Pensions

What’s the Difference Between a 401k & an IRA? Complete Guide

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A 401k and an IRA are both ways to save for your retirement. If you are looking for more information about how a 401k and an IRA can work together for your benefit, you are in the right place!

Saving for your old age is a smart move. Both 401k and IRAs allow you to put money away without paying taxes, which means much higher levels of growth during your working life. With either plan, your money will be growing without being taxed for your entire working life.

There are a lot of options out there when it comes to retirement accounts. Both 401k plans and IRAs will allow you to save for your future, but both programs have very specific rules. There are also an abundance of IRAs to choose from.

Let’s have a look at the options that are available, and how you can start saving for your retirement with a 401k and an IRA!

A 401k and an IRA can Work Together

The most important difference between a 401k and an IRA is that a 401k has to be set up by an employer, and an IRA is a personal retirement account that anyone can create for themselves. The amount that can be saved on a tax-deferred basis is also much higher with a 401k.

If you want to have a 401k, you will need to work for a company that creates them for its employees. Assuming you have a 401k from your work, you can also set up an IRA, and save even more money that can grow without being taxed.

The 401(k) Basics

Ok, so let’s assume that you work for a company that creates 401k accounts for its employees. If you can’t save via a 401k, feel free to skip this part, and just head down to the section on IRAs.

Everyone can open an IRA!

Ok, so for all of you that can use a 401k plan to save, let’s get it on.

Originally 401k plans were simple. The plan allowed employees to set aside some of their annual compensation on a tax-deferred basis, usually in the form of company stock.

Today, that has all changed. While many companies still offer 401k stock investment plans, there are other options as well. Employees can stash their earnings in many different kinds of investments, like mutual funds or ETFs.

In some cases, an employer will match their employee’s 401k contributions, which can be a great deal if you like to save for your future.

What is a 401k?

Read: What is a 401K? Complete Guide to This Retirement Plan

401(k) Rules

Like any tax-deferred savings plan, there is a maximum amount that can be saved every year via a 401k.

In 2019 employees under 50 years old can save up to $19,000. For people over 50, the cap is lifted by $6,000, to a total contribution of $25,000. Employers can add to that, and the combined total from both parties is $56,000, or $62,000 for people over 50.

The vast majority of people won’t hit the contribution caps, but for big earners there are options. Some ideas include annuities and deferred bonus packages, which have to be set up on a case-by-case basis.

401(k) Distribution

The distribution rules for a 401k plan are a little different from an IRA.

Like an IRA, the money inside of a 401k will grow tax-free. Unlike an IRA, a 401k will have one or more triggering events that allow distribution to take place.

In order for a 401k to pay out, one of the following events must happen:

  • When the employee turns 59½ years old.
  • If an employee experiences a hardship as defined under the plan if the plan permits withdrawals to help with the problem.
  • If the plan is terminated.
  • Otherwise, the employee’s retirement, disability or death would trigger the 401k to be distributed.

There are also lots of rules that surround how income from a 401k distribution is treated, and when distributions have to begin. Once you have a lot of cash in your 401k these rules will matter a lot more, but don’t worry about it while you are saving!

Anyone Can Save With an IRA

If you want to start saving for your future and don’t have an employer that sponsors a 401k plan, an IRA is the best option there is. Every IRA has different rules when it comes to how much you can save per year, and the most common type allows for $6,000 to be saved on a tax-deferred basis.

There are a lot of options for IRA plans, so let’s dive right into what you can do to start saving.

Traditional IRA

The first IRA format that was introduced is still the most widely used according to data from the Investment Company Institute. The idea of a traditional IRA is simple; you are able to save $6,000 per year without paying taxes on it, and it can grow tax-free until you are ready to retire (at age 59 ½).

There are seemingly unlimited ways to invest your savings, with most investment platforms offering some kind of plan for IRAs. Even if you don’t have a lot of cash to save every month, an IRA is still a good idea.

One of the big perks of the traditional IRA is that you will be taxed at the rate for the bracket you are in when you take the distribution, which is likely to be much lower than when you are saving. Retired people tend to make less than people who are in the workforce, which makes this kind of IRA, even more, tax efficient.

What is an IRA

Read: What is an IRA? Complete Guide to Individual Retirement Accounts

Roth IRA

You might have heard about Roth IRAs, and wondered how they are different from a traditional IRA. There are many small differences, but the biggest one is how a Roth IRA is funded.

Traditional IRAs are funded with income before it is taxed, but a Roth IRA is funded with income that has already been taxed. This might sound like a small difference, but it has some big implications.

Roth IRAs Work for Young Savers

As people get older, they tend to make more money (as they are working). More income tends to translate into higher taxes, which means that post-tax income is more ‘expensive’ as people progress in their professional life.

A Roth IRA is perfect for younger people who are still in a lower tax bracket and have ‘cheaper’ post-tax income.

The Roth IRA also has more flexible rules about how you can withdrawal money from the plan. Unlike a traditional IRA, a Roth IRA will allow you to withdrawal money you have deposited in the account at any time, without penalty.

Money that you have earned tax-free in the Roth IRA can’t be touched without a penalty, but overall the Roth IRA is probably better suited to younger savers who have less financial security.

If you want to be able to withdraw money tax-free from a Roth IRA, the account has to be at least 5 years old, and you have to be 59½ years old, or more. There are other allowances for hardship withdrawals from a Roth IRA as well.

SEP IRA

The SEP in SEP IRA stands for Simplified Employee Pension. It is technically an IRA, and has similar rules to a traditional IRA, at least when it comes to distribution. The rules for setting up and funding a SEP IRA are a little different and are geared toward small businesses.

A SEP IRA has to make the same contribution to every employee in the business based on a percentage of the employee’s salary. For example, if the employer makes a contribution of 10% to their own SEP IRA, everyone in the company will have to be given a 10% contribution to their individual SEP IRA.

The amount that can be contributed to a SEP IRA is much higher than the other types of IRA. In 2019 a total contribution of up to 25% of an employee’s salary can be contributed tax-free to a SEP IRA, as long as that amount doesn’t exceed $56,000.

A SEP IRA can also be set up for a sole proprietorship, where the owner is the one and only employee. Using a SEP IRA is a good way for a small business owner to match the kind of tax advantages that a 401k plan can provide, though there are many rules about how a SEP IRA can be set up and used.

Other Types of IRAs Exist

This isn’t an exhaustive list of IRAs, and you might find that a SIMPLE IRA or a Self Directed IRA is a good fit for your retirement planning. Each kind of IRA has benefits, and you can hold more than one kind. If you have questions about how to get an IRA started, talk to a tax professional.

How Should I Save for My Future?

The first set in getting ahead financially is setting up some sort of retirement account that allows you to avoid being taxed as your money grows. While there is no one-size-fits-all solution for savings, there are some important things to keep in mind.

As mentioned above, a Roth IRA probably makes the most sense for younger people.

If you are just getting into the workforce, you are likely in a low tax bracket. Once you stash your post-tax earnings in a Roth IRA, you will be able to access your savings tax-free when you are older, and in a higher tax bracket.

The kind of IRA you choose to open for yourself is important to consider, but the kinds of investments you make are going to determine how fast your money can grow.

The Importance of Risk in a Portfolio

It would be great of there was a way to make money without taking on any risk. Many investors struggle to take on riskier investments, like stocks, because they fear loss.

There is no way to overstate how important risk is to growing your money. When safe investments like government bonds are compared to stocks (with the exception of the early 1980s), the importance that risk plays becomes very apparent.

Staying in safe investments like government bonds and money market accounts will help to ensure that you don’t lose much, but there is also little chance that your portfolio will ever grow at more than 4% per year.

If you are already established, a 4% yield might be ok, but if you are 22 years old and have a portfolio that is worth $1,000, you need to introduce some risk into your investments. Tax-deferred retirement accounts are great, but it won’t mean much if your portfolio only grows by 2% per year.

There Are Lots of IRA Investment Options

If you do decide to open up some form of IRA, there are loads of options out there to choose from. Most stock brokerages have a variety of IRA account types, and these accounts can be used to buy just about anything that trades on stock exchanges.

Just because something can be bought on a stock exchange, it doesn’t mean that it is risky. There are many bond ETFs you can buy with a brokerage account, so you can create a diversified portfolio.

The last few years have also seen a rise in robo advisers, many of which have IRA and 401k options. The term ‘robo adviser’ is vague, and there are a tremendous number of different kinds of automated investment platforms you can use to invest for your future.

A 401k and an IRA Can Help You Get Ahead

Saving your money and getting a big tax break in the process is a great idea. If your employer has a 401k plan that you can opt-in to, it would be a good idea to do so. The contribution limit on a 401k is much higher than an IRA, which means more money saved every year.

Don’t worry if you are self-employed, or your employer doesn’t offer a 401k plan. There are lots of options when it comes to opening an IRA, so you can get started saving for your future!

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Nicholas Say grew up in Ann Arbor, Michigan with a father that would read him the Wall St. Journal along side of other bed-time fare. He has traveled extensively, and been lucky enough to study a changing global economy in person. Nicholas spent many years in the Southern Cone of South America, sometimes in the middle of the countryside where livestock starts its journey to all points of the globe. Today he is thoroughly bemused with the stance that Central Banks have taken in the wake of the 2008 meltdown. There is no telling what will come out of the global financial system next, but he is glad that he lives somewhere that gold can be bought and sold readily!

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