Tax Treatment of 401(k) Accumulation

• Contributions to 401(k )plans are not taxed in the current year. Instead, the employer deducts the appropriate amount from the employee's cash compensation and deposits it directly into the worker's 401(k) plan. The worker never receives the money and is therefore not taxed on it. No tax is due on interest, growth or capital gains until the money is taken out as income, generally in retirement.
  
  

Penalties for Early Withdrawal

• The 401(k) is designed to be a long-term savings vehicle for retirement. In exchange for the tax benefits, Congress has imposed a substantial penalty of 10 percent on withdrawals prior to the age of 59 and a half. This is in addition to any income tax due on the withdrawal, as withdrawals are fully taxable at the federal and state level. There are exceptions to the 10 percent penalty, however, including disability, to avoid eviction or foreclosure, to pay medical insurance premiums, to pay higher education expenses or to fund a down payment of $10,000 or less on a first-time home purchase. You can also make penalty-free withdrawals by committing to a series of substantially equal periodic payments over your lifetime, under Section 72(t) of the Internal Revenue Code.
  
  

Tax Treatment in Retirement

• Withdrawals after age 59 and a half are free of the 10 percent penalty, but are fully taxable as income at the federal and state level. However, Congress did not intend for the tax deferral benefit of 401(k) plans to last forever. You must begin taking taxable withdrawals -- called "required minimum distributions," or RMDs -- by April 1 of the year following the calendar year in which you turn 70 and a half. You must calculate your withdrawal amount according to a specific formula the IRS publishes in Publication 575.
  
  

Penalties in Retirement

• If you don't take your scheduled required minimum distribution for the year, the IRS charges a substantial 50 percent penalty on the amount they believe you should have withdrawn. In most cases, this is greater than the combined federal and state income tax bill you would be liable for if you had taken your RMD on schedule.