Retirement Plan Basics

• Retirement accounts in which the plan participant/owner invests are "vehicles" in which money to be used at some point in the future is given a current tax advantage -- as long as it stays inside -- in exchange for a future tax liability. Contributions to retirement plans reduce current income taxes. Additionally, as long as those funds are left in place until age 59 1/2 or later, the balances are permitted to accumulate free of any taxes on dividends or capital gains. Required minimum distributions from these plans must begin by age 70 1/2. Any distributions taken will be counted as ordinary income and will be taxed at that tax rate. Also, if distributions taken before age 59 1/2, a 10% penalty may apply.
  
  

401(k) Features

• Contributions to a 401(k) are taken immediately from the paycheck, reducing the amount of tax paid on that income. With IRAs the contributions are funded with after-tax money, and the tax deduction is recognized when taxes are filed. Also, many companies offer an employer matching contribution, up to a limit. This is just like getting an immediate return for participating. 401(k)s are also portable -- they can be rolled into another employer's plan (IRAs cannot).
  
  

Tax Treatment of Dividends

• Not to be confused with "plan distributions" (withdrawals at retirement), dividends are cash payments to shareholders paid as income by a company. With mutual funds, dividends are paid to the fund from all the companies in the fund portfolio, and then passed along to shareholders. Alternately, they can be reinvested into additional shares of the fund.
  
  Outside of a retirement plan, dividends are treated as ordinary income and taxed at the tax filer's income tax rate. In a 401(k), just as with other retirement plans, there is no need to account for dividends since they receive tax-free accumulation.
  
  

Tax Treatment of Capital Gains

• Like dividends, capital gains -- the profits made on the sale of a security -- on shares held in a retirement plan are not taxed. Unlike dividends, capital gains can have a lower tax treatment. Short term gains are treated as ordinary income and taxed at the income rate of the filer, but long term gains currently have a much more favorable tax rate. None of this matters on shares held in a retirement plan, however, because all accumulation occurs free of tax.
  
  

When Taxes Are Paid

• The IRS will get its taxes. It will happen in the future and at what may be a higher tax rate. No one can know for certain of the future tax rate. However, distributions -- the required withdrawals -- will be taxed at the higher ordinary income tax rate.
  
  Depending on the size of the plan and the age at which distributions begin, this amount of income could be sizable, and the IRS will know about it. The plan administrator is required to report this income to the IRS on form 1099-R, of which the plan participant will also receive a copy after the end of each year a distribution has been taken.