401(k) or IRA? Why Smart Investors Use Both
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Which retirement vehicle should you use to save for a secure retirement, an employer’s 401(k) or an Individual Retirement Arrangement (IRA)?
Both! The two complement each other, but they don't work exactly the same way. Here are some of the distinctions that define these two essential retirement savings vehicles.
Since they debuted in 1978, employer-sponsored 401(k) plans have grown to protect $5.3 trillion in retirement savings for more than 65 million Americans. (Read a brief history of the 401(k).) Named after the section of the Internal Revenue Code that regulates them, these accounts allow employees to contribute a percentage of their salary to a tax-deferred account administered by their employer. It also allows the employer, on a discretionary basis, to match a portion of the contributions its employees make. The money is invested in the investment(s) selected by the employer and accumulates tax-deferred until you begin to take withdrawals.
The IRA (Individual Retirement Arrangement) has been around even longer than the 401(k). They were created in 1974 as part of ERISA (the Employee Retirement Security Act). The important word here is “individual.” Anyone can open an IRA and fund it with taxable income. It can also be funded by a rollover from a previous employer’s 401(k) account. There are many types of IRA, the most common of them are Traditional and Roth. There also are SEP and SIMPLE IRAs which are retirement plans designed for small business owners. The money in your IRA accumulates on a tax-deferred basis just like the 401(k), and over time, and you are not taxed on any growth in value of your investment until you begin to take distributions. In some cases, your distribution may even be tax free if the IRA you choose is a Roth IRA.
One important distinction between 401(k) plans and IRAs is that, within a 401(k), the employer chooses the investments you can select from, whereas in an IRA you, the individual, can choose any allowable investment. In an IRA you may have to move your dollars to a provider that offers the investment you want.
The amount you can contribute to retirement plans for every tax year has a limit. The IRS sets limits on how much you can contribute annually to any retirement savings account. For 2019, you may contribute $6,000 combined to any Traditional and Roth IRA , or up to $7,000 if you are age 50 or older. You get to choose how often to contribute—monthly, quarterly, or in a lump sum—as long as your contribution is made by the April 15 IRA tax filing deadline.
The 2019 contribution limits for employees that participate in an employer’s 401(k) plan are $19,000 for workers under age 50, $25,000 for those older than 50. Your contributions are withdrawn from your paycheck each pay period and contributed to the 401(k). You will be able to track your contributions by examining your pay voucher or your account access provided by most recordkeepers.
An additional consideration in 401(k) plans is the notion of “vesting.” This is a legal term that means “to give or earn a right to a present or future payment, asset or benefit.” In the 401(k) realm, your plan may define a vesting period for the employer contributions such as employer matching contributions as well as profit sharing contributions. For example, you might have to be employed six years before your matching contributions are fully vested and belong to you. Every year that you work for the employer, the vesting schedule determines the percentage of the contribution that belongs to you. Note however, that the contributions you made from your own salary belong to you from the start and is never subject to a vesting schedule.
You should be aware that participating in both a 401(k) and an IRA may limit the amount of income you can shelter from taxes. What this means is that if you are participating in an employer plan, the benefit of using your Traditional IRA contribution as a deduction may depend on the level of your income. These limits are based on your modified adjusted gross income. Read more in IRS Publication 590-A. Other benefits such as the tax saver’s credit may not be available to you the higher your income level is.
Both 401(k) plans and IRAs offer significant tax benefits:
- Contributions to 401(k) plans reduce your taxable income when they are made. Taxation on all assets in your 401(k) account is deferred from taxation. Taxes are paid only when you begin taking withdrawals from your account. It is good to know however that you can only take distributions from your 401(k) account once you have reached a distributable event. Separation from service, death, disability, plan termination and normal retirement age are some of the common distributable events.
- The pre-tax contributions to Traditional IRAs may also reduce your taxable income when you make them. This is called a tax deduction. There are qualifiers that determine whether a tax payer can use their contribution as a tax deduction. As the account is tax-deferred, the assets and the growth in value are not taxed until you begin taking distributions.
- The money you contribute to a Roth IRA is “after-tax.” These contributions have no immediate tax benefits when you make them. However, if you satisfy certain criteria, you do not pay taxes on the distributions. In effect, this means that the increase in value over time is never taxed.
You will pay fees to an administrator for both your 401(k) accounts and IRAs. The administrator handles all of the recordkeeping and reporting to the IRS.
Because 401(k) plans are employer-sponsored, your employer selects the administrator. The administrator generates all reports for the plan including fees charged to the plan participants. This annual fee disclosure statement lists the fees associated with each of the services and investment choices offered by the plan as well as other types of fees related to the plan.
Of course, IRA administrators charge fees as well, and have the same duty to disclose them. But being able to choose your own IRA administrator—bank, brokerage, or a self-directed IRA specialist like The Entrust Group—puts you in charge. The amount of fees charged, and how they are reported, may be one of the factors guiding your choice of where to move your IRA to.
Choice of Assets
Although you can have both, here is where the differences between 401(k) plans and IRAs, especially self-directed IRAs, come into sharper contrast.
A self-directed IRA gives you the most control over the assets you own in your account. The IRS allows a wide range of assets, and a self-directed IRA lets you make the choice. A short list of the most popular assets among Entrust clients includes real estate, notes, precious metals, and private placements. Of course, you also can hold equities, bonds, and money market, exchange-traded, and mutual funds.
An IRA administered by a bank or brokerage is likely to steer you into those last four investment assets: equities, bonds, exchange-traded funds, and mutual funds since those are the types of investments they offer. These institutions are not usually set up to administer Real Estate or Precious Metals and other non-traditional investments as self-directed retirement plan administrators are. Self-directed retirement plan providers on the other hand do not offer any investments. Instead, they offer the platform to allow you, the investor, to invest in these types of investments under a retirement plan and maintain its tax-deferred status.
The investment choices offered by most 401(k) plans typically feature those same standard investment classes of securities. Many plans categorize them along a spectrum, from conservative (money market funds) to growth (equities). The latest wrinkle in 401(k) plans is the emergence of “target-date funds.” These are managed funds consisting of mutual funds whose asset allocation is age-based with a projected retirement year. Typically, the fund becomes more conservative as the target date—in this case, retirement—gets closer. In addition, many plans sponsored by employers that are publicly traded allow you to own company stock in your 401(k) whereas in IRAs they are prohibited.
In all cases, the ability to choose assets is important because having a diversified portfolio—a mix of different asset classes—is a tactic investment advisors recommend.
What to do with a previous employer 401(k) plan?
When you leave a job, you will have to decide what to do with the money in your 401(k) plan. It may seem easiest to leave the account where it is—let sleeping accounts lie, in effect. But that sleeping account may not deliver the investment performance and flexibility you need to ensure a secure retirement. For one thing, you will not be able to make any more contributions to that plan. You also won’t be able to change your investment choices beyond what is offered under the plan. If there is a change in administrator or other major plan change, you will have to go along with it. All of these restrictions point to the option of rolling over 401(k) plans at previous employers into an IRA.
An IRA is always under your control. You can move it from one custodian to another, or even multiple custodians. If eligible, you can make contributions or not, and change investment choices anytime. This is particularly true for self-directed IRAs, which puts you in control of the assets you own. And with a self-directed IRA, you have the option to choose your own investments that are typically not available at other financial institutions such as real estate, notes and others.
The process for moving funds safely, without tax liability or penalties, is described below.
Generally speaking, the rules governing Traditional IRAs and 401(k) plans make you wait until you reach age 59½ to withdraw funds without paying a 10% early withdrawal penalty. Other rules apply to accounts that are called Roth accounts that allow you to avoid paying income taxes on the amount you take out. Depending on your tax bracket, this can add up. For example, if you are in the 25% tax bracket, there may be a substantial tax liability on the amount of your distribution and if you are under the age of 59 ½, an additional penalty may apply which compiles with the taxes you will owe upon tax time.
There are a few exceptions to the penalty, and they are slightly different depending on whether the distribution is from an employer plan such as a 401(k) or an IRA.
Here are some examples:
- If you lose or leave your job at age 55 or older, and you take a lump sum distribution, you do not have to pay the early withdrawal penalty if you take money out of your last employer’s 401(k) plan.
- The penalty does not apply to money you withdraw from an IRA to pay medical insurance premiums after a job loss for a period of 12 weeks or more.
- Distributions from an IRA for qualified higher-level educations expenses.
Visit the IRS website to view a chart of the exceptions associated with each type of plan.
Because you have already paid taxes on the contributions to your Roth IRA, the withdrawal rules are different. You may make withdrawals of the contributions without paying tax or penalties at any time. Roth IRAs follow the ordering rules when taking a distribution. All contributions made to Roth IRAs are deemed to be distributed first. Conversion dollar are deemed to be distributed second. Conversion dollars are never subject to tax but could be subject to the 10% penalty if the Roth IRA holder is under the age of 59 ½ and none of the exemptions apply. Lastly, to take tax-free distribution of the earnings, a combination of events must be met such as death, disability, attainment of 59 ½ or purchasing a primary residence (maximum $10,000) as well as having owned the Roth IRA for at least five years. Meeting one of the four reasons plus the five-year period means that all distributions moving forward are “Qualified” meaning tax-free.
When a person reaches a certain age, non-Roth retirement plan holders are forced to take a distribution or are penalized 50% of the amount due to be distributed.
The magic number for required minimum distributions (RMD) from a 401(k) and a Traditional IRA is 70½. As previously mentioned, there are no RMDs for Roth IRAs while the Roth IRA holder is alive.
If reading this article has started you thinking about moving a 401(k) from a previous employer or an IRA that has been under-performing, there are ways to do it that preserve the tax-advantaged nature of the assets.
- A transfer is the act of moving the same kind of account from one firm to another. You can, for example, transfer your AnyBank IRA to an Entrust IRA. Transfers are not taxable events because the assets are never distributed to the account holder.
- A direct rollover is the event of moving assets out of an employer-sponsored 401(k) plan, 403(b) or governmental 457(b) plans into an IRA. Direct rollovers are done at your initiation with your prior employer. You will need to contact and instruct your prior employer to send the distribution of your 401(k) plan to your new or existing IRA custodian. Since the proceeds are payable directly to the IRA, direct rollovers are not taxable events because the assets are never distributed to you. In a direct rollover, it is important that the proceeds are made payable to the name of your new custodian for the benefit (FBO) of your IRA. As an example, “Entrust FBO John Doe Traditional IRA”.
- A rollover happens when you direct the administrator to distribute the funds in your IRA or 401(k) to you, the account holder. Because you receive the funds, this is considered a distribution. If you do not want to be taxed on the amount you received, you have 60 days to re-deposit the money into another tax-advantaged account to avoid being subject to taxes and penalties.
Three Things You Can Do Now
- If you have a 401(k) with your current employer, check your contribution levels. Adjust them during your open enrollment period, if necessary. Most employers allow their employees to redirect and rebalance their investment allocations. If you need assistance, consult with your financial advisor.
- If you have one or multiple former employer’s 401(k)s, take more control of these savings by directly rolling over the account balance to an IRA or multiple IRAs.
- If you want more control over the choice of assets in your current Roth or Traditional IRA, move it to a self-directed IRA.
You can open an account with Entrust online in just 10 minutes.