The world of retirement accounts is crowded. Do you know the difference between a 401(k) and an IRA? How about the difference between a Traditional IRA and a Roth IRA? To eliminate the confusion, we’ll break down what makes each type of retirement account different. Plus, we’ll provide a sense of which is best for your situation.
The three most popular retirement accounts are:
- Traditional IRA
- Roth IRA
- 401(k)
Traditional IRAs
A Traditional IRA is a tax-advantaged retirement account. These accounts are set up through a bank or investment advisory firm. Individuals can put just about whatever investments they want into their IRA — stocks, CDs, mutual funds, cash, and bonds — anything except options and other derivatives.
So, anyone younger than 70 ½, from a self employed worker to a non-working spouse, can open and invest in a Traditional IRA provided they have income. In this account, money is contributed and those contributions may be tax deductible on both state and federal tax returns, and earnings in investments grow tax-deferred. But there are contribution limits set by law. Total contributions to Traditional and Roth IRAs cannot exceed $5,500, or $6,500 for those above 50 years old. Any withdrawals made before someone turns 59 ½ incur a 10% withdrawal penalty on top of the income tax they’ll pay at ordinary income tax rates. This type of IRA is preferred for those seeking a current tax deduction, those who are ineligible for a Roth IRA due to too high of an income or those with the prospect of a lower tax bracket in retirement.
Roth IRAs
Roth IRAs are tax-efficient retirement accounts in which account holders set aside after tax dollars. Unlike a Traditional IRA, there are no current year tax benefits. However, with this type of retirement account, contributions and earnings can grow tax-free, and people can withdraw them tax- and penalty-free after age 59½, as long as the account has been open for at least five years. Once contributions are made, the same investment options exist as a Traditional IRA. If someone is 59 ½ and under and withdraws from a Roth that’s less than five years old, the earnings are subject to taxes and a 10% penalty. Income limits do affect eligibility to contribute to Roth IRAs. You can clarify your eligibility here.
401(k)s
Unlike the two IRAs, a 401(k) is an employer-sponsored tax advantage plan. This allows workers to invest a percentage of their paycheck, up to $18,500, if they are under the age of 50, before taxes are withheld. These contributions grow tax-free until the participant withdraws them after reaching a minimum age of 59 ½ years old (depending on the company’s plan rules, participants may not be able to withdraw while still employed regardless of age). When withdrawn, the funds are taxed as income at the participant’s current income tax bracket. Withdrawals before the age of 59 ½ are subject to an IRS penalty of 10%, on top of the ordinary income tax rates. Often times, employers have percentage match programs where they will match your investment as added contributions to your 401(k).
Within the 401(k) retirement account, many companies also offer a Roth option for saving. The maximum savings amount per year remains the same. However, funds going into the Roth portion of your 401(k) are post-tax dollars so that if you choose to put $200 per paycheck into the Roth, your take home pay will be $200 less. If you had chosen to put $200 into a traditional 401(k), the reduction in your take home pay would be more like $150-$170. The reason why you utilize a Roth 401(k) is because when you go to withdraw the funds, as long as you are over that magic 59 ½ age, you will receive it as tax-free income. Unlike a Roth IRA, employees can contribute to a Roth 401(k) regardless of income; thus again making it a very powerful tool for high earners who are ineligible for a Roth option otherwise.
So, choosing your 401(k) option can be very important. If you suspect that your tax bracket will be lower when you retire because of lower income or if you suspect tax rates in general will be lower, then a traditional 401(k) likely makes the most sense. Alternatively, if you suspect tax rates will be higher in the future (more likely now due to the 2018 tax cuts), then the Roth option can be a very powerful tool.
Exceptions
There are exceptions to avoid the penalties for early distributions from retirement accounts and they are as follows:
- Using the withdrawal (up to a $10,000 lifetime maximum) to pay for a first-time home purchase.
- Using the withdrawal to pay for qualified education expenses.
- Becoming disabled or passing away.
- Using the withdrawal to pay for unreimbursed medical expenses or health insurance if the individual is unemployed.
- The distribution is made in substantially equal periodic payments.
Additional Notes
All IRA contributions must be made in cash, which includes checks, as contributions cannot be made in the form of securities.
One other concept to know about are Required Minimum Distributions. Upon attaining the age of 70 ½, owners of Traditional IRAs and 401(k) retirement accounts (unless they’re still working and less than a 5% owner of their employer) are required by the government to begin taking minimum distributions from their accounts for the rest of their lives. However, Roth accounts carry no such requirement and can then provide significant financial planning power and flexibility for account owners.
Read more Twelve Points articles about retirement savings here.
