All About 401(k)s
A 401(k) plan is a qualified plan, also known as a defined contribution plan, offered by your employer into which you can make pre-tax or Roth/after-tax contributions directly from your pay. Typically, there are a set number of investment options from which you can choose to allocate your funds and current/future contributions. Your employer may make matching contributions or other types of contributions, like profit-sharing contributions, into the plan on your behalf. These contributions are always pre-tax. There are limits as to how much you can contribute to a 401(k) plan. For 2021, if you are under age 50, you can contribute up to $19,500 of your salary. If you are over age 50, you are eligible for an additional contribution amount of $6,500 for a total of $26,000. The maximum joint contribution by both employee and employer into a 401(k) plan in 2021 is $58,000 for those under 50 and $64,500 for those age 50 and older.
For the most part, you are fully vested in your own contributions and employer matching contributions; however, there may be a vesting period for some part of the employer match or depending on the type of contribution. A vesting period is a period over which you become fully entitled to the funds, and should you leave the company prior to meeting the vesting period, you must forfeit the remaining balance. A typical vesting period may be that after the first year you are 20% vested, after the second year you are 40% vested, and so on until you are fully vested after the fifth year. Withdrawing funds prior to age 59 ½ from a 401(k) may trigger taxation and the 10% early withdrawal penalty. Also, typically, you must experience a triggering event to receive a payout from a 401(k), such as retirement or change of job, death or disability, reaching age 59 ½, hardship, or plan termination.
Sometimes, employers will permit loans on 401(k) plan balances, and this allows up to 50% of the vested balance to be loaned up to a maximum of $50,000. You must repay the loan within 5 years. There are some exceptions to this rule if the loan is for a first-time homebuyer. The 10% early withdrawal penalty may be excused under certain circumstances including death, disability, SEPP, medical expenses, and if the employee separates from service during or after the year the employee reaches age 55. Regarding mandatory IRA distributions at age 72, with a 401(k), if you continue to work, you do not have to begin taking distributions until you retire.
All About IRAs
An Individual Retirement Account (IRA) is an account you establish that can accept rollovers from 401(k)s or other employer-sponsored plans, as well as tax-deductible and non-deductible regular contributions to help you save for retirement. You can open an IRA in many different vehicles including an annuity, a bank account or certificate, or a basic investment account. There are many types of IRAs including traditional IRAs, Roth IRAs, SIMPLE IRAs, SEP IRAs, and non-deductible IRAs. Like the 401(k), there are rules regarding the amount you can contribute. In 2021, you can contribute up to $6,000 into an IRA or $7,000 if you are 50 or older. If you meet certain requirements, the contributions can be tax-deductible. If not, then you do not receive a tax deduction in the year you make the contribution.
Unlike the 401(k), you can make contributions to an IRA based on your own earned wages, as well as your spouse’s. Also, if you or your spouse is eligible for a retirement plan through their employer, then the amount of contribution you can make to a regular IRA and deduct can be reduced or eliminated entirely. Unlike the 401(k), an IRA account may offer you a limitless suite of investments to choose from including individual stocks, bonds, mutual funds, commodities, etc.
While the 401(k) plan may allow loans, there are no such allowances from an IRA. Withdrawals from IRAs may also be subject to the 10% early withdrawal penalty (distributions prior to reaching age 59 ½); however, there are some exceptions to this rule which include death, disability, qualified higher education expenses, SEPP, qualified first-time home purchase up to $10,000, and medical expenses. Also, unlike the 401(k), you must begin taking mandatory distributions from the IRA account even if you continue to work past age 72.
In summary, here are the main differences between 401(k)s and IRAs:
- 401(k) plans may have a more limited suite of investment options from which you can choose.
- The contribution amounts and income eligibility figures differ between the two.
- IRAs allow you to make contributions based on a spouse’s earned income, while 401(k) plans do not.
- Fee structure is something to consider.
- 401(k) plans may allow for loans – IRAs do not.
- 401(k) plans allow you to defer mandatory distributions if still working at age 72+, while IRAs do not.
- 401(k) plans and IRA exceptions to the 10% early withdrawal penalty differ slightly – 401(k) plans do not allow an exception for qualified higher education expenses, but IRAs do. 401(k) plans do not allow the exception for up to $10,000 for first-time home buyers, but IRAs do. 401(k) plans do not allow the exception for health insurance premiums paid while unemployed, but IRAs do. Lastly, 401(k) plans do allow an exception for separation from service during or after the year the employee reaches age 55 (50 for public safety employees), but IRAs do NOT.
Stay tuned over the next few weeks for follow-up pieces on retirement accounts, where I’ll cover “Everything You Need to Know About Self-Directed IRAs and Non-Deductible IRAs” as well as “Items to Consider Before Cashing Out or Rolling Over a 401(k)”.
To discuss this content further or to ask any financial-life question you may have, we encourage you to reach out to us at 724.942.2639 or schedule a FREE/no-obligation time to chat with an advisor at your convenience.
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