What Does A Retiree Need To Know About Taxes, As They Apply To A 401K?

What does a retiree need to know about taxes, as they apply to a 401k? Any distributions from the 401k funds would be taxed just like any other investments. One of the many advantages of being old enough...

One of the many advantages of being old enough to retire is that you can now safely withdraw your 401k without any of the penalties associated with early withdrawal - assuming you are aged 59 1/2 or over. It is important to understand that everything in your 401k is now yours - the amounts you contributed through the years, the amounts your employer matched as well as any interest earned.

As with any tax issues you are advised to consult an experienced tax professional. Tax advisor and independent investment analyst Paul Dlouhy points out that "even though the money in your 401k may be yours now you have retired, any distributions from the 401k funds would be taxed just like any other investments".

So if you are in the enviable position of having just retired, when should you start to withdraw funds from your 401k? Generally, you are better off not withdrawing the money until you really need to - the longer it is in your 401k, the more interest the earnings will accrue. You may have other savings or retirement plans that you can live off without tapping into your 401k, however make sure to take distributions as required to avoid penalties.

One important thing to understand about a 40k plan is that having a 401k or another retirement plan will not affect the amount of Social Security benefits you will receive. This is one big advantage over a traditional pension when it comes to retirement - if your pension is from an employer who does not pay Social Security taxes - such as a government department - your Social Security benefit may be lower.

Dlouhy also explains that one drawback of leaving the money in your 401k for a long time is that eventually you will have to start taking money out of it. "If you haven't already been withdrawing money from your account, the IRS requires you to start taking money out by April 1st of the year after you reach the age of 70 and half". Ironically, even though you are retired, having to withdraw perhaps more money than you need to may push you into a higher tax bracket during the year you are taking out the money. This restriction does not apply to Roth IRA participants.

If you are lucky enough to retire early - that is, before the age of 60 - you are subject to the same choices as to what to do with your 401k funds - withdraw them, rollover the funds to another account or leave them where they are. (See question 7) There is one exception to the tax penalties for early withdrawal that some retirees try to take advantage of. If you withdraw money from your savings plan in equal or almost equal installments, amounting to one withdrawal per year throughout your lifetime, the IRS will not tax you. It's a relatively unknown loophole that can certainly help if you can afford to do it.

But for most of us Dlouhy emphasizes again "From a tax saving point of view, the best thing you can do is not withdraw from your 401k until you reach that magic age when you are permitted to do it".

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