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How 401k is taxed

how 401k is taxed


Best Answer: The withdrawal will be taxed as ordinary income so the basic tax bite will depend upon your marginal tax bracket. Then, if you are under age 59 1/2 when you take the distribution from the fund, you will pay an additional 10% penalty tax on the distribution. Therefore if you are in a 25% tax bracket you WILL pay 35% in total taxes. When you take the distro, 20% will be withheld for Federal income tax. Unless you're in the 10% tax bracket (very low income, inclusive of the distro) then not enough will be withheld to pay the tax and you may have to write a check for the difference at tax time next year or, more wisely, make an estimated tax payment using Form 1040-ES to avoid the chance of any penalties for underpayment of taxes.

One more MAJOR consideration is in order. Virtually ALL 401(k) plans restrict in-service distributions to certain exceptional cases only, such as to pay medical bills that exceed 7.5% of your AGI. In all other cases, you would need to QUIT your job to take a distribution from the 401(k).

A 401(k) (or any other retirement plan for that matter) is a LONG TERM investment towards your future. It should NEVER be used to cover current bills unless you are facing eviction, foreclosure or possibly bankruptcy. (Retirement funds are generally protected in bankruptcy proceedings so even potential bankruptcy isn't a good long-term reason to take a distribution.)

While current values of your investments are low, and

therefore the fund APPEARS to be losing money, consider the fact that your investments now while prices are low buy MORE shares in the various funds. When prices plummet, I tend to INCREASE my contributions as it will INCREASE my total holdings down the road and have a major POSITIVE impact on my total wealth at retirement time.

Don't fall into a short-sighted trap with what appears to be current losses. Make the bargain basement prices today work for YOU and your FUTURE. That's what you have the 401(k) for in the FIRST place. Quitting your job today and taking that distribution now could be the difference between Alpo and filet mignon in your "Golden Years."

Some 401(k) plans do permit you to borrow from your fund, however not all do. If yours permits you to do so then this would be the best way to proceed. You do pay interest on the loan, BUT all that interest goes straight back into the fund so you're really paying yourself the interest! One caution is in order though. If you leave that job before you pay off the loan in full, you have a VERY short period of time (days) to pay back the balance of the loan in full or it will be treated as a distribution from the fund and taxed as noted above.

Edit: If you want to get an idea of your marginal tax bracket, look at the Taxable Income line on your tax return. Then go here to figure your marginal rate:

Category: Taxes

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