Retirement accounts, from 401(k)s to traditional and Roth IRAs, offer lots of opportunities to grow your money with a tax advantage to boot. Participants in traditional 401(k)s, traditional IRAs, and Roth IRAs are not allowed to withdraw funds before age 59 ½ without penalty. If a hardship or life event makes this early withdrawal necessary, the typical penalty is 10% and the money withdrawn is taxed as income at the time it is received.
Retirement income is not immune to taxes. Taxes on required minimum distributions, including traditional IRAs and 401(k)s, are taxed on their gains and their pre-tax deductible contributions. However, because retirement is likely lower than when the individual was working this is typically taxed at a lower rate. The tax rate applied to this income is determined by the income of the recipient when the money is taken out. For the most recent tax year, this tax rate was capped at 37%.
A tax-deferred account offers immediate tax deductions for the full amount of the contribution. Future withdrawals from a tax-deferred account are taxed at your ordinary income rate. Tax-exempt accounts do not offer any tax benefits at the time of contribution. However, any future withdrawals are tax-free including returns on the investment.
A resident in Hudson was looking for the best way to begin saving for retirement. Confused about the difference between tax-deferred and tax-exempt accounts, he sought the advice of Merrimack Tax Associates.