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.

A 401(K) account is an employer-based retirement account and is governed by federal regulations and choices your employer makes for you regarding investments and 401(K) withdrawals. For example, there are limits on what you can invest in, limits on loans and withdrawals in both amount and purpose. There are also penalties if you withdraw money under certain circumstances.

401(K) rollovers are considered an IRA account, technically. They are both investment accounts set up for retirement. However an IRA account can be set up outside your employment, and could be invested in many more types of investment vehicles than a 401(K). Contributions to both a 401(K) and IRA are made before tax, and you pay taxes instead on the money you withdraw when you are retired. You can do a 401k withdrawal and also an IRA withdrawal both before and after retirement age, but if you withdraw before you reach the statutory age limit, there can be penalties and taxes due and owing. They also both have contribution limits, although in a 401(K) you can contribute more than to a traditional IRA account. Confused yet?

When you leave your employer, you have the option to leave the 401(K) behind with the employer’s fund manager, or you can instead do what’s known as roll over your 401(K) to a new brokerage. Your rollover account is often referred to by brokers as “rollover IRA”, because once you roll over into a new account, the new account is not technically a 401(K) account any longer. This instead is a traditional IRA to which you have moved your 401K() fund balances.

A 401k rollover to IRA can benefit you, because the rules get relaxed on the new account. You are not prevented from withdrawing money, as you might have been at your old job. You will still be responsible for paying the taxes and penalties, which can be substantial at nearly 40% of the withdrawal amount; for that reason a 401k withdrawal is never recommended except for emergencies, or if you qualify for an exception such as paying for college (you will still owe taxes). But when you rollover your account, you can now invest as you see fit, and are not limited to the investments your employer has chosen for you. You can also invest your 401k in cash vehicles such as U.S. Treasury notes or T-bills, or money market funds and CDs. The choice is now yours, not your employer’s.

One other reason to roll over is that you can convert into a Roth IRA account when you roll over your 401k. Money you invest in a Roth IRA is invested with after tax dollars, but when you retire, you pay no taxes on the money you take out. This can be a significant savings – you could pay less by paying taxes today instead of in the future when the value of your account has grown. When you covert from a tax-deferred account into a Roth however, you will owe taxes on the money you previously invested with a tax-deferral, so check with your fund manager for conversion details. Right now, there are regulations which allow you to pay the taxes owed over time, so it’s not such a big hit all at once.

Taking your 401k rollover to an IRA makes sense on a number of levels. By moving your retirement funds today, you can gain control over your financial future and improve your returns.

Here at Saving Cash Tips, we’re hosting Part 2 of the Investing Carnival. We’ve been checking out some posts on investing blogs around the web, looking for good ideas about how to invest. Here are some posts we think you’ll find helpful in your investing efforts:

In this tough economy it can be hard to stay focused on saving for retirement. At
Retire Early Guide they teach you effective savings tips so that you can stay on top of saving for your future now! The site covers topics such as paying off your mortgage faster, saving for your childrens education and cutting variable expenses!

Jim Cramer has given me great insight into the stock market through a service he created called Action Alerts Plus which allows us to watch as he makes his own trades through a charitable trust portfolio. Read my review and sign up for a free two week trial.

And here’s some good advice about 401k rollover options: When deciding to leave your current employer, you have more to think about than your new job. If you have invested in the company’s 401k you need to decide what you will do with your retirement funds.  Educating yourself about your rollover options is crucial before taking action.

Ty Coon over at Stock Market Investing Today has started his Poor Man’s Stock Market Investing Challenge. He’s helping people use a stock simulator to learn how to start investing in the stock market.

According to Stock Market for Beginners Guide, for all newbies who wish to make money in the stock market the difference in making big bucks versus losing is the education. To begin it is important to understand how the stock market works and how the stock exchanges operate. Understanding the stock market today will help avoid a few costly mistakes while you are a beginner. It will also help as then you will be a notch above those who venture into the stock market with no knowledge and understanding of the markets.

At 401k Rollover Answers, they’ve pointed out that in this time when many people are facing a job transition, one of the important details that can fall through the cracks is the question of what to do with one’s 401k account. It is a good idea to do some research before deciding what to do with the retirement fund from your old company. This article demonstrates some of the common mistakes people make, from cashing it out early, to forgetting they’ll need to pay back a 401k loan.

Hope you find these Investing Carnival links profitable!

I finally heard Suze Orman say it last night – to set up a self directed IRA rollover account with a discount brokerage so that YOU are in control of your funds. I don’t think you can get video of her broadcasts, I will keep looking for the link.

At the beginning of the downturn in mid-2008, she had some typical, conventional  things to say, you know, the old “if you’re in the market for ten more years then stay put” crap, but she’s coming around.  Now she is telling folks facing imminent retirement that they need self directed accounts and to set up 401K rollover accounts – and not leave them at the mercy of a former employer.

She also answered one caller, whose employer has stopped the match and who makes too much to contribute to a ROTH, telling her NOT to “keep putting in the max to your 401k”.  Wow – she instead said do a non-tax deductible IRA, then roll it into a ROTH each year.  Go Suze!   BTW – so many money types say only put in up to the match, then go ROTH or otherwise – Jim Cramer, now Suze.  Maybe some folks will get the message.

So what do you do? Open a self directed IRA or a 401k rollover account with a top rated discount broker.  Learn to invest money in the markets.  LEARN what works, for YOU. Don’t expect anyone to tell you the right thing to do.  Then place your own investments. Today, you can even open a Roth 401k with a discount broker.

And while I”m at it – I’m passing this article around to all of my friends.  The article, by Jeffrey Goldberg, is titled “Why I Fired My Broker” and it explains why you should too.  Read it and understand why your employer’s 401k managers and financial advisors generally are a waste of your time.

Why I Fired My Broker, by Jeffrey Goldberg

Their job is to make money for their firm.  Not protect you from downturns.  As long as their losses aren’t as great as the losses in the index funds, they consider that a “win”.

There are many ways to invest money that are safer for the long term, but you will have to learn more about investing, learn more about the markets, and not just expect to park your money in a mutual fund somewhere and let it sit.  This is not just a “down” market. This is potentially a stagnant market, with little or limited growth for years, even decades, to come.  It requires a different understanding to be successful, as opposed to just waiting out a temporary downturn in a bull market as has happened in the past.  You will have to learn the best way to invest money for yourself, and not rely solely on tee vee talking heads or even experienced financial planners to help you. Keep your $$ in a CD or high interest checking account so you have cash available when you need it.

Stay tuned here in the next few posts as I list some publications you really want to read.  These will not give you the same old buy and hold bull – they will explain why the “advice” you’ve been getting has been skewed against you from the beginning.  Start with Crash Proof, by Peter Schiff  (the new edition, Crash Proof 2.0, is coming soon!).

Bottom line:  Take advice from NO ONE. Not even us.  And read outside the lines folks.  Don’t take conventional wisdom for truth.

When you have a 401k plan at work, and you leave your job for any reason, you can choose between taking a 401k rollover into another brokerage account, or leaving your funds with your employer’s plan.  For a variety of reasons, it’s nearly always best to roll over your 401k.

With so many people saving more today, and also facing an increased possibility of being laid off and changing jobs, using the 401k rollover option is a way to maintain some control oer your retirement security.  Unfortunately, the roll over is not very well explained or understood by most investors.  It’s something we advocate very strongly – to get your money out of the hands of mutual fund managers who do not have your best interests at heart!  It might mean you need to take the time to learn to invest money beyond your current knowledge, but that is FAR better – and more profitable – than sitting idly and helplessly watching your retirement nest egg vanish without any comment from your plan administrator or your company’s mutual fund managers…

When you have a retirement plan set up by your employer, the investment options are always very limited. They don’t want to pay a lot of money in admin fees, nor take a lot of risk, by offering a wide selection of investment vehicles to their employees. The management headaches are too great.  And, their plan consultants are probably telling them all the same conventional crap about perpetual growth, stock market returns, etc etc. 

However, once you set up a self direct IRA using your 401k rollover, you can start investing in all types of vehicles for retirement that were previously unavailable.  Now, you can start taking control over your money,and not leaving it to the mercy of conservative – or worse, convention – mutual fund managers.

To roll over your 401k account, you first open a new, self-directed IRA account with your new broker of choice.  As you complete the paperwork, you’ll se that they ask if this is a rollover account.  If so, they will give you all the appropriate paperwork to have everything transferred from your employer’s plan.  As long as you aren’t taking any withdrawals from your retirement account, there are no penalties or taxes required. 

You have four main options when you leave your employer, as to what to do with your 401k rollover.  They are, in order of preference:

1) Cash in your account. BEWARE: if you cash out your account prior to your statutory allowance, you will pay taxes and penalties!
2) Stay with the retirement plan from your previous employer. This is where you could stay if you really just don’t care about what happens to your money. 
3) Transfer the balance of your prior retirement account into the retirement plan offered by your new employer. At least here you can keep an eye on it.
4) Open a Self Directed 401k Rollover IRA account with another broker or mutual fund of your choice, and transfer all retirement funds into that account.

We don’t recommend you ever do #1 unless you are in serous, dire financial difficulty.  You will lose roughly 40% of your account in fees and penalties.  As for options #2 and #3, these are both  conservative, hands off type decisions.  If you just don’t want to think about making your money work for you, or even think about it at all, then leave them in the hands of the mutual funds your employers have chosen for you.  But don’t complain when you lose money! 

Only by choosing #4 will you have a new chance to really build up your account balances for retirement.  With this account you will learn more about investing,  and have the option of buying and selling whatever investments you choose that fit your personal financial plan.  It’s not for everyone, but by learning a little about investing, you can gain a lot more secure retirement.

The biggest problem with employer retirement plans offered to employees is that they include a very limited number of investment choices. Of the ones offered, many overlap in the types of stocks and bonds they invest in. A study from Columbia University found that the median number of mutual funds made available to employees was just 13. And this included all funds, even money market funds, fixed income funds, and balanced funds, as well as stocks.

Since you have fewer investment choices within your 401k, your employer-sponsored plan hampers your ability to profit during different market trends and to reposition your retirement balance into accounts with stocks, bonds, mutual funds and ETFs that offer higher risk-reward profiles.

The best thing you can do is to set up a 401k Rollover account with a brokerage that will give you access to all the types of investments available in the market.  (We use TradeKing for all of our accounts, since they have great educational materials and really low fees.)  By opening up a 401k roll over IRA at another company, you can break out of the limits of your employer-sponsored plan and thereby increase exponentially the number of mutual funds, stocks, bonds, ETFs, money markets and more that you have available for investing. Choose a broker that has great resources for investors to learn, such as large investor discussion groups, materials about how to invest, training videos and so on. There’s always something to learn to grow your retirement account to its fullest potential.

It’s easy to see how you might improve our retirement account returns.  If you transfer $50,000 out of your 401k plan, and move it to the Rollover IRA, having a wider range of investment choices can mean that your annual return increases from 8% in the old 401k, to 12% in the Rollover IRA. After 20 years, your roll over IRA will be worth $482,315, more than twice the $233,048 that you would have had if you’d kept your funds in the employer-sponsored plan – and that assumes you haven’t added any deposits to your Rollover IRA.

So how do you set up a 401k rollover account?  There are two ways you can do it.  You can start by opening a Rollover IRA account with your new broker (also known as a self directed IRA, because now you call the shots!)  After that account is set up, you can contact your plan administrator from your former employer and ask to transfer your assets into the new account.

After that your two choices are to have the money sent directly from your previous 401k plan, into the rollover IRA account. This is known as a direct rollover. The second alternative is the indirect rollover, where you you take a distribution of the funds from the retirement plan, then deposit them yourself into your new roll over account.  Other than in the event some exception applies, you are given 60 days to get that distribution into the new account and avoid any taxes or penalties for a withdrawal.  Check with your old and new plan administrators to see which is right for you.

Now that you have set up your 401k rollover account, you can continually leverage that account each time you switch jobs, by moving any accumulated 401k investments into the rollover account.  You just have to instruct your employer’s retirement plan administrator to transfer your assets to the new IRA account.

There is also an option for your to continue to deposit funds to your new IRA, however check to see whether you are subject to limits regarding annual contribution amounts.

The bottom line is, why leave your retirement funds to sit in an account where they are not going to work as hard for you as possible?  Opening up your own self-directed IRA by transferring to a 401k rollover is your best option for growing your future retirement nest egg.   Your new 401k rollover, now opened up as a self-directed IRA, will give you much more control over growing your retirement savings.