401(k) Plans And IRA

We need money all the time, from young to old, from home to abroad. Income is a critical source of money. When we work, our paycheck is the income. Then what is our income when we're retired? My focus in this post is on the retirements in the US. If we earn enough credits before retirement, we can get Social Security. But there is a limit on how much we can get. What's worse, there is news that Social Security funds are going to run out. To supplement that, there are some options to consider: 401(k) Plans and IRAs (Individual Retirement Account). In this post, I'll show you the differences among common 401(k) Plan and IRAs, and what you should consider when you make contribution and withdrawal.

The idea about 401(k) Plan and IRAs is that you contribute while you're working. Once you are retired, you withdraw from them and those are your income. You usually make investments in the 401(k) Plan and IRAs. The earnings of those investments are yours too. The more you contribute, and the more the earnings are, the more you have when you're retired. There is a risk on the investment you make in the account. If you lose money in your investments, you'll get less too. There are always one risk or another no matter how you plan your retirement.

Differences Overview

The 401(k) Plan is sponsored by an employer. That means it's the company you work for to open and administrate the plan. On the other hand, IRA is opened by you. You can have both. That is not the only difference. From tax perspective, there can be pre-tax, Roth, and after-tax. I'll compare IRAs and 401(k) in most common categories. Common IRAs include Traditional IRA and Roth IRA. Depending the source of the contribution, 401(k)'s contribution can be pre-tax, Roth, and after-tax. They can be inside the same plan.

Category	Traditional IRA	Roth IRA	Pre-tax 401(k)	Roth 401(k)	After-tax 401(k)
Tax on contribution	Yes, maybe deductible	Yes but NOT deductible	No	Yes	Yes
Deadline to contribute	Tax return filing deadline (not including extensions)	Tax return filing deadline (not including extensions)	The calendar year end	The calendar year end	The calendar year end
Tax on qualified withdrawal	Yes	No	Yes	No	Yes on the earnings. No on the contribution.
Investment selections	Many	Many	Depend on plan	Depend on plan	Depend on plan
Who can participate	Anyone	Anyone	Employer sponsored	Depend on plan	Depend on plan
Contribution limit	Yes	Yes	Yes	Yes	Yes
Required minimum distributions	Yes	No as long as the owner is alive	Yes	Yes	Yes
Loans	No	No	Depend on plan	Depend on plan	Depend on plan
5-year holding period for qualified withdrawal	N/A	Begins January 1 of the year a contribution is made to any Roth IRA	N/A	Separate for each Roth account and begins on January 1 of the year contributions made to that account. If one Roth account is rolled into another, the earlier start date applies.	N/A
Beneficiary	Anyone	Anyone	Anyone but, if married, spouse must consent to non-spouse beneficiary	Anyone but, if married, spouse must consent to non-spouse beneficiary	Anyone but, if married, spouse must consent to non-spouse beneficiary

A Typical Example

The above is a quite high level overview. It may be difficult to understand how that relates to you and impacts your retirement plan. Tax is very important. Here is an example what happens in a typical and qualified scenario for each of the account.

Let's say you contribute $10K. Your balance in the account grows to $25K when you're retired and you withdraw $25K. There is $10K from the initial contribution, and $15K from the earnings of your investment. There are $10K contribution, $15K earnings, and $25K withdrawal.

When you do that in the Traditional IRA. The $10K is from your after-tax income. You may be able to deduct that from your tax return on the year you make the contribution. You should check deduction limit. That matters when you withdraw. When you withdrawal, you must pay the tax on the earnings portion which is $15K. As to the contribution portion, which is $10K, you only need to pay the tax on the amount that's deducted.

Now if you do that in the Roth IRA. That $10K is from your after-tax income. The downside is you cannot deduct that in your tax return. The upside is you don't need to pay tax when you withdraw those $25K from the account. Both the earnings ($15K) and the initial contribution ($10K) portions are not taxed.

In the case of 401(k), if you choose pre-tax (most case), That $10K is from your pre-tax income. That means that $10K isn't included when you calculate the tax you need to pay. But when you withdraw, both the earnings ($15K) and the initial contribution ($10K) portions will be taxed.

If you choose to make the Roth contribution in your 401(k), it's the same as Roth IRA. That $10K is from your after-tax income. You don't need to pay any tax on the earnings and initial contribution when you withdraw.

If you choose to make after tax contribution in your 401(k), same as Roth contribution, that $10K is from your after-tax income. You need to pay tax on the earnings portion ($15K) but you don't need to pay tax on the initial contribution portion ($10K).

What Happen in Withdrawal

It seems relative simple from the above examples. It's quite straightforward on the tax when you make the contribution. There are more to navigate when you need to withdraw. The examples above are for the qualified withdrawal. You need to pay extra attentions when they're not qualified, because you not only need to pay the tax on the withdrawal at your tax bracket, but also may need to pay additional 10% penalty tax.

Qualified Withdrawal

The details may be different in different accounts and be adjusted in future. You should check the IRS websites or other resources to get a complete list.

For the traditional IRA and pre-tax 401(k), you need to be at least 59.5 years old.

If it's Roth IRA, you need to have your account open for more than 5 years. In additional to that, you need to meet one of the criteria:

1. You're 59.5 years old when you withdraw.
2. You're permanently disabled.
3. You inherit the account and take the money out.
4. You take up to $10,000 as the first time home buyer.

If it's Roth 401(k), you need to have your Roth portion set up for more than 5 years, and you need to meet one of the criteria:

1. You're 59.5 years old.
2. You're permanently disabled.
3. You inherit the account and take the money out.

Early Withdrawal

If you withdraw before you're 59.5 years old or is not qualified, you're doing early withdrawal. You need to pay the income tax on partial or whole of your withdrawal and pay additional 10% tax as the penalty. The penalty tax is only applied to the taxable portion of your non-qualified distributions.

For the pre-tax 401(k), you need to pay your regular income tax and the penalty on all your withdrawal.

For the traditional IRA, you need to pay your regular income tax on all your withdrawal and the penalty on the earnings and the contribution portion if it's deductible.

For Roth 401(k) and Roth IRA, your contribution portion will be tax free and penalty free. But the earnings portion is subject to regular income tax and penalty.

For after-tax 401(k), I don't find too much data about that. Assuming the same principal still holds, which is you only need to pay tax once, It'll be similar to Roth 401(k). That is you only need to pay the regular tax and penalty on the earnings portion.

Early Withdrawal Penalty Exceptions

But as how complicate the rules are, there are exceptions to the penalty. The rules are of course different according to the accounts.

Traditional IRA

1. You're permanently disabled.
2. You need to cover medical expenses when it exceeds a certain amount of your adjusted gross income.
3. You need to cover qualified medical insurance premium during unemployment.
4. You need to cover qualified higher education expense.
5. You buy, build, or rebuild the first home.
6. You inherit it and withdraw funds as beneficiary.
7. You take a qualified reservist distribution - a distribution from a retirement account to a military reservist or member of National Guard called to active duty.
8. You have a new baby.

Roth IRA

1. You reach 59.5 years old.
2. You're permanently disabled.
3. You need to cover medical expenses when it exceeds a certain amount of your adjusted gross income.
4. You need to cover qualified medical insurance premium during unemployment.
5. You need to cover qualified higher education expense.
6. You buy, build, or rebuild the first home.
7. You inherit it and withdraw funds as beneficiary.
8. You take a qualified reservist distribution - a distribution from a retirement account to a military reservist or member of National Guard called to active duty.
9. It's due to IRS levy of the qualified plan.

401(K)

1. You reach 59.5 years old when you leave your job.
2. You're permanently disabled.
3. You need to cover medical expenses when it exceeds a certain amount of your adjusted gross income.
4. You need to cover qualified medical insurance premium during unemployment.
5. You inherit it and withdraw funds as beneficiary.
6. There is an immediate and heavy financial need.
7. You take a qualified reservist distribution - a distribution from a retirement account to a military reservist or member of National Guard called to active duty.
8. It's due to IRS levy of the plan.

Alternatives to Early Withdrawal

Some 401(K) plan allows borrowing from it. When you take the loan, you need to pay the principal and the interest. There are two benefits though

1. Unlike early withdrawal, you don't need to pay the income tax or the penalty.
2. Unlike taking personal loan, the interest you pay goes back to your 401(K) account, adding to its balance.

What you lose here maybe the potential growth of your investment in your 401(K) if you didn't take a loan. The loan is counted in dollars. The growth of your 401(K) depends on the shares of your investment. So if that investment keep going up, when you pay back your loan, you'll have less shares in your investment comparing to the case if you didn't take the loan.

This is intend to be an overview of what common retirement accounts are and what you need to know when you contribute and withdraw. I encourage you to review them with a professional such as an accountant, or read the articles in IRS website. There are much more details and potentially changes at each year.