401(k) Plan Withdrawals and Your Taxes

For a comfortable retirement, you may need to amass hundreds of thousands of dollars in savings before leaving work. To meet that end, you can put money into a 401(k) plan, which does feature tax breaks for long term savers. 401(k) withdrawals, however, do trigger ordinary income taxes that will subtract away from your bottom line. Before plotting comprehensive investment strategy, you should become familiar with basic tax law, as it relates to the 401(k) vehicle.

Identification

401(k) contributions are made with pre-tax money out of your paycheck. In some cases, your employer will also match your contributions on a dollar-for-dollar basis. Once the money is in your account, you can purchase mutual funds that will grow on a tax-deferred basis. Tax deferral means that you will not owe taxes on interest payments, dividend income, or realized capital gains as they occur within your 401(k). At retirement, your 401(k) withdrawals will be taxed as ordinary income.

Ordinary Income Taxes

As of 2010, ordinary income is taxed at 10, 15, 25, 28, 33, 35, and 39.6-percent rates. The progressive U.S. tax code features brackets, where higher levels of your income are taxed at higher rates. For example, you may report $30,000 in taxable income as a single filer — without taking a 401(k) withdrawal. At that point, your taxable income between $0 and $9,225 would be taxed at 10 percent ($922.50). From there, your remaining $21,675 in taxable income would be taxed at 15 percent ($3,251.25 + $922.50 = $4,173.75).

After taking a $10,000 401(k) withdrawal, however, you would owe taxes on a higher taxable income of $40,000 and move into a higher tax bracket. As a single filer, taxable income between $37,451 and $90,750 is subject to 25 percent tax rates.

Early Withdrawals

You generally cannot withdraw money out of your 401(k) account until age 59 ½ — without a 10 percent additional tax penalty. For early withdrawals, you would pay the 10 percent penalty on top of the higher ordinary income taxes owed from the withdrawal. In some cases, you may be exempt from the 10 percent additional tax penalty. For example, you could bypass the 401(k) early withdrawal penalty if you are permanently disabled or are using the money to pay for medical expenses that exceed 7.5 percent of your taxable income. The IRS defines permanent disability as being unable to perform any job.

Required Minimum Distributions

At age 70 ½, you are required to begin taking withdrawals from your 401(k) account. Your required minimum distributions (RMDs) take the size of your account and life expectancy into considerations. To calculate your required minimum distribution, you will complete worksheets within Publication 590, which is the IRA instructional booklet. 401(k) and IRA plans share similar RMD rules. If you fail to take your required minimum distributions, you will be subject to tax penalties.

For greater flexibility, you should consider combine a taxable brokerage account alongside a 401(k) plan. At any time, you can pull money from your taxable brokerage account and avoid the additional tax penalty for early retirement account withdrawals.