IRA vs 401(k)

December 11, 2015 | by James Behr Jr & Christopher Paleologus

401k-rollover-ira

Are your retirement savings invested in the best type of account for you? Identifying that you need to save for retirement is an important first step but knowing what types of accounts your money should be held in is a close second. Two of the most common accounts are the 401(k) plan offered by employers and the Individual Retirement Account (IRA). Both account types offer several benefits but depending on your current situation, one could prove more useful to you than the other.

 

What is a 401(k)? A 401(k) plan is typically sponsored by your employer and funded by contributions from pre-tax income. Some employers will offer to match your contributions up to a certain amount or a full 100% match of your contribution up to the combined contribution limit of $53,000. If financially possible we always recommend contributing up to the match. Anyone with an employer offering a 401(k) plan may contribute up to $18,000 for 2015 and 2016, with added catch-up contributions of $6,000 for individuals 50 or older. These contributions can lower the amount of income you have to pay taxes on since they will be made using pre-tax dollars. Your savings will grow within the plan and when you reach the age of 59 ½, you are able to begin taking withdrawals which are then taxed at your ordinary income tax rate. Any distributions taken before age 59 ½ can result in an early withdrawal penalty. One drawback to 401(k) plans is that investments are limited to those offered through the plan.

 

What is an IRA? An Individual Retirement Account (IRA) allows individuals to save for retirement on a tax deferred basis. The two most common types of IRAs are the Traditional and Roth. The contribution limits for IRA accounts in 2015 and 2016 is the lesser of 100% of your earned income or $5,500 annually ($6,500 if you are 50 or older). A major advantage of an IRA is the investment flexibility it offers you.

A Traditional IRA is funded with pre-tax income and earnings on investments grow tax deferred until you withdraw money at retirement when it is taxed as ordinary income. Any individual under the age of 70 ½ with earned income may contribute to an IRA. You are able to deduct contributions to a Traditional IRA from your taxes if you are a single filer earning less than $61,000 ($118,000 if married filing jointly) for the year 2016 and are covered by a retirement plan at work. If you are not covered by a retirement plan at work, there is no income limit for your deductions unless your spouse is covered by a retirement plan at work and you are married and file jointly. Traditional IRA distributions must be taken once you reach age 70 ½. There can be an early withdrawal penalty for any distributions taken before age 59 ½.

A Roth IRA is funded with contributions that are non-deductible but distributions are free of federal income tax at retirement forever. Roth IRAs can only be contributed to by a single filer earning less than $132,000 (less than $194,000 if married filing jointly) in the year 2016. Since a Roth IRA is funded with post-tax income withdrawals are not required upon reaching age 70 ½.

So which account is best for you? Maximizing contributions to both a 401(k) plan and an IRA would be an ideal situation but not everyone has the financial capability to do so. Here’s what to do: Contribute to your 401(k) up to the employer match. If you don’t get an employer match, look to contribute to a Roth IRA. If you are unable to contribute to a Roth IRA and are covered by a plan at work, you will not be able to deduct contributions to a Traditional IRA, therefore using your employer sponsored plan would work best. If you aren’t covered by a plan at work and are not eligible to contribute to a Roth IRA then make a contribution to a Traditional IRA. When you have contributed the maximum to your IRA and if you have money remaining, contribute the rest to the 401(k).

Choosing between one type of account and another can be difficult and here are some key considerations to keep in mind:

-Although anyone can contribute to a Traditional IRA, if you are not going to qualify for the tax deduction, contributing to an IRA will only allow for tax deferred growth.

-401(k) plans have yearly contribution limits that can be greater than three times the limits on IRAs and can have the added benefit of an employer match. Be sure that you are not missing out on any match your employer offers. This is equivalent to a 100% gain on your contribution.

-When you leave a job, you are no longer allowed to contribute to that 401(k) plan. Investors should consider rolling over their 401(k) to an IRA. IRA plans offer greater investment flexibility, ranging a multitude of investments whereas 401(k) plans are usually limited to a certain mutual fund family.

-It is important to remember that in certain circumstances, distributions prior to age 59 ½ can cause an early withdrawal penalty.

Contributing to any type of retirement account is necessary to plan for your future. The earlier you start, the easier and better it can be for retirement. There is no universal answer as to which type of account is best for you. The answer can change over time if your financial, employment, and/or life situation changes. If you have questions about your current investment situation, would like a free 401(k) plan review, or are interested in rolling over a 401(k), call us at (610) 825-3540 or email us at jbehr@bluebellpwm.com or cpaleologus@bluebellpwm.com.

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