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Generally, tax-exempt investments pay less interest than their taxable counterparts. In order to estimate the tax consequence and compare to a tax-exempt against a taxable investment, subtract your current federal tax bracket from 100, and then divide your tax-exempt yield by this number, giving you the equivalent taxable yield of your taxable investment.
No, you do not have to pay taxes on a 401(k) account. The 401(k) account can grow tax free until you begin making withdrawals after you retire. At that time, you will pay taxes on the amount of income that you have during your retirement years.
Some categories of mutual funds are relatively better for individual investors in terms of taxes because of the current tax codes. The dividends you may receive for bond funds may be taxed at a higher rate than dividends from equities, yet municipal bond funds may be exempt from federal and/or state taxes, depending on the holdings within the portfolio.
The IRS defines hardship distributions from a retirement plan as when a participant has an immediate and heavy financial need to access his retirement plan account in order to satisfy that need. The IRS may limit how much of your account may be accessible. For further information, please talk to your plan administrator or tax professional.
Some expenses that qualify under the IRS hardship definition may include: medical expenses of a participant, spouse, or other dependents; costs related to the purchase of a principal residence (excluding mortgage payments); tuition payments; educational fees, room, and board for the subsequent 12 months of post-secondary education for the participant, spouse, or any dependents; any expenses necessary to prevent eviction from the participant's principal residence or mortgage foreclosure; funeral expenses incurred by the participant or dependents; and certain expenses that may be incurred because of damage to the participant's principal residence. The IRS rules also allow for some of this early distribution to be used to pay taxes on the distributions related to the above hardship events.
When you contribute to your 401(k) or retirement plan, you make contributions before you pay taxes on the amount of your contribution, and you pay taxes on what remains of the income or wages, less the amount of your annual retirement plan contribution. When you retire and begin to withdraw money from the retirement account, you must pay taxes on this ordinary income at that time. In this way, you are able to contribute to your retirement plan using pretax dollars instead of after-tax dollars.
If you make withdrawals from a retirement plan before you reach age 59 Y2, the IRS assesses a 10% penalty on the amount you withdraw. Some retirement plans allow you to pay taxes now on contributions, instead of when you retire.
The advantage of a 401(k) investment is that money goes in before taxes, so you can earn interest on all of that cash until you actually withdraw it.