What are the differences between a 401K and an IRA?

401(k), IRAs
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An IRA and a 401K are similar in many ways.  But biggest difference is how much you can contribute.

Here is more information about all the various retirment accounts out there:

What you need to know about Every type of Retirement Account NOW

 

Traditional IRA

The Traditional IRA is the most common type of IRA.  You can contribute up to $5500 per year ($6500 if you are 50 or old including the catch-up contribution).    Depending on your household income you may be able to deduct your contributions to an IRA, potentially lowering your current tax bill. (There are limits to contributions and deductions see IRS Table below.)

Another benefit of an IRA is you invested will grow on a tax deferred basis, and you will not incur taxes until you start taking money out of the account.  This is a retirement account, and funds need to stay in the account until at least 59 ½ to avoid a 10% IRS penalty.   Withdrawals will be taxed as regular income once you have reached the ripe old age of 59 ½.   With proper tax planning advice the goal would be to pay less taxes on this income in retirement than you would while you are working full time.

 

401(k) Plans or Profit Sharing Plans

401(K) are the most common for private sector employees.  Much like a Traditional IRA your contributions are tax deductible, and your investments will accumulate on a tax deferred basics.  Again you should leave you money in the account until you are 59 1/2.  Withdrawals will be subject to ordinary income taxes.  Plus that pesky 10% penalty for early withdrawals (pre 59 ½).  There will also be required minimum distributions from 401(K) plans starting at 70 ½.

There are a few reasons to love 401(K) plans. First off they can be funded right out of your paycheck, which will make it easier to stick to your contributions.  Second they have much larger contribution limits.  “Maxing Out” you IRA may sound great, but in reality if you are starting late or have above average income (household income above say $50,000) putting way just $5500 per year will most likely leave you taking a big dip in your standard of living during retirement. In 2017 you can contribute up to $18,000 per year to a 401(K) plan.  If you are 50 years wise or more you can also make a “catch-up” contribution of up to $6,000.  Meaning a potential $24,000 contribution per year each.  To make this even better your employer may match some of your contributions, and/or offer a profit sharing contribution.

You can potentially have combined contributions (employee, employer, and any profit sharing) of $54,000 per year.  That jumps to $60,000 per year if you have reached 50 years old (2017 numbers).  There will often be a vesting schedule for the employer contribution, meaning if you leave your job within a certain period of time you will forfeit some of the matching or profit sharing contributions.  With that in mind be aware of when you give notice, you don’t want to quit one day before another vesting deadline. (This may sound obvious but I guarantee you most people forget about this when they overwhelmed with the excitement of their next job.)

Depending on how you look at it a big benefit or big drawback of a 401(K) plan is the limited investment options.  You may get stuck with some crappy investment options, or the plan may not have a great array of choices.   For some the limited choices may make getting started easier, other may grumble about being limited to a select group of investments, or not being able to utilize their favorite investment selections. In the grand scheme of things I’m pretty ambivalent on this point, I’d rather get a generous company match and good investment options, than amazing options with no match, or the lower contribution limits of a traditional IRA.

 

Live for Today, Plan for Tomorrow.

 

DAVID RAE, CFP®, AIF® is a Los Angeles-based  financial planner with DRM Wealth Management, a regular contributor to Advocate MagazineHuffington PostInvestopedia not to mention numerous TV appearances.  He helps smart people across the USA get on track for their financial goals.  For more information visit his website at www.davidraefp.com  or the Financial Planner LA blog.

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