Stashing away money for retirement is a good idea, but putting it away in a tax-advantaged retirement account like a 401k plan is a great idea. Even better, your employer may even kick in extra money to match all or a portion of what you put away. However, before you defer your salary, make sure you know when you can get the money out if you need it.
Accessing Your Funds
Just because you have money in your 401k plan doesn't mean that you can access it whenever you want. The IRS restricts distributions from the 401k plan until after you turn 59 1/2 years old, when you are permanently disabled, when you leave the company, or when you have a qualifying hardship. Qualifying hardships depend on the specific rules of your company's 401k plan. Examples of possible hardship distributions include taking money out to avoid your home being foreclosed or catastrophic medical bills.
Taxes and Penalties
Money that you defer into your 401k plan is not taxed in the year you earn it. Instead, the taxes are deferred until you take distributions, so Uncle Sam will be expecting to hear about all of your 401k plan distributions on your tax return. In addition, if you are not 59 1/2 years old when you take the 401k distribution, you will owe an additional 10 percent tax unless you qualify for a specific exemption.
The IRS exempts specific early distributions from the 10 percent additional tax. Not all hardships qualify for the exemption: you must meet a specific exception. Exceptions include retiring after you turn 55, suffering a permanent disability, have medical expenses that exceed 7.5 percent of your annual gross income, or have the IRS levy the 401k plan. However, if you lose your job and spend the money on living expenses, the IRS doesn't give you a break: you still owe the penalty.
The IRS doesn't allow you to sit on the money in your 401k plan and reap the benefits of tax-sheltered growth indefinitely. Beginning in the later of the year you retire or the year you turn 70 1/2, you have to start taking minimum required distributions. The amount of the minimum distribution is calculated by dividing your 401k plan's value as of the end of the prior year by your life expectancy. To find your life expectancy, you use the life expectancy tables found at the end of IRS Publication 590.
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