BetterTrades

What is a better trade-off, 401K vs IRA

One of the most commonly asked questions that financial advisers hear is whether it makes more sense to put money into a 401(k) or put the funds in an IRA. There are several tradeoffs to consider when contemplating this decision.

Much of the decision making process depends on the type of investment in question. Is it a regular 401(k) or a Roth 401(k)? Is it a traditional IRA or a Roth IRA? These questions are important to ask before determining whether the tradeoff will make sense.

Contributions to a 401(k) are deposited as tax deferred, with the funds taxed at a normal income bracket when disbursed. The idea is to put the money aside until later in life, when you'll be paying via a low tax rate. Contributions to a Roth 401(k) have already been taxed, meaning no additional taxes will be due at the time of disbursement.

In a traditional IRA, contributions are post tax money. Contributions to the IRA are tax deductible, which reduce your tax basis for the year. The distributions are taxed at the normal income. Contributions to a Roth IRA are made with post tax money and no taxes are due under normal disbursements.

There are limitations to the amount of money you can contribute to each plan. In a 401(k), a person is permitted to contribute $16,500 per year if younger than 50, $22,000 per year if older. Since some companies who offer a 401(k) have a plan to match the funds set aside by the employee, the total contribution must be less than 100 percent of the salary or no more than $46,000. Contributions to an IRA are limited to $5,000 per year for age 49 and younger, and $6,000 a year for age 50 and older.

Distributions can begin in all accounts at age 59½. In either case, the Roth accounts must be "seasoned" or opened for at least five years before funds can be drawn. Anyone who wants to withdraw funds early faces a tax, typically a 10 percent penalty plus taxes.

Contributors face forced withdrawals with some accounts. A 401(k) and Roth 401(k) require an investor to begin withdrawing funds by the age of 70½, unless still employed. A penalty of 50 percent of the minimum distribution could be required. There are no withdrawal requirements for a Roth IRA.

The decision between choosing a Roth IRA or a Traditional IRA depends on whether you are likely to be in a higher tax bracket in the future (in which case a Roth IRA is better) or a lower tax bracket in the future (in which case a conventional IRA is better). Roth IRAs have a bit more flexibility in terms of early withdrawal. If your tax bracket does not change while you are working vs. when you retire, you will end up with the same amount of money in a Roth IRA as a conventional IRA for a donation less than the maximum allowable. If you save the maximum allowable amount in an IRA and you stay in the same tax bracket, there is a tax advantage to the Roth IRA.

Everyone has a different investing situation and different financial needs. You should ask your accountant or financial adviser many questions about your situation before deciding which tradeoff is best for you. Everyone has a different situation and must decide for themselves what makes the most financial sense.

• 401K vs IRA
• Broker or Online
• Fundamental or Technical
• Investing or paying down debt?
• Renting vs. Owning
• Savings vs. Credit Union