The U.S. Social Security program was never intended to serve as a retirement account.
In order for individuals to maintain a consistent lifestyle, they will most likely need some type of long-term savings plan.
The best savings plans available for individuals are IRAs, Roth IRAs and 401K plans. For the unsophisticated investor, all three of these investment products are easy to understand, implement and use.
Before deciding which one of these plans offer the most advantages for a particular individual, it is important to understand and define these products.
- Individual Retirement Account (IRA) – The investor is permitted to contribute pre-tax dollars on an annual basis into an investment account of their own choosing. The maximum amount is determined by IRS guidelines. The contributions may not be withdrawn until age 59 1/2 or penalties will be assessed. Any amounts withdrawn thereafter will be taxed upon withdraw.
- Roth IRA – Contributions into Roth IRAs are made with after tax dollars. Roth IRAs are guided by the same contribution rules as IRAs regarding with one caveat, the taxpayer must have annual income of less than $99,000 ($156,000 for joint-filers) in order to qualify for this product. Any amounts withdrawn after age 59 1/2 are tax exempt, that includes the earnings. Earnings on early withdraws are fully taxable and early withdraws are not subject to penalties.
- 401K Plans – These are employer sponsored plans. Individuals contribute a certain percentage of their pre-tax wages into the account on a per paycheck basis. In Most plans, employers offer some type of matching provision. Employee contributions are restricted based on IRS guidelines. Early withdraws (before age 59 1/2) are subject to penalties. All Withdraws are taxed when withdrawn.
Comparison of IRA vs 401K
Investment Products – With an IRA, the investor has a much wider range of investment products to choose from with few restrictions. Investment products in an employee sponsored 401K plan are restricted as determined by the employer and plan administrator.
Tax Advantages – For tax purposes, both of these plans receive the same treatment for both contributions and withdraws.
Contribution Restrictions - IRA contributions are limited to annual amounts of $5,500 or $6,500, depending on age. 401K plan limits are set at $17,500 or $23,000, depending on age. Also, the total employee/employer contribution cannot exceed $46,000.
Matching – 401Ks are the only retirement plans that have an employer matching component.
Loans – Loans are not available against IRA contributions. According to IRS regulations, loans are permitted against 401K contributions. The loan amount is restricted to the greater of $10,000 or 50% of the “vested employee balance”. Most plans have strict requirements for approving loans.
Comparison of Roth IRA vs 401K
Investment Products – Same as regular IRAs
Tax Advantages – Roth IRA contributions are made with after-tax dollars. Upon withdrawal, the entire amount, including earned income, is tax exempt. There are no early withdrawal penalties. On a 401K plan, the entire amount withdrawn is subject to taxes since the deposits were made on a pre-tax basis. Early withdraws are subject to penalties.
Deposit Restrictions – Roth IRAs have a maximum annual income requirement of $99,000 for individuals ($156,000 for joint-filers). Otherwise, the restriction comparison is the same as regular IRAs.
Matching – Same as regular IRAs
Loans – Same as regular IRAs
NOTE: The comparison of a Roth 401K vs 401K yields the same results as the 401K vs Roth IRA comparison.
Once they understand the product differences, it is up to the investor to determine which product best meets their needs.
If the employer offers a matching contribution, the 401K should always be the first choice. They are essentially offering free money. Otherwise, the main determinant is whether or not the investor wishes to defer taxes with the 401K or IRA, or receive tax exempt revenue at retirement with the Roth IRA.
The other issues to consider are early withdraw penalties, investment choices and loan opportunities.