Today we take a look at two popular retirement options: the 401(K) and the IRA. Each have their own advantages and disadvantages, so I break those down in today’s article.
What Is a 401(k)?
This kind of account is a tax-deferred retirement savings account that tends to be offered by businesses to employees. There are different ways that the said employees may contribute money, which include having a percentage of their salary contributed on their behalf. This is known as a salary and contributed 10,000 deferral. Learn why it’s called a 401k.
Employee Contributions to 401(k)
Note that the contributions that are made to this account are what are known as pretax. This means that whatever the contributions add up to would see your taxable income for that period reduced by whatever amount the contributions turn out to be.
To put this into perspective, imagine that you earn $100,000, and $20,000 of this was meant to be contributed to your 401(k). In that situation, your taxable income would be $80,000 instead of $100,000, provided that any other variables are equal.
Employer Matching in 401(k)
A 401(k) account introduces the principle of employer matching. Effectively, this means that the employer will match a portion of the contribution made by the employee. The limit will typically be outlined and understood. The calculations may be done based on the annual contribution of the employee.
For example, if the amount that the employee contributes represents 10% of their salary, then the employer may match contributions up to half that amount, which would be 5% of the said salary.
Note that the policy for matching can be calculated in a series of ways. the only limitation is that the employer will not exceed IRS limitations.
Additionally, an employee who doesn’t contribute a certain percentage may not qualify for a match.
401(k) Withdrawal Rules
Since these are retirement accounts, you’ll find that there are rules imposed on when withdrawals can happen. For a 401(k) account, withdrawals are not allowed to happen before the account holder reaches 59 1/2 years old. There may be an exception based on the financial situation, for example, but without this, there will be a tax penalty incurred.
Defining an IRA
Another kind of retirement account is an individual retirement account or an IRA. These are investment-based retirement accounts, characterized by contributions that for the most part will be tax-deductible
IRA Contribution Rules
Apart from the tax-deductible element, there are the earnings, which are allowed to grow tax-free. However, distributions will be taxed as ordinary income during retirement. Note, however, that there is the concept of a Roth IRA as well. Here, the contributions are made with after-tax dollars.
Therefore, in the year of the contribution, there is no tax deduction received. This creates one of the more favorable tax benefits which sees qualified distributions at retirement not having a taxation element to them.
Types of IRAs: Traditional and Roth
The choice of a traditional IRA or Roth IRA will depend on which setup is more favorable considering that the system will tax deduct traditional IRA contributions.
If you go the traditional route, you likely favor an immediate tax break, which means that the amount of taxable income is reduced by the contribution amount.
Some people may not be eligible to deduct traditional IRA contributions, which makes a Roth IRA a good option for them, especially considering the tax-free growth on investment gains.
IRA Withdrawal Guidelines
Account owners are expected to make withdrawals in retirement whether they have a traditional or Roth IRA. Nevertheless, only the traditional variation sees a penalty being applied to early withdrawals. This is calculated at 10%.
Contrasting 401(k) and IRA
What does the IRA vs 401(k) conversation look like from a taxation perspective? A 401(k) will see contributions lower taxable income in the year made. Distributions will then be taxed as ordinary income unless the account holder has a Roth 401(k).
A traditional IRA treats taxation the same way, provided that the contributions made are deductible. A Roth IRA, on the other hand, provides no tax benefit immediately, with the trade-off being the qualified withdrawals in retirement being tax-free.
Contribution Limits Comparison
Note that the annual contribution limits for any kind of retirement account will be adjusted over time. For example, in 2023, someone holding a traditional or Roth IRA would be allowed a regular contribution limit of $6,500, which also allows for a $1,000 catch-up contribution for those older than 50 years old.
A 401(k) allowed for a $22,500 contribution, with a catch-up amount of $7,500 for those over 50 years old.
It’s a good idea to keep abreast of where the contribution allowances stand annually.
Early Withdrawal Penalties
Traditional IRAs and 401(k) accounts allow for penalty-free withdrawals in retirement, provided that the account holder is at least 59 1/2 years old. Should funds be withdrawn earlier than that, the 10% penalty fee highlighted above will apply.
Roth individual retirement accounts (IRAs) do not have this penalty, provided that the account has been open for at least five years. In such a case, there will be no penalty or tax on the withdrawal.
Understanding Required Minimum Distributions (RMDs)
401(k) plans have a minimum distribution requirement, which begins at age 73. This is expected to be moved to age 75 in 2033. While traditional IRAs operate in the same fashion, a Roth IRA is different in the sense that it does not have any such requirement when retirement comes around.
Weighing Pros and Cons of 401(k) and IRA
Benefits of 401(k)
When you put IRAs vs 401(k) plans, many will tell you that the biggest benefit of the latter is the potential for the employer match that was highlighted above. Normally, it’s about 3% or 6% of the account holder’s salary. You can think of it as money that’s being earned simply for contributing to the account.
Beyond that, it’s pretty effortless to save via a 401(k) plan. Based on the choices of the account holder, contributions are automatically deducted from their paycheck, which are then invested based on their requirements.
Finally, there is the fact that there is a traditional pretax 401(k) vs an after-tax Roth 401(k), both of which will be offered by some employers.
Drawbacks of 401(k)
On the drawback side, there are the withdrawal penalties that are characteristic of standard 401(k)s and IRAs.
Additionally, if you do not wish to take the minimum distributions outlined once the set age is reached, there is no way around it.
Finally, employer matching may be based on a certain amount of contributions being made by the account holder. Therefore, if you do not wish to make that level of contribution, you may not be eligible for the matching benefit.
Advantages of IRA
Traditional and Roth IRAs are beneficial in different ways. The traditional variation allows the account holder to benefit from a lower taxable income in the year that qualified distributions are made.
Additionally, when the income tax on withdrawals becomes effective during retirement, this will be at a time when the account holder falls within a lower tax bracket.
On the Roth IRA side of things, withdrawals are tax-free and become allowed with no penalties just five years into having the account.
The fact that it applies taxation immediately means that it’s suitable for those who expect to be in a higher tax bracket when they get to retirement.
Limitations of IRA
One of the biggest limitations is the annual contribution limit that an IRA holder is allowed. It places a cap on those who may want to contribute more than the designated amounts.
Note also that there is an income-based qualification that applies to both accounts, which may simply prevent people from using them.
Deciding Between 401(k) and IRA
Situations Favoring a 401(k)
There is no one-size-fits-all with these kinds of accounts. If you work somewhere that offers a 401(k), it’s generally a good idea to take advantage of it, especially if the principle of employee matching is in the cards.
It’s also a good idea if you wish to make greater contributions since the limits that are applied to such accounts are a lot more favorable.
Scenarios for Choosing an IRA
An IRA is perfect for those who may not have the privilege of having any kind of 401(k) access through their place of employment.
Additionally, there is the concept of a spousal IRA. This will allow a working spouse to put retirement funds aside for another spouse who may not be employed.
You may also find that an IRA is a good way to simply save outside of work since you are not necessarily limited to one account type or the other.
Merging 401(k) and IRA: Optimal Benefits
The lack of a limitation means that people are allowed to look into the idea of combining both types of accounts. Some retirement savers are so determined that they will simply contribute to both.
On the bright side, the respective limits apply to each independently meaning that the total contributions that can be made don’t need to be limited by just a single account type.
Note, however, that the tax benefits that apply to IRA contributions work differently based on where your income lies as well as other factors.
Many people will find that they simply did not save enough for retirement, and having both accounts is one strategy to avoid that pitfall.
Exploring Other IRA Types
Now, it’s time to take a brief look at what SEP and SIMPLE IRAs are.
SEP IRAs: An Overview
The acronym “SEP” stands for Simplified Employee Pension. This applies to self-employed people and small business owners who will make tax-deductible contributions to the accounts of their employees, with withdrawals being handled as taxable income.
There is an eligibility amount that must be considered. In 2023, for example, employees would need to receive no less than $750 to qualify. While employers can make requirements less restrictive, they cannot make them more restrictive.
Understanding SIMPLE IRAs
SIMPLE stands for Savings Incentive Match Plan for Employees. Both small businesses and their employees will contribute to the employee accounts here with pretax dollars.
There’s a minimum income requirement of at least $5,000 over any two preceding calendar years with an expectation to receive the same amount during the current calendar years.
Again, the IRS allows employers to apply less restrictive policies if they so desire, but more restrictive ones are not allowed.
Investment Strategies for 401(k) and IRA
Diversification in 401(k) and IRA
Investment portfolio diversification is always encouraged since the failure of one investment does not imply the failure to invest overall.
Consider the idea put forward above of having both an IRA and a 401(k), which can both come together to create a situation where there is more likely to be enough savings in retirement.
Managing Investment Risks
The diversification approach is one of the tried and tested ways to be able to manage the risk that comes with investing a bit better.
Another great approach is to opt for a mixture of high-risk and lower-risk investment options since doing so offers a measure of safety.
Maximizing Employer Match in 401(k)
In many cases, the employee handbook at a given workplace will outline all that needs to be known about how 401(k) contributions work. Employer matching can effectively be seen as free money, which is why you are advised to maximize it as much as possible.
Once such a system is in place, you should contribute as much as possible. After all, this is one of the biggest benefits of having a 401(k).
A good point to note is that employer contributions don’t count toward the annual contribution limits.
IRA Investment Options
When an IRA is held by a brokerage or investment firm, you will find that there are more investment options offered. These will include bonds, stocks, CDs, and possibly even real estate. There are some assets, however, such as art that IRS rules simply don’t permit within an IRA.
Rollover Options: 401(k) to IRA
Understanding Rollover Process
Should you have an existing IRA, you can transfer your 401(k) balance to it. Note that this will mean that it will be difficult to roll the money back later if you so desire.
If this is a concern, you could open a new traditional or Roth IRA, which you should now intimately understand. The point here is that you need to choose a rollover account type that applies to you.
Next, a rollover IRA provider needs to be chosen. Note that this choice is not necessarily going to make a big impact on the growth of your investment. However, your choice will determine the fees that you pay, as well as the resources and investments that you will have access to.
The first option is an online broker, which allows greater self-management, or a robo advisor, which exercises more control over your portfolio but costs a fraction of what the human variation will.
Next, you move the money, which your IRA provider will help you to do. First, reach out to the former employer’s plan administrator to start the rollover process by completing a few forms. You will then request a check to be sent to the new provider account balance.
The new provider will give clear instructions on how the check is to be made out. Bear in mind too that depending on the provider, it’s also possible to just wire the funds.
With a direct rollover, you’ll never touch the money yourself. An indirect rollover uses the account holder as a middleman. It is more complex and comes with penalties if the transfer isn’t completed within 60 days.
Tax Implications of Rollover
If an indirect rollover 60-day time limit is missed, the money is treated as an early withdrawal. This means that an income tax is applied, as well as a potential 10% penalty.
A 20% amount will be held back with an indirect rollover. This means that reclaiming this money requires you to deposit the full amount yourself into the IRA account balance.
Timing a Rollover
Usually, the best time to do this is when you either leave your job or are starting a new one.
Frequently Asked Questions
Is a 401(k) considered an IRA for tax purposes?
Not all retirement accounts are built equal. While traditional IRAs and 401(k) accounts are taxed similarly, they are not considered the same.
Can you lose money in an IRA?
Yes. Remember that the money is being invested in assets such as stocks, which could see gain or loss.
Can you roll a 401(k) into an IRA penalty-free?
This is possible, provided that the prescribed process is followed to prevent the rollover from being treated as a distribution.
Is it better to max out 401(k) or Roth IRA?
If it is affordable to do so, maximizing a 401(k) is a better idea, especially in cases where employer matching is available.
Can I take a loan from my IRA or 401(k)?
A 401(k) may allow up to 50% of your account value up to $50,000 to be borrowed while no loans against an IRA are allowed.
A 401(k) and an IRA are both options you can include in your retirement strategy individually or combined. It’s all about understanding your income, situation, and goals to make the most sound decision. Be sure to lean on the information above to ensure that you have the best understanding of both account types.