There are many retirement savings plans available to consumers. One of the most popular is an IRA, or individual retirement account. Some investors may have the availability through their employer to opt into what is called a 401(k) retirement savings plan. There are different investment and tax considerations for each. The following is an overview of both IRA’s and 401(k)’s, as well as which may be more appropritate to each investor. We also include links after each section to articles you may find useful.
- ERISA – A description of the Employee Retirement Income Security Act, and how it affects employees and employers.
- Deferred Compensation – A fact sheet listing information about retirement plans from Wisconsin’s State Government.
- Pensions – Information on how traditional pensions relate to post-ERISA retirement plans.
IRA’s are Individual Retirement Accounts. Within an IRA one can purchase a variety of investments like stocks, bonds, CDs, or sometimes even investments like real estate trusts. The contributions to an IRA are typically “post-tax,” meaning that one has already paid income tax on it. As such, when one withdraws from their IRA they pay capital gains tax only on the gains. Contributions to an IRA are typically deductable from one’s income taxes. The only tax advantage of an IRA is that capital gains taxes are deferred until one retires. IRA’s require the payment of additional tax penalties if one withdraws prior to age 59 ½.
- Traditional IRAs – The tax implications of a Traditional IRA, from the Internal Revenue Service.
- IRAs and Tax Credits – A guide to how IRA’s relate to income tax deductions.
- How do I determine my IRA Deduction? – Tips from California’s State Government.
In the 1970s the government passed legislation collectively called ERISA. This legislation, among other things, created what is called the 401(k) plan, named so because of the section in which it is specified. 401(k) plans are only available to employees. As such 401(k) plans are referred to as employer sponsored retirement plans. Typically companies have to have a certain number of employees and offer the plan to all employees, or at the very least all employees who meet certain criteria, like number of hours worked. The 401(k) allows employees to defer tax on their income if they place it into such a retirement plan. Contributions to a 401(k) are taxed only after one begins to withdraw from the plan, which means that gains grow on a larger amount. Employers can also contribute to 401(k) plans of employees, adding an incentive for employees to participate. For example, many employers will match any employee contributions up to a limit, meaning if an employee puts, for instance, 5% of their salary into the plan the employer may match that 5% so that a total of 10% of one’s earnings are invested each year, and before income tax is subtracted from one’s earnings. 401(k) plans can save on taxes since one usually is in a lower tax bracket in retirement years when one begins withdrawing from a 401(k). There are tax penalties for early withdrawal (prior to age 59 ½) from 401(k) plans.
- 401(k) Plans – This is a good primer on 401(k) plans.
Differences Between 401(k) Plans and Traditional IRA’s — Pros and Cons
IRAs and 401(k)’s each have their advantages. Here are a few of the pros and cons of each.
Pros of IRA’s
- IRA’s can be opened by anyone with funds to Invest.
- IRA’s typically have few restrictions on the types of investments one can invest in.
- In many cases one can borrow from an IRA without having to pay taxes.
Cons of IRA’s
- There is an limit as to how much one can invest in an IRA each year. This limit is typically lower than for 401(k)’s.
- Contributions are post-tax.
- There is no matching employer contribution for IRA’s.
Pros of 401(k)’s
- Contributions are pre-tax.
- One can withdraw funds after retirement and have it taxed at a lower income tax rate if they are in a lower tax bracket than pre-retirement.
- Employers often offer matching funds.
- There are higher limits when investing in 401(k)’s.
Con’s of 401(k)s
- Usually one can only invest in a small number of investments.
- Usually one does not have the ability to choose who manages their funds, or which company manages their 401(k).
- If one leaves an employer, part of the 401(k) may not have matured.
- Traditional vs. 401(k) – The differences between both types of retirement products.
What is a Roth IRA?
A Roth IRA is a type of IRA, funded with after tax dollars, which offers tax-free withdrawal of proceeds in retirement. Like a Traditional IRA they are limited to how much one can contribute every year. Roth IRA’s do not require distributions to begin at any age. Also they can be rolled into another IRA, or Roth IRA, so potentially they can be passed on to a beneficiary without the beneficiary having to pay taxes on contributions. As of this writing, to contribute to a Roth IRA an individual must make less than$ 95,000 annually, and a married couple cannot make more than $150,000 annually.
- Roth IRAs – Another retirement planning option.
What is a Roth 401(k)?
A Roth 401(k) is similar to a Roth IRA in that proceeds are tax-free. That said not all employers offer Roth 401(k)’s. Roth 401(k)’s do require distributions to begin by age 72 ½. Like Roth IRA’s, money is contributed on an after tax basis.
- The Roth 401(k) – A guide from Investor.gov.
What is a rollover?
A rollover is when funds in one type of investment account are moved into another. This can occur when someone wants to move funds from a 401(k), especially one from a previous employer, into an IRA, or sometimes into the same account as a current employer. Often there are a variety of tax considerations to rolling over funds. When deciding to roll over money it is best to consult a tax and investment professional to ascertain whether one is better suited by rolling over the funds, or by leaving them in an existing account.
- Can I rollover my IRA Contributions? – A guide from the US Office of Personnel Management.
- The Rollover Savings Account – How to avoid negative tax repercussions in a rollover.
Which is Better, Roth or Traditional IRA?
In general it is important that one consult an tax accountant or financial planning professional when considering retirement products. It is also very important to consider the minimum ages for retirement, which can change, as well as the maximum age before distributions must be made from plans.
- Retirement Savings & Tax Credits – Facts about various tax advantages of retirement plans.
- Retirement Planning – Advice, and a free retirement calculator, from the Department of Social Security.