IRA vs 401k
The earlier you start planning and saving for retirement the better off you will be in the later years of your life. This doesn’t mean that you won’t have any savings at all if you don’t start until later because there are several plans you can choose from at any time in the process of your career. Two of the best plans for US residents to consider are known as Roth IRA and 401k. Not only will they help you put away money for retirement, but they are tax deductible. Even though they are both commendable products, it is important to know the specifics of each one and how they are different from each other.
About the 401k plan
Your employer initiates a 401k plan and you decide how much you want to contribute to the plan each month. The employer will then hold back this amount, usually a percentage of your earnings, and deposit it into the fund. Interest is paid on the money and both grow over time as you continue to contribute. Some employers match the amount that you contribute.
The amount of money you contribute to your 401k plan is tax free. You can claim $4000 of contributions per year on your income tax return. However, when you retire and start withdrawing the funds, you pay the taxes at this time. Essentially the taxes on the contributions are deferred until later in your life.
Because the intention of a 401k plan is to provide you with an income after you retire from your career, it is not in your best interests to withdraw any money from the plan before you reach the age of 59.5. If you do so, it will cost you money because the government will impose a penalty in the amount of 10% of the funds that are in the account. There are circumstances, though, that will allow you to take advantage of your 401k when you are younger than 59.5. These include being eligible for disability, the need to pay for medical care or in the case of a natural disaster.
You can also borrow money from your 401k plan. The amount you borrow though is restricted. You are only permitted to borrow up to 50% of the amount of the fund or to a limit of $50,000. This loan is tax free as long as you repay it in full within five years, unless you are using the money to buy your first home.
Among the various types of 401k plans available, the most popular are the traditional 401k, safe 401k and harbor 401k.
About the Roth IRA
The easiest way to explain what a Roth IRA retirement plan is all about is to say that it is very similar to a permanent savings account. Like the 401k plan you have to be 59.5 years of age in order to withdraw funds from the account. You must also have paid into the fund for at least five years. However, you still pay the taxes on the money you invest, which saves you from paying taxes after you retire. You don’t have to pay taxes on the interest you earn on the money you save either.
Many people are choosing to take out Roth IRA retirement savings plans instead of a 401k plan because of the tax issue after they retire. You can invest up to $4000 per year, but if you are over the age of 50, you can invest a little more – $5000 per year. You will have to pay a penalty if you withdraw any money before you reach the age of retirement, but you can continue to invest in the plan up to the age of 70 and there is no stipulation that you have to take any money out of the account.
Differences between 401k and Roth IRA
The differences that exist between these two retirement savings plans are not easily detected unless you delve further into each one. Whether or not your employer contributes to the 401k plan, you don’t have to pay taxes on the amount you contribute, even though it is earnings. You do, however, have to pay taxes on the monthly amounts you receive from the plan after you retire. There are no tax-free benefits on the contributions you make to a Roth IRA, but neither do you have to pay taxes on the withdrawals.
Another difference lies in the management of the plans. You don’t have any say in how the money you contribute to a 401k plan is invested or controlled because this is the prerogative of your employer. However, the money you contribute to a Roth IRA is yours and you manage it on your own.