How to properly cash out of an IRA, 401(k) or 529 savings plan

Advisors


The U.S. government wants to encourage citizens to save for retirement and for advanced education, and one of the best incentives for saving is a tax break. These plans work differently in how the investor ultimately gets the tax break. In a traditional IRA or 401(k), the tax break comes at the beginning on the contributions the saver makes that year.

For example, assume you contribute $5,000 to a traditional IRA or 401(k) plan in 2017 and you make $50,000 in wages and other income that year. When you do your taxes prior to the April 15, 2018, deadline, you will be taxed only on $45,000 of income because you deferred $5,000 that year into your qualified retirement account. Roth IRAs and Roth 401(k) plans have a different tax treatment.

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The 529 plan offers a different kind of tax break. In this account, the money that is contributed to the plan in a particular year is before-tax money that does not reduce your taxable income. In other words, if you contribute $5,000 to your child’s 529 plan in 2017 and you make $50,000 in wages and other income that year, your taxable income for 2017 is still $50,000.

When you do your taxes in the early part of 2018, you will still be taxed on $50,000 of income because the $5,000 did not reduce your taxes in 2017. For a 529 plan, the tax break comes years later, when your child heads to college. Assume that over 12 years of his or her growing up, you contributed $30,000 to your child’s 529 plan. The $30,000 you invested earned $5,000 in capital gains. When you start to take the money out of the 529 plan to pay for qualified college costs, that $5,000 of gains comes out without incurring tax.



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