that are tax deferred. It is very much like the IRA or Individual Retirement Account that many people use, but larger amounts of money can be placed into a 401K account. Also many times employers will match certain percentages of the contributions a person makes into a 401K which is in essence free money to the account holder. However, funds in a 401K account cannot usually be withdrawn until a person reaches retirement age. If a 401K withdrawn occurs early, then under most circumstances the account is subject to a ten percent penalty in addition to whatever taxes are owed at the current taxation rate. The idea behind a 401K , just like a standard IRA, is that a person will be in a lower tax bracket when he reaches retirement age. 401K accounts help the economy in several ways, among them by encouraging investment. They are also cheaper for companies to operate than traditional pension plans. Other accounts that are similar to the4 301K include versions for nonprofit organizations, and special accounts for people who are self employed. This are basically simple versions of the 401K and follow many of the same rules, and are known as SEP or simplified employee pension plan, and Simple IRA. A financial advisor can explain the differences between the types of accounts and which one is right for an individual. Another type of retirement account that is mentioned often in the news is the Roth IRA. The Roth IRA differs from a 401K or a traditional IRA in that the money deposited in the account is taxed, and is considered “after tax dollars” rather than “before tax dollars” as with a 401K. But, all funds deposited into a Roth IRA and everything that those funds generate, in the way of interest or dividends, is tax exempt in the future, which over the course of several years can create tremendous growth.
It is interesting to note when discussing 401K withdrawal and related subjects that the 401K account, named after the section of the US tax code that created and authorized it, has become so popular as a vehicle for savings and retirement that many other countries informally refer to similar programs as 401K type accounts. These accounts are popular in Japan, Australia and Canada among many other countries.
Of course there are other reasons for a 401K withdrawal and some of them are seen by the IRS as valid and legitimate. For instance purchase of a home, or to avoid foreclosure on a family home, unforeseen medical expenses, or sending a child to college with related medical expenses. Most people see these as valid reasons to tap into savings plans and the Federal government agrees. A 401K withdrawal under these circumstances is seen as legitimate and will not be versions of the 401K designed for very small businesses. There are also versions of the 401K account designed for those employed by non-profit organizations. And there is a cousin called the Roth IRA, which is the only retirement account that is not tax deferred. With a Roth IRA after taxes are paid money is placed into the account, but that account is never taxed again, allowing it to accrue large amounts of money over the years since the interest and principle are not taxed, and quickly multiply. Funeral expense for the account holder, the account holder’s spouse, or children is also taken into account and allowed as a valid reason for 401K withdrawal by the IRS.
A 401K withdrawal should never be undertaken for frivolous reasons or seen lightly. The 401K account is primarily there to help with retirement so only true and real emergencies should be considered as possible reasons for a 401K withdrawal. Of course, if a person follows Federal standards and guidelines when it comes to 401K withdrawal then they are probably doing just fine.