Learning about an IRA vs. a Roth IRA and an IRA vs. a 401(k)
Saving for when people plan to retire is crucial for everyone. If you do not make saving a habit, you might find yourself unable to leave the workforce when you grow older. You might also not have enough money to live comfortably after you retire and struggle to make ends meet.
Retirement planning is essential for making certain that you will have enough money to live comfortably after you retire. As you are thinking about how to save for when you retire, you should understand the major types of retirement account options that are available to you and how they compare for your retirement planning. It is important for you to compare an IRA to a Roth IRA and to compare an IRA to a 401(k). This can help you to choose the retirement accounts that can offer you the most benefits.
An IRA compared to a Roth IRA differs in how your contributions are made. For an IRA, the contributions that you make are made on a pre-tax basis, and they may be deductible during the year in which you make them. For a Roth IRA, your contributions are made on an after-tax basis and are not deductible. You should be aware that you will be taxed at the time that you make withdrawals from your traditional IRA account. By comparison, you are not taxed on the withdrawals that you make from your Roth IRA account after you retire.
Like an IRA, 401(k) contributions are made on a pre-tax basis. You will not be taxed until you begin making withdrawals. Unlike IRAs, 401(k) plans are employer-sponsored plans and have higher annual contribution limits. However, your investment choices for a 401(k) may be more limited.
Statistics on IRAs, Roth IRAs, and 401(k) plans
In the U.S., 35 percent of households report that they have traditional IRAs while an additional 36 percent report that they have Roth IRAs. Among workers, 57 percent work at businesses that offer 401(k) plans. People whose employers offer employer-sponsored plans participate at a rate of 91 percent. Middle-class workers who have access to a 401(k) plan through their jobs have 30 times more savings than people who do not have 401(k) plans.
All of these types of plans can help you to reach your financial goals for when you retire. While 401(k) plan access is strongly correlated with having higher savings, people should not overlook individual retirement account options including traditional IRAs and Roth IRAs. People might be less likely to have these types of accounts because they are set up on an individual basis, and they might be less aware of their benefits.
What is an IRA? How does a traditional IRA work?
An IRA is an individual retirement account. There are several different types of IRAs. One of the most popular types is a traditional IRA. Anyone can open a traditional IRA account, and the contributors are the individuals who own the accounts.
Traditional IRAs have annual contribution limits that depend on your age. If you are younger than age 50, you can contribute a maximum of $6,000 per year. If you are age 50 or older, you can contribute a maximum of $7,000 per year. Money that is contributed to a traditional IRA goes in on a pre-tax basis. When you begin taking disbursements, you will pay taxes at that time at your ordinary income tax rate.
You cannot take early withdrawals from a traditional IRA without being penalized. If you make an early withdrawal from an IRA before you reach age 59 1/2, you will have to pay a 10 percent penalty on top of the income taxes on your withdrawal amount. However, there are some IRA early withdrawal exceptions, including the following:
- Rollovers if money is deposited into new account within 60 days
- Distributions to beneficiaries after death
- Medical expenses that are unreimbursed and that exceed 10 percent of your Annual Gross Income
- Health insurance premiums if you are unemployed for at least 12 consecutive weeks
- To pay for qualified higher education expenses
- $10,000 for a first-time home purchase
Traditional IRAs also have required minimum distributions of 4 percent of your account balance per year beginning on April 1 of the year after you turn age 70 1/2.
The advantages of a traditional IRA include the following:
- Greater investment choices as compared to a 401(k)
- Contributions may be deductible at the time that they are made
- Savings can grow on a tax-deferred basis
The disadvantages of a traditional IRA include the following:
- Relatively low annual contribution limits
- Taxes when you take disbursements
- Penalty for taking an early withdrawal from an IRA in most cases
Why is it important to compare an IRA vs. a Roth IRA and an IRA vs. 401(k)?
Comparing an IRA to a Roth IRA and an IRA to a 401(k) is important for several reasons. A comparison between these types of accounts can help you to understand the advantages and disadvantages of each of them. For example, an IRA compared to a Roth IRA might allow you to deduct contributions during the tax year in which they are made. While contributions to a Roth IRA are not deductible when they are made, you do not have to pay taxes when you begin taking disbursements.
When you compare an IRA to a 401(k), you will notice that both types of accounts allow you to make contributions on a pre-tax basis. However, the contribution limits differ. For a 401(k), the contribution limits for an employee are $19,000 per year if the employee is younger than age 50. If the worker is older than age 50, he or she can make a total contribution of $25,000 per year. An IRA compared to a 401(k) offers many more investment options. Most 401(k) plans allow you to choose between around 20 investment choices while IRAs offer a much larger selection.
IRA and Roth IRA comparison
A comparison of an IRA and a Roth IRA demonstrates different advantages of each of these types of accounts. While both have the same contribution limits, the way in which contributions are made and how they are taxed differ.
People who believe that they will be in a lower tax bracket when they retire might want to choose a traditional IRA. Those who believe that they will likely be in a higher tax bracket when they retire may benefit from opening a Roth IRA.
Details about a Roth IRA
A Roth IRA can be opened by individuals independently of their jobs. However, there are some maximum income limits to open a Roth IRA. If you are single, your ability to make contributions to a Roth IRA begins to phase out once you earn $122,000 and is eliminated completely once you earn $137,000. If you are married, the phase-out for maximum contributions begins when you earn $193,000 and is eliminated when you earn a combined $203,000 or more per year.
If you are younger than age 50, you can contribute a maximum of $6,000 per year to a Roth IRA. You will be able to make an additional $1,000 per year in contributions if you are age 50 or older. The contributions that you make go in after tax so that you will not have to pay taxes at the time of disbursement.
If you withdraw your earnings before you reach age 59 1/2, you will have to pay a 10 percent penalty. However, some types of withdrawals are exempt from the penalty. The following types of withdrawals will not incur a Roth IRA early withdrawal penalty:
- Withdrawals because of disability
- Death of the Roth IRA owner
- Used to pay unreimbursed medical expenses that exceed 7.5 percent of the AGI of the Roth IRA owner
- Used to pay for medical insurance for people who have been unemployed for longer than 12 months
- Used to purchase a home as a first-time homebuyer
- Used to pay qualified higher education expenses
- Used to pay back taxes because of an IRS levy
Roth IRAs do not have required minimum distributions when the account owners reach age 70 1/2. The owners can also continue contributing to their Roth IRAs for as long as they want.
An IRA compared to a Roth IRA allows you to deduct your contributions on your tax returns when you make them. However, you will be taxed at your ordinary income tax rate when you begin taking disbursements.
The advantages of a Roth IRA include the following:
- No taxes when you take disbursements
- Can withdraw your contributions at any time after five years has passed
- Several exceptions to the early withdrawal penalty
- No required minimum distributions
- Can continue contributing as long as you want
The disadvantages of a Roth IRA include the following:
- Cannot take deductions for your contributions
- Maximum income limits
- Relatively low annual contribution limits
IRA vs. Roth IRA
In contrast to a Roth IRA, an IRA may allow you to claim deductions for your contributions during the year in which you make them. Your contributions are made on a pre-tax basis, so your savings can grow tax-deferred. This can help you to enjoy significant earnings over time. You will pay taxes on your withdrawals at your ordinary tax rate. Finally, a traditional IRA has required minimum distributions that begin when you reach age 70 1/2.
IRA vs. 401(k)
When you compare an IRA to a 401(k), there are several similarities and differences that will become apparent. The first similarity is that these are both types of accounts to which your contributions are made on a pre-tax basis. Both an IRA and a 401(k) allow your savings to grow tax-deferred until you retire.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement plan that might be offered by your employer as a fringe benefit. Self-employed people are also able to open individual 401(k) accounts on their own. Individuals and employers in for-profit companies qualify to participate in a 401(k).
Contributions are made on a pre-tax basis, and you are taxed at the time of disbursement. An IRA and 401(k) comparison reveals that 401(k) plans have much higher contribution limits. If you are under age 50, you can contribute up to $19,000 per year. If you are age 50 or older, you are allowed to contribute $25,000 per year. Employers may choose to make non-elective contributions to their employees’ 401(k) accounts, but they are not required to do so. Some employers offer company match programs up to a certain percentage.
If you take an early withdrawal of the money in your 401(k) account, you will face an early withdrawal penalty of 10 percent in addition to the taxes on the withdrawal amount.
Your savings are allowed to grow on a tax-deferred basis. For a 401(k) account, a triggering event that may allow you to begin making withdrawals include reaching age 59 1/2, becoming disabled, or upon your death. Some plans require you to both reach the minimum age and to separate from service before you can start taking withdrawals. Like an IRA, you will have to begin taking required minimum distributions at age 70 1/2.
Traditional IRA compared to a 401(k)
An IRA compared to a 401(k) has the following differences:
- Broader selection of investment choices
- Lower annual contribution limits
- Is not an employer-sponsored plan and can be opened by anyone
The similarities of an IRA and a 401(k) include the following:
- Contributions are made pre-tax
- Savings can grow tax-deferred
- Withdrawals from both accounts are taxed at the time of disbursement
- Early withdrawal penalties for withdrawals made before age 59 ½
- Required minimum distributions beginning at age 70 ½
A rollover is when you roll funds over from one account into another. This might include an IRA rollover, a 401(k) rollover, or a backdoor Roth IRA. Here is an overview of each of the different types of rollovers.
You are allowed to roll over the funds that you have in an IRA to another account without being assessed a penalty for an IRA early withdrawal as long as you follow the IRA rollover rules. The rollover will not count as a taxable event for IRA early withdrawals as long as you roll the money over within 60 days.
Contributors to rollover IRAs are individuals. The full amount of the old IRA account can qualify for a rollover and will not count against the annual contribution limits. There are early withdrawal penalties for taking withdrawals from a rollover IRA before reaching age 59 1/2. Rollover IRAs also have required minimum distributions beginning after you reach age 70 1/2.
To complete an IRA rollover that follows the IRA rollover rules, you can complete the following steps:
- Decide whether you want to roll over the funds into a Roth IRA or a traditional IRA. If you choose a Roth IRA, you will have to pay taxes on the amount that you roll over;
- Open the rollover account at the financial institution or firm of your choosing;
- Ask your existing plan administrator for a direct rollover to your new institution; or
- Request that they send a check to you and to not withhold any taxes since you will be depositing the money into a new account within 60 days;
- Make certain to deposit the money into your new account within 60 days; and
- Choose your investments.
Backdoor Roth IRA
A backdoor Roth IRA is a way for people whose incomes exceed the maximum income limits to benefit from opening a Roth IRA. To open a backdoor Roth, you can follow a few steps. The tax rules may allow high earners to enjoy certain tax benefits such as the ability to take distributions after they retire without paying taxes.
The contributors to a backdoor Roth are individuals. If you are a high earner and roll over funds into a Roth to create a backdoor account, you will not be able to make annual contributions to it. Otherwise, the same contribution limits apply if your income does fall under the maximum limits of $6,000 for people under age 50 or $7,000 for people over age 50.
You are able to withdraw your contributions from your Roth without paying penalties after five years have elapsed. If you withdraw your earnings before age 59 1/2, you will incur a 10 percent penalty unless you do so because of one of the previously described exceptions.
There are no minimum distributions that are required at any time. To set up a backdoor Roth, you can complete the following steps:
- Establish a traditional IRA and fund it;
- Convert the IRA to a Roth using paperwork that will be given to you by the administrator; and
- Pay taxes on the amount that you roll over to your new Roth account, including on your contributions and on your gains.
You can also choose to complete a 401(k) rollover account into a traditional IRA or a Roth IRA. Many people choose to complete 401(k) rollovers of their accounts with their former employers to new accounts so that they can keep better track of their investments and have more investment options. Here is how to roll over a 401(k):
- Open an IRA account;
- Contact the 401(k) plan administrator to initiate the rollover;
- Either ask for a direct rollover to your new IRA plan or an indirect rollover;
- If you choose to take an indirect rollover, make certain that you deposit the money into your IRA account within 60 days; and
- Choose your investments.
Traditional IRA rollover vs. 401(k) rollover
You can choose to roll over your 401(k) balance to a traditional IRA or to the 401(k) that is offered by your new employer. Because of the greater investment options and lower fees of traditional IRAs, it might make more sense to roll your balance over to a traditional IRA.
Retirement investment options for your financial plan
When you are planning, you are not limited to opening only one type of account. You can open multiple accounts to derive the different types of benefits offered by each account. For example, you can participate in your employer’s 401(k) plan and try to contribute the maximums. You can also open a Roth IRA if you meet the income guidelines so that you can benefit from the ability to take disbursements from the account tax-free. You can also open a traditional IRA. However, your total IRA contributions may not exceed the annual contribution limits.
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