There are numerous ways to save for retirement in America, such as defined contribution plans, pensions, guaranteed income annuities (GIAs), and profit-sharing plans, to name a few. Defined contribution plans involve either an employer, employee, or both making regular contributions into an account. Pensions are the employer’s sole burden and they payout monthly to retired workers based on years of service. The other most familiar terms are 401(k) and IRA.
In America, a 401(k) is an employer-sponsored pension account. The name is derived from subsection 401(k) of the Internal Revenue Code. Amounts are deducted directly from employees’ paychecks, and some companies match each contribution with an equal amount of their own. Although many people are familiar with a 401(k) concept, not everyone understands how the tax works, thereby missing out on ways to minimize the potential unnecessary tax burdens from this type of account.
If you have a traditional 401(k), the amount you pay is based on your tax bracket. The more money you earn, the more you contribute. The money is meant to be left untouched until retirement, which is why there is an early-withdrawal tax penalty of 10% for taking money out before reaching the age of 59 ½. The way you pay taxes on a 401(k) depends on whether you choose a traditional or Roth. Traditional withdrawals are not taxed until you use the money, paying the current date at the time of withdrawal. Roth 401(k) contributions are taxed in real-time from paychecks at the current tax rate. The advantage is there is no tax to pay upon retirement, as long as the account is older than five years and the recipient is not interested in early withdrawal.
By law, even Roth accounts must payout required minimum distributions (RMDs) at age 72. This is the required minimum amount you must take to avoid tax consequences, even if the person is still working. One way to avoid RMDs is to consider IRAs instead of 401(k)s.
IRAs are individual retirement accounts created by people outside of their employment. People can choose between a traditional IRA and a Roth IRA. Traditional IRAs charge ordinary income tax on withdrawals from a traditional account. Much like a Roth 401(k), taxes are not charged on Roth withdrawals that meet the five-year requirement and age minimum.
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