One of the best advantages of contributing
towards a 401k retirement savings account is tax deferral.
The contributions you make towards one come out of your
GROSS Income (meaning your income before taxes are cut).
Tax deferral on 401k savings accounts has 3 advantages:
1) Your current taxable income is
lowered. For example, if you earn $10,000 per month, and
contribute 10% of it towards a 401k retirement savings
account, then your current taxable income is lowered to
90% x $10,000 = $9000. Instead of paying taxes on the
$10,000, you will be paying taxes only on the $9000!
2) You could thus put this $1000
into a savings account and let it earn you interest!
3) Note that you will be taxed on
this $1000 when you withdraw it upon retirement. However,
during retirement, you will most likely be in a lower
tax bracket (because you will stop working). This means
you will have to pay lower taxes on this $1000 which will
have grown to more than $1000 thanks to compounding interest
and your investments.
Any dividends and interest earnings
that you make on your pre-tax 401k contributions are just
put back into more investments and accumulate your earnings
tax-deferred over time. All of these earnings will NOT
be taxed until you withdraw them upon retirement.
Note: If you withdraw this money before the age of 59.5,
you will be charged a 10% early withdrawal penalty fee
as well as pay local and federal state taxes.
As mentioned before, if you withdraw
money before the age of 59.5, you will be subject to a
10% early withdrawal penalty fee as well as pay your local
and federal state taxes. There are however a few exceptions
to this rule:
- Leaving your current employer at
the age of 55 or higher
- Becoming disabled (as defined by
the Internal Revenue Code)
- Facing unexpected medical bills
(these bills should not exceed the total 401k deductions
on your income tax return)
- Withdrawing money in equal installments
over your total life expectancy
Here are some of the reasons that
allow you to make 401k hardship withdrawals:
1) Large medical bills for you, your
spouse or family
2) Buying a house (your primary residence) - this excludes
the mortgage payments
3) Paying university and post-secondary school fees for
your children, dependents, spouse, etc
4) To prevent foreclosure of your home... (Read
more about 401k hardship withdrawals here)
