Figuring out taxes and your 401k can be a complicated topic. This particularly comes up when you go to make 401k withdrawals.
A traditional 401k is different from other types of accounts in one key sense, and that is how your taxes are handled. Your contributions for your account are taken from your pretax income. This means that before the money you owe for taxes are taken out money for your retirement account are taken out. This makes a number of things happen.
First of all, it lowers your yearly income as far as the federal government is concerned, which may lower you into a lower tax bracket, which would then lower the percentage you owe in taxes, saving you money right now.
This also frees up some more money for you to save right now and invest in your account.
However, when you go to make withdrawals, you will then owe taxes on this money–making it less of a deduction and more of a deferral. You are only putting off paying taxes until you make withdrawals from the account.
At this time you will have to pay on this money. Both federal and state taxes. If you cash out money from your account before reaching the retirement age (fifty nine years and six months of age) then you will also owe a ten percent early withdrawal penalty on top of these taxes.
Depending on your tax bracket the tax percentage can total twenty to thirty percent. This can be a huge blow.
It’s important to remember when looking at this blow, however, that you would have been paying on this in the first place. The advantage to putting this off is that it may lower your bracket in the year you make your contributions, and the money will be invested and earn you returns over the years, helping you grow your savings and reach your retirement goals.