Why do people have to pay back money they take out from their retirement, it’s their money right?
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You are, I believe, referring to tax-advantaged retirement savings (e.g. 401K). In this case the income that was placed in the retirement fund was deposited in the fund before income tax was paid on that income. The system was designed to encourage people to save money so that they wouldn’t be homeless and eating cat food when they retired (because, for instance, companies were essentially stealing pension money from pension funds). When you withdraw from that fund pre-retirement you are defeating the purpose for which the tax advantage was given to that money.
Here’s a deal, put your money here until you retire, tax-free. If you really want it, fine, pay the back taxes.
The idea is the following: put the money in a retirement savings 401K, other countries have equivalents too. You don’t have to pay income on that money.
That encourages you to safe, but that’s not all it is.
It also gets you some of that money back which you could used to build some more wealth.
Once you’re retired, you’re likely to have less income, so while you now have to pay taxes on the savings, you will likely pay less due to having lower income. The deal is basically: we’ll defer the taxes you’d have to pay to give you an incentive to save and you’re likely to pay less taxes on that money later on too.
I assume you’re talking about 401 program. You’re not “paying back money”, but merely paying taxes that were owed at your time of deposit to the 401k. It’s designed that it’s removed when you retire and are no longer at your peak earning power. Therefore, whereas you would have paid a higher percentage of taxes, now you’re in a lower tax bracket. Of course if you remove money prior to your retirement age, there will be a penalty. First normally a 10% early withdrawal penalty in addition to paying ordinary income tax on that money. So save money for your retirement and build on those savings, then withdraw at lower tax rates.
The person is setting aside their money into a special spot for a specific purpose. Because the person is putting their money aside for this special purpose of retirement, the government has not required the person to pay taxes on that income like everyone else is required to pay.
The government is making a deal with the person. Ok, if you set some of your own money aside for retirement we consider that such a good thing for us as a country (the government will be less likely to have to pay for you when you stop working) that we will not take out our regular portion in taxes. The money is set aside pretax. Before taxes are taken out.
If you break the deal taking out the money, which is something you have the ability to do, you will have to pay the taxes on your money because it is no longer being used for the special purpose of retirement and you get a bit of a slap on the wrist for breaking the deal by have to pay a 10% penalty.
When you get a loan from your special purpose money, you are essentially borrowing your own money with no third-party lender involved. No credit check is needed and all the your loan payments, including interest, go right back into your 401(k) account and it does not effect your credit score.
As long as you pay it back in time, you avoid paying the taxes on the money you borrowed from yourself and the interest rate is lower than just going out and getting a regular loan.
Being able to borrow from your special purpose money if something comes up and you need it encourages people to set more money aside.
you pay taxes on retirement money when you put it into a NORMAL account, instead of the retirement account. Thus early withdrawal from a retirement account is treated as income, and taxed as such, but is probably taxes at a higher bracket than it would be if it was withdrawn after you leave the workforce.
Nobody mentioned a 401k loan yet, so if that’s what you’re talking about (and your plan allows it), you essentially take a loan out against the balance (up to 50k) and have to pay it back plus an interest rate (often +2 to the prime rate) “to yourself”. If you default on the loan it becomes a taxable distribution, and you need to pay taxes on the remaining unpaid balance. Plus an excise tax if you’re under 59.5.
(Based on my employment in the retirement sector in the USA only)
It’s still earned income, and you will ALWAYS pay taxes on any documented money you earn. The real question is, do you want to pay them now or later?
401k/IRA: Skip tax now, pay tax later (when you withdraw)
Roth IRA : Pay tax now (before you deposit), skip tax later.
Prefer the Roth since I plan to make more as I get older, avoiding the higher tax bracket later in life when withdrawing.
If for some reason you plan to be in a lower tax bracket toward retirement, the IRA is more beneficial.
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