Congratulations if you have reached the point in your financial life where you are starting to look beyond simply having a savings account and want to really put your money to work! Taking advantage of some of the options you have out there to grow your money tax free can result in the potential for thousands of extra dollars in your nest egg. That is what IRA vs 401k Central seeks to do – provide you with the right information you need to help make your best planning decisions!
The Power of the IRA vs 401k:
So is an IRA better than a 401k, or vice versa? The answer: It depends! Your unique situation will dictate whether or not you qualify for one, the other, or both.
But why go with one or the other? Get to know how the strengths and weaknesses of both, and you can leverage them to make the biggest nest egg you can make! Consider that:
- Both plans have great tax advantages,
- You could potentially grow your portfolio up to one million dollars and beyond more quickly than if you just used only one of the methods.
So why not make the best of all the alternatives you have in front of you. Read on to learn more about each one and how you can use it to your benefit.
What is An IRA?
An IRA (Individual Retirement Arrangement) is a special type of U.S. investment account that is intended to help you save for retirement by giving you a break on your taxes. An IRA is setup by an individual, so it has no ties or connections to your employer.
Although there are several types of IRA’s, the two most common ones that people invest in are Traditional and Roth IRA’s. Here are the IRA basics:
- A Traditional IRA gives you a tax break up front (in the form of a deduction on your income taxes). After that, the principal and earnings grow tax-free. When you finally retire, you then pay income taxes on the money you withdraw. This is why these accounts are often referred to as “tax-deferred”.
- A Roth IRA is the opposite – You pay your taxes on the money up front when it is first invested (in other words, you don’t get a tax deduction on your income taxes). After that, the principal and earnings grow tax-free. When you finally retire, you don’t pay anything on the money you withdraw.
What is a 401k?
A 401k is another type of U.S. tax advantaged savings plan that is also intended to help people save for retirement. However this one is done through a plan setup by your employer.
The name refers to section 401(k) of the U.S. tax code that allows for individuals to set aside a portion of their paychecks free of taxes in preparation for retirement.
A 401k plan allows you to divert money from your paycheck before income taxes are taken out, and places them in a special investment account. The contributions and earnings are then allowed to grow tax-deferred until you decide to withdraw them for retirement.
401k plans started to became a popular substitute for traditional pension plans starting in the 1980’s, and eventually became the dominate offering for most private and public firms. Unlike a pension plan where the employer controlled the how the retirement account was invested, how much you had to contribute, and how much you’d eventually get, a 401k gave individuals the power to decide for themselves how the money would be managed. Each individual is allowed to make up their own mind about how much they want to save and how their money should be invested.
Who Can Contribute?
IRA: To start an IRA, you simply need to have earned income. That generally means having a job or some sort of income that you report to the IRS.
401k: To participate in a 401k, it has to be offered through your employer.
Which One Was Created First?
The 401k was not created until 1978. Throughout the 1980’s and 90’s as pension plans started to become phased out, the 401k plan gained tremendous popularity.
The Traditional IRA was first introduced with the Tax Reform Act (TRA) of 1986. It’s counterpart the Roth IRA (named for Senator William V. Roth, Jr.) was introduced as part of the Taxpayer Relief Act of 1997.
How Much You Can Contribute?
IRA: Both the Traditional and Roth IRA have a 2013 maximum allowable contribution of $5,500 per year. If you’re age 50 or older, then you make an additional catch-up contribution of $1,000 for a total of $6,500 per year.
401k: The amount of money you can contribute to your traditional or safe harbor 401k (called your elective deferrals) in 2013 is $17,500. If you’re age 50 or older, then you make an additional catch-up contribution of $5,500 for a total of $23,000 per year.
All of these limits are subject to periodic cost-of-living increases.
Is There an Employer Match?
IRA: No. Since this is an account setup by an individual, your employer will more than likely not be making any contributions to it.
401k: YES! Most employers will offer some type of matching contribution, and this is a HUGE advantage for the 401k. If your employer does offer some type of match, make sure you participate enough to take complete advantage of the full amount offered by your employer. To not do so would be like leaving money on the table!
What Can I Invest In?
IRA: IRA’s can generally be any variety of investment options ranging from safe to risky, such as:
- Mutual funds
- Real estate
Whenever you open any of these types of accounts as you normally would, the financial institution will usually give you the option to designate it as an IRA.
401k: A 401k plan is setup by your employer; generally with a large financial institution. Depending on which one they go with, there will usually be some offering of mutual funds, stocks, ETF’s, etc.
What are the Income limits?
- Traditional: Between $95k to $115k if you have a retirement plan at work and between $178k to $188k if you don’t have a retirement plan through work.
- Roth: Between $178k to $188k
Note that for Traditional IRA’s, you can still contribute even if you exceed the maximum allowable amount. You just simply don’t get to take the deduction. But you still get to invest the money and let it grow tax free. You also have the option to later convert it to a Roth!
401k: There are generally no maximum upper income limits for contributing to a 401k plan. There is however one caveat when it comes to something that IRS defines as Highly Compensated Employees.
Withdrawal Rules and Penalty:
Traditional IRA and 401k: You are allowed to start withdrawing your money after age 59-1/2. If you do so before that, the IRS charges a mandatory 10% penalty (called an excise tax) in addition to ordinary income taxes on the amount withdrawn.
Both types of accounts let you withdraw your money penalty free a number of other ways:
- Separate from employment (and retire) in the year turning age 55
- Apply for Substantially Equal Periodic Payments (SEPP).
- Becomes disabled as per section 72(m)(7) of the Internal Revenue Code
- Through a loan (if allowed by the investment company)
For a Roth IRA: If you absolutely need to access your money, you can withdraw your Roth IRA contributions (the principle) and not the earnings after 5 years tax free. However, restrictions do apply!
Required Minimum Distributions:
Traditional IRA and 401k: The IRS has Required Minimum Distributions (RMD’s) for both plans starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires. That means that you are required to take out a certain minimum percentage each year (and pay taxes on it).
For a Roth IRA: You don’t have to take required minimum distributions at age 70-1/2 like you do with a Traditional IRA, 401k, and other retirement accounts.
401k: If you leave your job, you do have the option to rollover your balance into an IRA. Depending on the financial institution, there can be a number of variables that will dictate whether this is the best move or not.
IRA: You can’t convert a Roth IRA to a Traditional IRA. But you can convert a Traditional IRA to a Roth.
Traditional IRA and 401k: When you pass away, you can leave your money to your heirs. However, estate and income taxes may apply.
Roth IRA: Your heirs can inherit a Roth IRA to an heir without tax implications or penalty.
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