What is a Tax-Deferred Savings Plan?
A tax-deferred savings plan is usually an account that is associated with a person’s retirement savings, such as a 401(k) plan or an IRA. Tax deferred plans are also available for other purposes, including education savings plans. These plans work by deferring any taxable income accumulated in the account until a particular date or until the money is withdrawn, depending on the details of the account.
What are the advantages of a tax-deferred savings plan?
The most obvious advantage of these plans is the ability to save money without the need to pay current income taxes. This can be extremely helpful when trying to grow a retirement fund. The money deposited in these accounts, as well as any interest accumulated, is not taxable unless the amount deposited is in excess of what the law allows. In many cases, a person’s tax rate will be lower upon retirement than it is while they are working. By utilizing a tax-deferred savings plan, a person can avoid paying the higher tax rate while they accumulate retirement funds. The fact that taxes are not deducted up front also means that there will be more money in the account in the beginning, which can increase the amount of interest accumulated over time. There may be other advantages to tax-deferred plans as well, depending on the type of plan utilized. For example, in the case of a 401(k) plan, most employers have a system where contributions to the plan can be automatically made from a person’s paycheck. This can provide an easy method to add money to a tax-deferred plan over the course of a person’s career.
Do I have to meet certain requirements to participate in a tax-deferred savings plan?
Participation requirements will vary depending on the type of plan chosen. For example, in the case of a 401(k) plan set up through an employer, there might be requirements in regards to how long a person has been with the company, or whether they are a full-time employee. There can also be restrictions on how much money can be deposited into these accounts on a tax-deferred basis.
How will money be deposited into my tax-deferred savings plan?
If you are participating in a tax-deferred plan through your employer, such as is the case with a 401(k) plan, then it will generally be set up for deposits to be made directly from your paycheck. In these cases, money may also be deposited by your employer, often matching your contributions up to a certain amount. If you have set up your own IRA plan, you will be responsible for depositing money into the account.
When can I withdraw my money from a tax-deferred savings plan?
This depends on the type of tax-deferred savings plan chosen. In the case of a 401(k) or IRA account, the money should be withdrawn after reaching the age of 59 1/2 in order to prevent the 10% penalty that will result from an early distribution. If you are contributing to a 529 plan, this money should be withdrawn only to pay for qualifying educational expenses. Of course, it is always possible to withdraw your money from a tax-deferred plan early if you absolutely need to, but doing so is not financially advantageous.
What is an early distribution?
The term “early distribution” means taking your money out of one of these accounts before the designated time. Taking an early distribution will require the taxes to be paid on the money withdrawn, plus there will be a 10% penalty.
Are there any circumstances when I can withdraw my tax-deferred savings plan money early without paying penalties?
There are some circumstances that allow money to be withdrawn from a tax-deferred plan before the designated time without the need to pay fees. Although you will still be required to pay the taxes on the amount withdrawn, you can avoid the extra 10% early withdrawal fee as long as the proper criteria is met. These circumstances include a first-time home purchase, qualified education expenses, unreimbursed medical expenses, and under certain disability situations. However, it is very important to understand these criteria completely before attempting to withdraw money early to avoid potential problems.
