What’s the difference between 401(k)s and IRAs?
Written by Paul Henderson, CFP®
401(k), IRA, Roth IRA, Roth 401(k). Sometimes it can feel as though deciding to save money just opens the door to a flood of acronyms and code words. You know you should do something, but where to start?
If you are ready to put money away for retirement, here is a quick introduction to two types of accounts you have probably heard of, but might not know much about: an Individual Retirement Account (IRA) and a 401(k) account.
What is an IRA?
Like its name suggests, an IRA is a retirement account that you set up by yourself, for yourself. There are two main types of IRAs, Traditional and Roth. While both serve the same goal — saving for retirement — there are some key differences which we will touch on below.
Each year, individuals can contribute a set amount ($6,000 as of 2020) to either a Traditional IRA or a Roth IRA. Once the cash is in an IRA, it can then be invested, typically into a combination of stocks and/or bonds. This is where the key benefit of IRAs kicks in: investments in an IRA grow tax-deferred. There are no taxes on capital gains, dividends, or interest. This is in contrast to a typical investment or “taxable” account. The idea is that savers have an incentive to save for retirement and the money which would have gone toward taxes instead allows savers to accumulate more money for retirement.
Traditional IRAs have another benefit. Contributions to Traditional IRAs can be tax-deductible if you do not have access to a retirement plan through your employer. Or, if you do have access to such a plan, contributions may be partially deductible within certain income limits. The downside is that withdrawals from your Traditional IRA are taxed.
Conversely, Roth IRA contributions are not tax-deductible and therefore distributions are not taxed. Additionally, account owners maintain the right to withdraw their contributions at any age without penalty.
How much can I deposit in an IRA?
As of 2020, individuals can contribute $6,000 to either a Traditional or a Roth IRA in a year. Individuals over age 50 can contribute $7,000. Roth contributions are limited based on income. Traditional IRA contributions have no income cap but deductibility is limited.
When can I withdraw money from my IRA?
Money saved in an IRA is available to you starting at age 59 ½. Prior to this age, you will typically incur a 10% early withdrawal fee on top of taxes if you pull any funds out of your Traditional IRA or investment earnings out of your Roth IRA. (There are specific instances where funds can be accessed early without penalty, check with your financial advisor or CPA if the need comes up). On the other end of the spectrum, you must begin taking distributions from your IRA at age 72. A required minimum distribution (RMD) is the minimum amount that you must withdraw (and thus pay taxes on) from a Traditional IRA each year. RMDs are not required for Roth IRAs.
What is a 401(k)?
401(k) accounts are similar to IRAs. They are accounts meant to aid an individual in saving money for retirement. Like IRAs, 401(k) accounts also come in traditional and Roth. The key difference is that a 401(k) account is set up by an employer for an employee. Employers create the 401(k) plan that best suits their needs and then allow employees to enroll as plan participants.
The role of the employer means that each plan looks slightly different. For example, investment options are vetted by the employer and then offered to plan participants; different rules around early distributions are set by each employer; and employers are able to set their own method for matching participant contributions.
How Much Can I Deposit in a 401(k)?
401(k) accounts have substantially higher contribution limits than IRAs. The 2020 contribution limit for a 401(k) is $19,500 and those over age 50 can contribute an additional $6,500.
For 2020, total contributions to a 401(k) account can reach $57,000 ($63,500 for 50+) when factoring in employer contributions.
When Can I Withdraw Money from my 401(k)?
In general, 401(k) accounts have the same rule as IRAs when it comes to withdrawals. Pulling funds before age 59 ½ is likely to incur a 10% penalty. There are nuances, those over age 55 have more flexibility, hardship withdrawals are typically possible, etc. But the intent is that retirement savings are meant to be for retirement. However, one unique distinction for 401(k)s is the ability to take loans from your account provided that the loan is repaid with interest. Loans are capped at the lesser of 50% of the account value or $50,000 and must be repaid in order to avoid fines, but they do provide an interesting option for self-financing in certain cases. It is important to note that if you leave your job while the loan is outstanding it must be fully repaid in order to avoid taxes and penalties.
What about rollovers?
Another way to take money out of a 401(k), and still qualify for continued tax-deferral, is via a rollover. This involves money going from one retirement account to another. The most common example is when you move on from a job. When leaving, you are typically faced with three primary choices: leave your 401(k) account in the current plan, move it to your new employer’s 401(k) plan, or roll it over to an IRA. The best choice will depend on the plans involved and your specific situation. It is important to know your options when making an informed decision.
If you don’t have either an IRA or a 401(k) it is almost certainly time to open one. These accounts are key components of a successful retirement plan. Because everyone’s situation is unique, we are happy to talk with you to determine your needs and find the solution that serves you best. If you have a 401(k), or IRA, but aren’t sure if you are using or investing it to its full potential, that’s worth a conversation too.
Have an old 401(k) with a previous employer that you need help tracking down or would like to consolidate?
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