Enjoying a high standard of living without the income provided by job is the primary focus of retirement planning. A 401k plan is a common type of retirement account that employers offer to their workers as a job benefit. A 401k plan can be a powerful vehicle to help you build wealth for retirement, but federal regulations place limits on many aspects of 401k plans like tax benefits, contributions and withdrawals.
The money you contribute to a 401k plan comes out of pre-tax income, which means you don't pay income tax on the funds when you contribute them. Instead, you pay income tax on 401k contributions when you withdraw them during retirement. In addition, you don't have to pay taxes on any investment gains that your 401k earns until you withdraw the gains. This delay of payment of tax on gains is known as "tax deferral." Delaying payment of tax until retirement can allow investments to grow faster and reduce taxes because your income tax rate during retirement may be lower than your current rate.
Considering the tax benefits of a 401k plan, you might be tempted to contribute a large portion of your total income each year to avoid as much tax as possible. The government limits the amount that you can contribute to a 401k plan. CNN reports that the maximum contribution to a 401k plan is $17,000 in 2012 or $22,500 if you're 50 or older.
Life is full of unexpected events like car crashes, storms and illnesses that may create a need for quick cash. Tapping into a 401k plan may seem like an obvious solution to immediate financial needs, but the government restricts early 401k withdrawals. The IRS says that withdrawals you make before the age of 59-and-a-half are subject to a 10 percent early withdrawal tax penalty on top of normal income taxes. This penalty makes early withdraws very expensive so it is generally best to avoid early withdrawals if at all possible.
Required Minimum Distributions
The government forces you to start taking money out of your 401k plan during retirement through "required minimum distributions." "Distribution" is another word for withdrawal. According to the IRS, you have to start making withdrawals from a 401k plan at the age of 70-and-a-half and if you fail to make required distributions, the amount you fail to withdraw is subject to a 50 percent tax penalty.