Entries Tagged '401k IRA' ↓

Often people use the account names “401K” and “IRA” as though they are the same thing. This post will help to clear up what exactly is meant by a 401K vs. an IRA account and other retirement options.

401K or IRA

First, both of the terms 401K and IRA refer to retirement plans. They have some similarities, but they are not the same thing! For starters, a 401(K) is specifically the name of a particular type of employer-sponsored retirement plan. In this type of account, you contribute money from your paycheck into a tax-deferred retirement account. The rules for a 401(K) account are set out in the IRS regulations, and 401(K) refers to the section of those laws which set up this type of account. The term IRA is sometimes used for any kind of retirement account, as it stands for “individual retirement account”. However, the IRA is mainly meant to refer to what is called a traditional IRA, where you can contribute money even if your employer does not have a plan, and you can deduct the money from your taxes, so there is still a tax advantage to depositing money. For both of these accounts, you don’t pay taxes on the money you contribute, but you will pay taxes at the time you withdraw in the future, at whatever your taxable rate is at that time.

401K Accounts

Most of the time, it maybe easier to use the 401K if you have one at work. Many employers offer these, but many do not. If you do have such an account at work, your employer may also provide a “match”, which means they contribute money to match the amount you deposit, up to a certain limit. You can find details about this from your human resources person. With a 401K account, the money is taken automatically from your paycheck, so you don’t have to have as much discipline to remember to deposit on your own. It can be easy to fund this way.

IRA Accounts

For an IRA, though, you can deposit up to certain limits each year, and you can also fund a spousal IRA for your spouse, even if he or she is not working. There are also limits to the contributions on a spousal IRA. With an IRA, you can open this account at a bank or brokerage of your choice, but be sure to ask what options you have to invest. Many times, you will want to go with a broker who can set up a self directed IRA where you can invest in stocks, bonds, mutual funds and other vehicles. Some banks will only offer a selection of mutual funds, which isn’t always the best way to invest. Especially in volatile or uncertain markets, go with an account where you can move money to the right place depending on where the best investment choice is for you.

For the past decade or two, with the growth of IRA retirement accounts and employer-sponsored 401(K) accounts, more and more people are saving for retirement using these vehicles.  It’s widely assumed that Social Security will not provide enough money to live in a style to which many people have grown accustomed, and a way to save tax-free for the future is to open a retirement account.  Subject to IRA tax rules, you can invest pre-tax dollars, or in the case of a Roth IRA, after tax dollars, and have the funds grow until you are eligible to withdraw in retirement. 

Lately however as the stock market has been more volatile, many individual investors are foregoing their IRA contributions because they haven’t learned how to invest for long term growth in any but a bull market.  Many investors think that putting their retirement money in mutual funds is the only option they have to invest, and some individuals with retirement accounts aren’t even sure of the difference between the terms “IRA” and “mutual fund”. Hopefully we can clear up some of the confusion, and offer some ideas for finding good stocks to buy to keep your portfolio growing whether the market goes up or down.

Depending on the type of IRA you have, you may or may not have a good selection of investment choices.  This is also true of 401(K) account plans at most employers.  For example, many people open IRA accounts or retirement accounts with their bank, or an online bank, that restrict the choices available.  This means that there are likely several mutual funds, or particular mutual fund companies, that you can invest in, but you’re prevented from investing in ETFs, individual stocks, currencies, certain types of bonds, and so on.  These banks or employers do not want investors to come back complaining that they lost money in a particular stock, but as we’ve all seen, the potential for losses exists in all investment areas. 

As a result, poor information about investments, as well as the lack of education on the part of investors, are big reasons that people believe they don’t have to know anything about the markets, except to put their money into a so-called “good growth stock usual fund” and leave it there forever until they’re rich at retirement.  That scenario is now officially a pipe dream, and the best advice you can get is to move your money into a self directed brokerage account that gives you real choices and information.  You’ll need to take some time to learn to invest, and take that information into your planning process.  This is the only way you will be able to build a portfolio that can weather the coming economic turbulence.

When you switch to a self-directed IRA account, whether it’s a rollover 401k, or a new traditional IRA, you effectively open a brokerage account which you alone control. You are still subject to the withdrawal restrictions and penalties that apply to retirement accounts, but you can now invest in any investment vehicle which your broker offers.  This could include individual stocks, currencies, government and corporate bonds, options, mutual funds, ETFs, or any type of similar investment.  With this type of account, the choices for investment are much broader, and allow the investor to make decisions based on their personal financial plan, their own risk tolerance, and other goals that may or may not be fulfilled through the limited choices offered by employer-based plans or certain bank plans.

An important thing to remember is that with a self directed account, you can still invest in conservative investments like bonds and CDs or money market funds, or find good stocks to buy that match your investmnet goals, but you also have the ability to buy and sell holdings as you choose, or select new vehicles that fit your financial goals better. “Self directed” does not equate to “risky”.  It merely means you are now in control of your money and your financial future, which is the best way to make sure your money is working in ways that match your unique defined needs.

You’ve been saving for retirement, maybe you have been getting a company match; you have also either been adding to a Roth IRA account, or recently converted your regular IRA into a Roth to get the tax-free withdrawals in retirement. But now we are having a financial meltdown, and you know you can pull the funds from your Roth without the same penalties as in a 401K or traditional IRA.  You need the money, and you’re thinking about taking an early 401k withdrawal.  But should you withdraw from your 401k or Roth IRA?

When you withdraw from a traditional IRA or a 401(K), you pay taxes and penalties, because the intent of those accounts is to hold the money for retirement. Your contributions have been tax free, and you will pay taxes when you retire.  Withdrawal after 59-1/2 are taxable, but are also penalty free.  But if you want to withdraw before that time, you will not only pay the taxes you avoided earlier, but a penalty to prevent you from doing so.  Now comes the Roth IRA.  We’ve set up a 401k rollover into a Roth IRA, or opened a new Roth account, to take advantage of the future tax benefits.  We contribute to Roth accounts with after tax dollars, and as a result, in retirement we can withdraw from our account tax free also. It’s for this reason, because the growth in the account is also tax free, that many financial advisors are now recommending that you invest in a Roth for retirement. But there is a down side. Because there are not taxes to be paid, withdrawals, at least of the money you initially deposited, are penalty and tax free.  And when people who don’t save have retirement funds they can pilfer from, they start withdrawing form their future.

The vast majority of Americans have little to no money saved for their retirement over and above what they hope to get from Social Security. this grasshopper vs. ant mentality was possible a few years back, when it seemed like prosperity had nowhere to go but up.  But today, there is a distinct possibility that we will not see growth – of home values, salaries, or anything that would normally put money in our pockets – for a long time.  Even for people who have a twenty year time horizon before they retire, if the current situation in the United States is anything like the deflation Japan suffered, the likelihood may be that there will be little to no growth in any stock or savings accounts for the next ten years. 

So, do you really want to deplete what you have now, while you can still earn and save and sell off possessions, and be more broker when you’re 75 years old?  With life expectancy increasing, do you really want to be working that waitress job at 69 years old because you took money out of retirement to buy a new $40,000 car when you were 55?  Is it harder to ask your child to pay for college today by working their way through, or to expect them to support you alongside their own family in twenty years?  We tend to think in short term time horizons, and today’s needs may be immediate, such as a health care emergency, or job loss.  But using retirement funds to support a lifestyle that was built on credit and can no longer be supported unless you use up retirement money is a foolish choice.  By taking money out of your Roth IRA withdrawal, or a 401K withdrawal, you are essentially hoping that your kids or the government will be able to support you because you will have nothing left.  One is unfair, the other just plain crazy.  You really should get better 401k advice to decide what is your financial priority bore you take out the money.

Remember too that if things go horribly wrong, and you do have to file for bankruptcy, your retirement money cannot be touched by your creditors. That money stays put because it has a purpose to fulfill. If you use it all up and then declare bankruptcy anyway, you have truly robbed yourself.  It’s much better to tighten your belt as much as you have to right now, and leave that retirement money where it is – ten or twenty years down the road.

Putting money aside for retirement is an important step for any wage earner. Pension plans are going the way of the dinosaur, and the only option other than Social Security is if you save your own money in a tax-advantaged retirement account, such as a 401(K) plan at your place of employment.

There are many options available for retirement accounts, both employer sponsored and through your own brokerage account. At your job, your employer has an option to offer a 401(K) retirement account, which lets you put pre-tax wages into a retirement investment account. Not all employers offer this, and if you can’t take advantage of a 401K, you can use a traditional IRA, or Individual Retirement Account.

Don’t get confused, as there is no such account as a 401k IRA – they are two separate types of accounts. However, depending on how much you earned, and your tax filing status, you may be able to invest in both a 401k and an IRA. Once you earn over a certain limit, you can no longer qualify for the IRA.

The amount you invest in an IRA is tax deductible off your federal income taxes. However, the maximum you can invest each year is much less than a 401K, so if you have a 401K option at work, that is probably the better of the two if you want to stash as much money as possible.

Both types of accounts have specific limits. For the tax year 2010, the maximum you can invest in a 401K is decided by your employer, as a percentage of your income, but not more than $16,500, or $22,500 if you are over 50 years of age. For a traditional IRA, the maximum investment is $5,000, or $6,000 if you are over 50 years old. This is also limited to the maximum amount you earned in 2010. (You can learn more about retirement account limits at the U.S. Internal Revenue Service website.)

You can see that there is a big difference in how much you can put away for your retirement. If you are able to put aside the maximum amount of your wages, you should discuss it with a tax advisor or your employer’s benefits manager, to see what your individual allowances are. Putting as much aside as you can may be a good idea. But remember, you will also need to know what the investments are that you’re investing in, not just how much money you can put aside.

Remember also that you can always invest as much money as you want in other accounts – they are just not tax-deferred or otherwise tax advantaged accounts. If you put money into a self-directed brokerage account, you will pay taxes on the capital gains earned in that account. But you also have options such as tax-free municipal bonds, where you can invest with lower tax impacts. The bottom line is, don’t think you are only limited to your 401K and IRA options for financial security in retirement. Work with a financial advisory to consider all of your options, once you’re reached your retirement account limits.