- Simon transfers $1,000 today into his 401(k) or IRA account.
- He invests the $1,000 in a diversified stock index mutual fund such as Vanguard Total Stock Market Index Fund (VTSMX).
- The dividends and capital gains income from the fund are reinvested back into more shares of the fund.
- Simon does nothing else with that $1,000 until age 68, at retirement.
- His $1,000 initial investment is now worth $22,378 (assume a 7.25% rate of return).
How does an IRA work? Roth vs. Traditional?Keep in mind that an IRA (Individual Retirement Account) can be set up and contributed to on your own. A 401(k) needs to be administered by your employer. So if you are a freelancer, unemployed, or your current company does not offer a 401(k), than an IRA is your only option. There are two common types of IRA accounts. A traditional IRA and a Roth IRA. Both accounts allow your money to grow tax free! Both traditional and Roth IRAs have some similarities:
- Both accounts cap annual contributions at $5,500 for 2016 and $6,500 for those over age 50.
- Account owners can invest in most types of stock, bond and cash investments including mutual funds, exchange traded funds (ETFs), and individual stocks and bonds within the account.
- There is no required minimum distribution. You never have to withdraw the money and can pass the account on to your heirs.
- As long as you are older than 59 ½ or meet the required other requirements, the withdrawals from the account are tax-free.
|Features||Traditional IRA||Roth IRA|
|Who can contribute?||You can contribute if you (or your spouse if filing jointly) have taxable compensation but not after you are age 70½ or older.||You can contribute at any age if you (or your spouse if filing jointly) have taxable compensation and your modified adjusted gross income is below certain amounts (see 2017 and 2018 limits).|
|Are my contributions deductible?||You can deduct your contributions if you qualify.||Your contributions aren’t deductible.|
|How much can I contribute?||The most you can contribute to all of your traditional and Roth IRAs is the smaller of:
|What is the deadline to make contributions?||Your tax return filing deadline (not including extensions). For example, you can make 2017 IRA contributions until April 17, 2018.|
|When can I withdraw money?||You can withdraw money anytime.|
|Do I have to take required minimum distributions?||You must start taking distributions by April 1 following the year in which you turn age 70½ and by December 31 of later years.||Not required if you are the original owner.|
|Are my withdrawals and distributions taxable?||Any deductible contributions and earnings you withdraw or that are distributed from your traditional IRA are taxable. Also, if you are under age 59 ½ you may have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.||None if it’s a qualified distribution (or a withdrawal that is a qualified distribution). Otherwise, part of the distribution or withdrawal may be taxable. If you are under age 59 ½, you may also have to pay an additional 10% tax for early withdrawals unless you qualify for an exception.|
How does a 401(k) work?A 401(k) is another type of retirement account, created by your employer for the employee’s benefit. Employees have the opportunity to contribute a portion of their salary into the 401(k) account. The amount of your employee contribution reduces your taxable income. In many cases, employers also match a portion of the employee’s contribution into the account. A great benefit of the 401(k) over the IRA is the high contribution limits – employees can contribute up to $18,500 per year into their account in 2016 with a catch-up contribution of $6,000 for those over age 50. Add in the employer’s contribution and this is a powerful retirement savings vehicle. A disadvantage of the 401(k) is that employees are constrained by the available investment choices within the account. In other words, the employer chooses a list of funds within which the investors can invest. Some plans may not offer optimal funds for their employees or offer funds with high fees. Additionally, some 401(k) plans charge employees higher than average fees and expenses. Here are the basic differences between IRA’s and 401(k)s: More about 401(k)s:
- 401(k) Basics for your First Job
- 6 Important 401(k) Mistakes to Avoid
- How and Why to Change Your 401(k) Setup Percentages
- Is a 401(k) Match Tax Deductible?
Which Account Should I Invest in if I Can’t Afford to Contribute to Both?First, if there’s an employer match, always invest in the 401(k) the amount necessary to receive the employer match. This is bolded because its’ very important. You don’t want to ignore free employer money. From there, it becomes a matter of choice:
- If the fund choices are good and the fees are low, you may want to invest as much as you can in the employer 401(k).
- If the 401(k) doesn’t offer low-fee index funds and charges administration fees that are high, you may want to switch to a Roth IRA, opened at a discount broker.
- If you want greater flexibility in fund choice because you morally object to the 401(k) fund options your employer has offered (or you object for whatever reason), an IRA will allow you to hand pick funds yourself.