The U.S. has several different types of plans to help taxpayers with retirement. The most common plans are 401(k) plans and individual retirement accounts (IRAs).
401(k) plans are U.S. employer-sponsored plans that allow employees to contribute a portion of their wages. Employers often make pre-determined contributions or “matching contributions” to their employees’ plans, as well.
In contrast, IRAs are individual retirement plans available to most U.S. taxpayers who earn wages or other employment income.
The taxation of these plans depends on whether they are “traditional” plans or “Roth” plans. (Both 401(k) plans and IRAs can be set up as either traditional or Roth.)
Traditional plans are tax deferred. Owners make contributions using pre-tax dollars (or receive a tax-deduction for their contributions). Investments grow tax-free. Then, when owners or heirs take distributions from the accounts, the distributions are taxed at the recipient’s personal marginal tax rate, which may vary year to year.
In contrast, Roth plans involve paying tax upfront. Owners make contributions with post-tax dollars. Then, investments grow tax-free, and distributions are not subject to tax.
In general, under traditional plans, owners must wait until the age of 59.5 to start withdrawing the funds. Early withdrawals that do not qualify for an exception may result in a 10% early withdrawal penalty.
Furthermore, traditional IRAs require that owners start taking at least minimum distributions at the age of 70.5. Failure to take a minimum distribution may result in a 50% excise tax on the amount not distributed as required.
The goal under most traditional IRA and 401(k) plans is to withdraw the money when the individual’s tax bracket has decreased (i.e., to contribute during the highest earning-power years and withdraw during the lowest earning-power years).