Effect of Taxes on 401k Retirement Savings Accounts

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.

Dividends & Earnings

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.

Early Withdrawal Penalty Exceptions

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

401k Hardship Withdrawals

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)