Tax-deferred investing has some strings attached, but it doesn’t have to tie you in knots. The one tangle you can’t avoid is owing federal income tax—plus state and local tax if they apply—at your regular tax rate on your retirement income. If the income is paid from your 401(k) plan, a percentage of each payment will probably be withheld to cover what you owe.
One argument for taking as little as permitted from your 401(k)—though not so little that you withdraw less than the required minimum—is that it reduces your annual income tax bill. But remember that anything that remains in your account at your death becomes part of your estate, potentially vulnerable to estate taxes.
If you take an early withdrawal, which usually means taking money out of your account before you turn 59½, you may owe an additional 10% penalty on the amount you take. However, if you retire, change jobs, or stop working at 55 or later and begin withdrawals, that penalty won’t apply.
There’s another alternative if you want to begin withdrawing early. You can set up what’s known as a series of substantially equal withdrawals over a period of at least five years or until you turn 59½, whichever is longer. The tax applies, but not the penalty. The drawback, though, is that you will probably have used up a substantial portion of your savings before you’re ready to retire. That could leave you short of cash when you need it.
| Taxed Sooner, Not Later The only withdrawals that aren’t taxed are the after-tax contributions you may have made to your account, if any. But you can’t take that money first, or as a lump sum. Rather, you must calculate the percentage of each withdrawal that it represents. |
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