Did you know that Individual Retirement Account (IRA) and 401(k) plans are retirement savings accounts which have valuable tax benefits, and you can contribute to both at the same time?  The wizards behind MoneyWizard.co will help you choose a savings plan that suits your lifestyle. Read on to find everything that you might need to know about these two accounts.

What is an IRA or 401(k) account?

A 401(k) is a qualified retirement plan that provides the opportunity to save and invest in preparation for retirement on a tax-deferred basis. Your employer usually sponsors this account. On the other hand, an IRA is established at a financial institution and it provides the ability to save for retirement with tax-free growth or on a tax-deferred basis.

What are the eligibility requirements for an IRA or 401(k) account?

Having earned income is a requirement for contributing to a traditional IRA, and your annual contributions to an IRA cannot exceed what you earned that year.. The only exception is when you are married and you file your tax returns jointly. In such a case, a contribution may be made to a spousal IRA for a spouse not in employment. 

On the other hand, a 401(k) account can only be accessed through your employer. This is a retirement plan sponsored by companies where contributions are made directly from the paycheck. The 401(k) provisions may vary from company to company. In the US for instance, some companies may require that you have worked for a certain period of time before you become eligible to make contributions to the account.

Should you roll your 401(k) to an IRA or your new employer?

Contributions to a 401(k) account are made through payroll deductions. Therefore, any employee on payroll can choose to have a certain amount automatically deducted from their paycheck and deposted into their account. Even so, there are employers that offer to contribute on behalf of eligible employees; however, an employer’s contribution is dependent on the company’s policies. Typically, a matching contribution ranges from 2–10% of the employee’s income and is contingent upon an employee’s particular level of participation. For an IRA, you may set aside a given amount every year, which is then deposited into the account, or have deposits automatically done at regular intervals.

Should you max out your 401(k) or Roth IRA?

Contributions to an IRA by individuals below 50 years of age was capped at $6,000 in 2020. For older contributors, those above 50 years, the IRS allows deposits of up to $7,000. The case is quite different for 401(k) contributors as the annual limits are higher. For contributors below 50 years of age, a contribution of up to $19,500 is permissible. Contributors older than 50 years can deposit a total of U$26,000 in their 401(k) account.

Should I use a Roth IRA or 401(k)? 

Financial advisors recommend that you contribute at least 10% of your income for retirement and the savings should be increased gradually. Beginning your savings journey early gives greater room for your investments to compound. Utilizing the 401(k) has the advantage of reducing your tax bills significantly.

Should I rollover to IRA or 401(k)?

Whether you count an IRA or 401(k) among your investment vehicles, contributions to these accounts allow you to decide how your money is invested. In a 401(k) plan, employers suggest modes of investment. If you are saving with an IRA, the services of a financial institution or advisor who oversees the account may be needed. According to Sara Hornick, a Michigan-based executive partner and financial advisor affiliated to Hudson Wealth Management, IRAs have more investment options when compared with 401(k) accounts.

Reflecting the cost of administration and management, 401(k) fees are charged by the plan provider and the individual funds within the plan. Although individual investors don’t have much control over plan provider fees, they can choose investment funds within their 401(k) with lower expense ratios. Roth IRAs have several costs associated with them, including account maintenance fees, commissions, and expense ratios. In general, accounts that charge less in management fees provide fewer investment opportunities. Contrary to this, accounts that charge higher fees provide greater, more actively managed services, including financial recommendations and how to personalize your portfolio. When settling for an investment option, determine the risk levels that make you comfortable and the external guidance you will need during decision making.  

What is the withdrawal criteria for an IRA or 401(k) account?

Holders of both IRA and 401(k) accounts are required to wait until they are 59 years and six months before they can make withdrawals. Making withdrawals earlier will result in fines and penalties. The fines may be up to a 10% penalty charge on the amount withdrawn from the account and an additional tax on the withdrawal may be imposed.

However, holders of both accounts are exempted from the withdrawal penalty in certain circumstances. Holders of 401(k) accounts who exit from employment at the age of 55 or above are allowed to withdraw from their 401(k) without incurring additional tax. This is not the case with IRA holders, who are permitted to make withdrawals without being taxed in specific circumstances, such as health insurance following a layoff.

What are the benefits of an IRA account?

• IRA accounts allow you to make contributions of up to $6,000 per year ($7,000 if you’re 50 years of age or older). It allows you to deduct the amount of the contribution from your income upon filing your federal and state income tax return.
• Even if tax-deductible in the year when a contribution is made, any earnings accumulated in the IRA account will be fully tax-deferred until when they are withdrawn.
• When tax-deductible, contributions reduce your adjusted gross income. This provides a basis for the calculation of particular itemized tax deductions and your tax rate.
• Even though you can begin making withdrawals from the age of 50 years and 6 months, you can wait until you are 70 years and 6 months. This allows the money to keep on accumulating tax-deferred investment income until when you are 70.5 years.
• It gives you an opportunity for making extra retirement savings contributions even when covered by the employer-sponsored 401(k) plan.

What are the benefits of a 401(k) account?

• Savings are pre-tax. Therefore, you do not pay taxes until when you withdraw the money at retirement.
• It allows your savings for retirement to grow tax-deferred.
• Since contributions are not consideredincome, you will be in a lower tax bracket, thereby reducing your tax bill.

Which is better: 401(k) or IRA?

You are allowed to make contributions to both an IRA and a 401(k) as part of your retirement plan. Using both accounts is considered best practice. One approach entails depositing the maximum amount possible to a 401(k) every year. Then, you can deposit additional money in an IRA. This increases the amount of tax-free funds that will be saved for your retirement every year.

The wizards behind MoneyWizard.co will help you consider the specific benefits of each savings plan in order to make a decision that suits your retirement needs.