401(k), IRA’s & Roth IRA’s
401(k) Retirement Plans
Introduced in 1978, the 401(k) plan has become the most popular employer-sponsored retirement plan in the United States. Millions of Americans rely on the money they invest in these plans to support themselves in retirement.
- A 401(k) is a qualified retirement plan, which means you are eligible for special tax benefits.
- You can invest part of your salary up to an annual limit.
- Your contributions come from your pre-tax income (that is, no tax has been deducted from it).
- Your employer may or may not match some of your contributions.
- The money is usually invested in various mutual funds of your choice.
- Generally, you cannot withdraw money without tax penalties until you are 59½ years old.
Roth 401(k) Variant
Although not offered by all employers, Roth 401(k) is an increasingly popular option. This version of the plan requires employees to pay taxes immediately on their contributions. However, after you retire, you can withdraw your money without being taxed on your contributions or capital gains.
The Rollover Option
Many retirees migrate 401(k) plan balances to traditional IRAs or Roth IRAs. This rollover allows you to escape the limited investment opportunities often present in 401(k) accounts.
Once you decide to roll over, it’s important to do it correctly. With a direct rollover, money is sent directly from your old account to your new account, with no tax implications. With an indirect rollover, the money is first transferred to you and full income tax is due on the balance for that tax year.
If you have employer stock in your 401(k) plan, you are eligible to take advantage of the net unrealized appreciation (NUA) rule and receive capital gains treatment on the earnings. This may lower your tax bill significantly
To avoid penalties and taxes, a rollover must take place within 60 days of withdrawing funds from the original account
Individual Retirement Account (IRA)
An Individual Retirement Account (IRA) is a tax-advantaged savings account that individuals can open for long-term savings and investments.
Similar to the 401(k) account that employees receive as a benefit from their employer, IRAs are designed to encourage people to save for retirement. Anyone with earned income can open an IRA and enjoy the tax benefits these accounts offer. However, unlike a 401(k), an individual can open an IRA without going through an employer.
- Individual retirement accounts (IRAs) are retirement savings accounts with tax advantages.
- Types of IRAs include traditional IRAs, Roth IRAs, Simplified Employee Pension (SEP) IRAs, and Savings Incentive Match Plan for Employees (SIMPLE) IRAs.
- Money held in an IRA usually can’t be withdrawn before age 59½ without incurring a hefty tax penalty of 10% of the amount withdrawn.
- There are annual income limitations for deducting contributions to traditional IRAs and contributing to Roth IRAs.
There are many types of IRAs, but the most common are:
In most cases, contributions to traditional IRAs are tax deductible. So, putting $4,000 into your IRA will reduce your taxable income for the year by that amount. After that, when you withdraw your retirement money, it will be taxed at your normal income tax rate. This way your money grows on a deferred tax basis in a traditional IRA.
Contributions to the Roth IRA are not tax deductible, but eligible distributions are tax exempt. Your contributions to a Roth IRA come from your post taxed income, but then you don’t have to pay taxes on your investment gains. When you retire, you can withdraw money from your account without income tax on withdrawals. The Roth IRA also has no required minimum distribution (RMD). If you don’t need the money, you don’t need to withdraw it from your account. Regardless of age, as long as you have eligible income, you can contribute to the Roth IRA.
Self-employed people such as independent contractors, freelancers, and small business owners can set up a SEP IRA.
SEP IRAs are subject to the same withdrawal tax rules as traditional IRAs. SEP IRA contributions for 2022 are capped at 25% of total compensation or $61,000, whichever is lower.
A SIMPLE IRA is also for small businesses and the self-employed. This type of IRA is subject to the same withdrawal tax rules as traditional IRAs.
Unlike a SEP IRA, a SIMPLE IRA allows the employee to contribute to the account and requires the employer to contribute as well. All contributions are tax deductible and can classify the company or employee to a lower tax rate.
What Are Required Minimum Distributions (RMDs)?
A traditional IRA holder must begin receiving his RMD from age 72 onwards and the distributions are based on account size and personal life expectancy. Failure to do so may result in taxation of 50% of the required distribution amount.
What are the benefits of an Individual Retirement Account (IRA)?
An Individual Retirement Account (IRA) provides a way to get tax benefits while saving for retirement. Depending on the type of IRA you use, your IRA can reduce your current tax amount now or when you retire. Investment gains are generally tax-free.
Additionally, the IRA is insured by the Federal Deposit Insurance Corp. (FDIC) is a government agency that provides protection in the event of a financial institution’s insolvency. The FDIC covers customer deposits up to $250,000 per account in most cases that are held by FDIC-insured banks or savings and loan associations.
How is a 401(k) plan different from an IRA?
Both 401(k) plans and IRAs provide tax advantages for employees who invest for their retirement. The main difference is who provides them. A 401(k) is typically provided by the employer and contributions are automatically deducted from the employee’s paycheck.
Some companies even match employee contributions. 401(k) plans have higher contribution limits, but anyone can set up an IRA, regardless of employer. However, most 401(k) plans offer a limited selection of mutual funds and exchange-traded funds (ETFs) to choose from, whereas a typical IRA offers a wide selection of funds, stocks, and other securities.