The Dreaded 401K Tax
While contributions in the before-tax account of 401K plans are not ordinarily subject to 401K taxes, certain circumstances may cause the imposition of tax. The most common reason to incur 401K tax is to withdraw funds before you reach retirement age. This does not refer to loans, but to withdrawals; however, in the event that you leave your company and cash out your 401K to roll it over, you will be subject to tax on any portion of the loan that has not been repaid unless you take the funds and reinvest them into your new 401K plan.
The government backed the birth of 401K tax-free funds because of simple rules of life. During our working life, we tend to have income generating on a regular basis including regular salary increases. When you retire, the consensus is that you will have less money coming into your household, so the 401K tax will automatically be less. Of course, this does not hold true for those who work for companies who still have a traditional pension plan in addition to a 401K, but starting in the late 20th century, many companies began to do away with their pension plans and offer only 401K plans, often taking funds from the pension plans and transferring them into the 401K plans. For those who collect both pension and 401K, however, it's unlikely that you will experience much of a reduction in salary. There is, however, a portion of pension that is not subject to 401K tax. This varies by state on the state level, but your tax advisor can keep you up to date on the amount of pension that is tax-exempt when that time comes.
Keep in mind that although the 401K tax will not affect you as you are saving for your retirement, it will be an active participant when you retire and start collecting on the funds that you have invested over the years. This may not be deducted from your period distributions, so make sure that you set money aside to pay your 401K tax when the time comes to do so. Even though taxes are an inevitable part of life, a 401K plan, if setup properly, can easily give you plenty of money for retirement even after paying taxes. So if the thought of taxes is keeping you from opening a 401K, then stop thinking about taxes and start saving for retirement.
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