*Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for investment, tax, legal or accounting advice. You should consult your own investment, tax, legal and accounting advisors before engaging in any transaction.
What is the difference between a 401(k) and an IRA? Can I have both at the same time? Will that save me more money, or just give me a headache? Are there rules or restrictions to either account?
The US retirement system is a far from perfect system – it’s convoluted, confusing, and there are so, so many rules. It might be why nearly 40% of all Americans don’t bother saving for their retirement at all. In our fast-paced, crazed from sun-up to sun-down lives, sitting down and attempting to sort through the complicated labyrinth of paperwork and restrictions, just to figure out where you can safely store your nuts for the winter, is the last thing any of us wants to do. But it is probably the smartest thing you could be doing with your time. You don’t have to be a financial wizard to figure this all out; you just need to understand a few basic principles and you can feel confident that, when it’s time, you can retire comfortably and with ease.
What’s the difference?
That’s easy…sort of. The three major areas of difference between a 401(k) and an IRA are tax treatment, investment options, and employer contributions. We’ll go into a little more detail below:
- 401(k): If you’ve ever wondered why it’s called a 401(k), wonder no more. It’s named after Section 401(k) of the Internal Revenue Code (IRC), which is more commonly referred to as the IRS tax code. 401(k)s are employer-sponsored deferred income plans. To contribute, you tell your employer how much of your pre-tax income out of each paycheck you’d like to designate to your 401(k). Any contributions made to the account are not taxed by the IRS. Taxes are deferred until you reach retirement age and begin making withdrawals from the account. Often, 401(k)s come with an employer-matched contribution. So, for example, your employer might match 50% of what you contribute, up to 3% of your annual salary. There are also solo 401(k) plans that you can set up, independent of your employer.
- IRA: An Individual Retirement Account or IRA, is a type of savings account set up by individuals to set aside money for their retirement. There are several types of IRAs: Traditional IRAs, Roth IRAs (IRAs that are set up directly between you and an investment firm), SIMPLE IRAs (established by employers or self-employed individuals), and SEP IRAs (for small-business owners). For the most part, contributions to an IRA are tax deductible. So, if you contribute $5,000 annually to your IRA, you can claim that as a deduction on your income tax return. Similar to a 401(k), your contributions are not taxed by Uncle Sam, that is until you retire and being making withdrawals.
Things to Consider
Now that you can officially tell the two types of accounts apart, you might still be wondering if having both types of retirement funds set up is worth it. To help you decide that, consider the following:
- Savings: Yes, having more than one account can help you squirrel away more money. But you have to pay attention to those pesky restrictions to make sure which types of accounts you can contribute to simultaneously. (We’ll get to that later).
- Taxes: Remember that there are two types of retirement accounts: tax-deferred and after-tax. It may be beneficial to have a combination of these accounts as your tax-bracket in retirement may be different than the one you’re in now.
- Convenience: More accounts = more hassle at tax time. Plus, it can be harder to manage your asset allocation when you have multiple accounts open at a time.
- Cost: Watch out for account fees, investment charges, minimums, and more. The more open accounts you have, the more money you might be spending on these sorts of things.
Rules and Restrictions May Apply, See Attorney for Details
As with anything, there are rules. And no shortage of them. And to make it more fun, the powers that be like to switch them up every now and again. Here are the rules of the game, starting in 2017:
- First, there are restrictions on how much you can contribute to different accounts. The 2017 contribution limit for a 401(k) is $18,000; $24,000 if you’re 50 and over. Additionally, you can also deposit up to $5,500 in a Roth or traditional IRA for 2017 ($6,500 if you’re 50 and up). That’s the combined limit for both types of IRAs, by the way. You can’t put, say, $5,500 each into an IRA and a Roth IRA. If you’re maxing out your 401(k) and have more to save, opening a Roth IRA can help you stash away another $5,500 or $6,500 a year.
- Second, there are restrictions on how much you can deduct from your taxes. If you’re contributing to a 401(k) or other employer plan, you can open a traditional IRA as well, but you may or may not be able to deduct that chunk of savings from your taxes, depending on your income. Just remember: it gives you the chance to save more, and your contributions will grow, tax-free.
- Last, there are specific income restrictions on Roth accounts. If your modified adjusted gross income (MAGI) is $186,000 or less in 2017 (married filing jointly), you can contribute up to the full amount in a Roth. As your income rises above $186,000, your ability to contribute phases out.
If you’re nervous or uncertain about your financial stability going into retirement, consider contacting a Financial Advisor or Attorney for help. You can always give us a call at (410) 535-6100 or send us an email at firstname.lastname@example.org if you need help and we can point you in the right direction.