Ensuring to invest for your future in a 401(k) or IRA is smart financial planning, however, financial planning is not just about making smart investments for your future but knowing how to best use the accumulated funds at the time of retirement. Read this guide to know about your options for withdrawal of 401(k) or traditional IRA and the tax implications they carry.
A 401(k) is a retirement plan offered by employers to employees, where the employer has the option of contributing to the plan. The money deposited into the individual’s 401(k) account is tax-deferred, meaning, he/she does not have to pay taxes on it until the time of encashment, which is usually at the age of retirement, post 59 ½ years of age. The employee can choose how little or how much he/she wants to contribute, which will be deducted from his/her salary before taxes, thereby lowering his/her taxable income.
An Individual Retirement Account (IRA) works as a retirement investment account, that can be opened by individuals at banks and brokerages. The money invested is tax deferred and he/she can deduct the amount from his/her income to reduce his/her tax slab. Up to a maximum of $5,500 and an additional $1,000 after 50 years of age, can be invested in an IRA,
A Roth IRA is an “after-tax” account, which means an individual does not get any tax deductions. However, the investment is tax free and withdrawals also tax free. The main different between IRA and Roth IRA is the time at which tax is paid, before or after. The contribution limit remains the same for Roth IRA of $5,500 per year with an additional $1,000 available after the age of 50.
The IRS allows people of age 55 years and above, who retire or lose their jobs, to start taking distributions or withdraw their funds in their 401(k) account without the 10% penalty being imposed. However, the funds can only be withdrawn from the job you just quit/left and not the funds from your previous 401(k) accounts from previous employers.
[ Read: Cashing Out 401k Early ]
According to the IRS, once a person reaches 59 ½ years of age, he/she are entitled to withdraw the funds in his/her 401(k) account, either in one lump sum or at periodic distributions, which can be determined, with the aid of a financial advisor/tax planner. Withdrawal post this magic age, is penalty free and taxed as per the income tax slab category you fall into.
If a person chooses to continue working, then he/she can defer withdrawal or take lower periodic installments, based on the advice a tax advisor provides. However, keep in mind that while the amount withdrawn will have no penalties, it will be subject to income tax.
The IRS allows individuals to defer withdrawing their 401(k) funds after they reach 59 ½ years of age, should they wish to. However, once an individual reaches 70 years of age, the IRS requires him/her to make minimum withdrawals. The IRS requires individuals to withdraw the funds so that the amount is not transferred to heirs, resulting in a loss of tax revenue for the IRS. But taking the required mandatory distribution from your 401(k) in addition to your regular income might result in being pushed into a higher tax bracket.
Opting Roth IRA rollover is an advantageous method an individual can choose, as it offers tax free growth on the investments and withdrawals, as the amount invested in a Roth IRA, is taxed at the time of withdrawal of 401(k).
If at the age of retirement, the account holder decides to encash the entire amount in his/her 401(k) or IRA, then the amount will be subject to federal and state taxes. The money will be considered earned income and could result in the individual being in higher income bracket, resulting in paying more taxes being paid on the entirety. For any type of distribution/withdrawal, the individual will need to submit form 1099R along with his/her annual tax return.
If an individual chooses to withdraw the money in his/her 401(k) account in installments then he/she has the option of choosing from the following installment options. When an installment plan is chosen, the account remains open and investments continue to grow during the distribution period.
Any withdrawals/distributions from your 401(k) and IRA must be reported with your annual tax return using the IRS form 5329. The tax rate on the amount received will be taxed as per the income tax slab rate, unless it is an early withdrawal, which will attract an additional 10% penalty.
For NRI’s who have decided to move back to India, the question arises of what to do with the 401(k) account which is back in the U.S. On one hand it might be beneficial to leave the money untouched until you reach the retirement age of 59 ½ and then consider the available options. However, just as residents are subject to withdrawal taxes and penalties, the same is the situation for NRI’s, with minor differences such as the rules of Double Taxation Avoidance Agreement(DTAA), which will apply.
If you happen to be in India when you reach the U.S. retirement age, which allows you to withdraw the funds in your 401(k) account, then you can make a lump sum withdrawal, which will be subject to taxes in the U.S. and India. Therefore, in accordance to the rules of DTAA, you will need to request the payer to not withhold taxes in the U.S., as you will be taxed in India on your global earnings, which an expert tax advisor should be able to handle ensuring you maximize on tax savings. Withdrawals prior to 59 ½ years of age, will be subject to the 10% penalty. To avoid the penalty for withdrawals before the specified retirement age, you can avail of rolling over the funds into a traditional or Roth IRA.
Since a traditional IRA is the same as your 401(k), you can withdraw the funds in your 401(k) and roll it over into an IRA without any consequences. Moreover, as not all employers allow the funds to be rolled over into an IRA, having an international address will work in your favor.
As discussed earlier, Roth IRA is similar to IRA, except that there are no taxes on withdrawals, except on the earnings from dividends and interest. Rolling over into a Roth IRA also has no consequences. If at the time of your re-settlement in India, you belong to a lower income bracket, it might be financially wise to rollover into a Roth IRA and pay the taxes owing, so that at time of withdrawals you are not subject to taxes.
Withdrawing your funds from your retirement accounts such as 401(k) and IRA can have complex tax implications regardless of the time of withdrawal, distribution or the country from where you choose to cash out your funds. Wise financial and tax planning can ensure you pay the least amount of taxes possible.
A: If you are cashing out prior to age 59 ½ you will be subject to the 10% penalty and federal and state taxes, which will take a huge chunk out of your money. So you may want to explore other early withdrawal options, such as hardship withdrawal or penalty free withdrawal options. Therefore, unless it is absolutely necessary, you can transfer your 401(k) to your new employer and continue contributing and cash out at the time of retirement.
A: If you have changed employers, and are trying to locate the funds of your 401(k) funds of a previous employer, you can:
A: If your payments are coming by cheque, you can cash the cheque at your bank or credit union. Also banks throughout the nation, where you hold no account, will cash your 401(K) cheque for a minimal fee, provided you have valid ID proof.
A: Yes, however If you are cashing out your 401(K) before the retirement age, then you will be subject to penalties and federal and state taxes, unless in cases of hardship or penalty free withdrawal options.
A: If you are switching jobs then before you decide to cash out your 401(k), you may want to consider rolling over the funds into an IRA or Roth IRA, as the amount will be subject to taxes, penalties and added to your income, thereby increasing your total tax liability for the year.
To ensure you avail of the best tax savings options available to you while cashing out your 401(k) or IRA, enlist the aid of the international tax experts who will maximize your tax deductions and reduce your tax liability.