What is a 401(K)?
A 401K is an employer sponsored savings plan. As an employee, you decide how much you want to contribute to your retirement plan each month and your employer automatically deducts this amount from your paycheck. The employer then puts this money in the 401(K) where it can generate returns. The money can be invested in a variety of ways including mutual funds of stocks and bonds. Although the employer is the one that puts the money in the account, you as the holder of the plan determine how you want the money to be allocated among different assets.
What are the benefits of a 401(K)?
One benefit of a 401K is that you are not taxed on the money you contribute to the plan when you make the contribution. Even though it is technically income coming out of your paycheck, this money is contributed to the 401K tax free. Another advantage of a 401K is that many employers have a matching contribution plan. This means that the employer specifies some set amount that they will contribute to your retirement plan. For example, they might add 50 cents for every dollar you contribute, up to a limit.
How much can you contribute to a 401(K)?
If you are under the age of 50, you can contribute up to $17,500 (2013) a year. If you are 50 and older, you are allowed $up to 23,000(2013) a year to catch up. The more you contribute each year the better. Try to contribute the maximum amount if you can. You at least want to make sure you contribute enough to meet the requirements for your employer’s matching contribution.
With a 401(K), you cannot make any withdrawals until the age of 59 1/2 years. If you choose to take money out of the account before then, there is a 10% early withdrawal fee. Once you turn 70 1/2 years old, you are required to start making withdrawals and there is usually a minimum amount you have to withdraw each year. When you make withdrawals is when you are taxed on the money. This money is included in your taxable income and it is taxed as ordinary income.
What is a Roth IRA?
IRA stands for individual retirement account and it is another means to save money for retirement. You make contributions to your account but in contrast to a 401(K), these contributions are taxed at the time of the contribution. However, the money is not taxed when you make withdrawals.
A Roth IRA is different from a traditional IRA and provides many benefits for young people.
What are the benefits?
A Roth IRA can be beneficial to younger people. Although you are taxed on the contributions you make up front, chances are that you are in a lower tax bracket while making these contributions that what you will be in when you start making withdrawals in retirement. So in the long run, it is likely to save you money.
How much can you contribute to a Roth IRA?
If you are under the age of 50, you can contribute $5,500 (2013) a year. If you are over the age of 50, you are allowed to contribute $6,500 (2013) a year to catch up. There is no minimum amount required to contribute by federal law although the financial institution is likely to have a minimum amount to open the account. However, the more you can give the better.
The rules for withdrawals from a Roth IRA are more flexible than those of a 401(K). First of all, withdrawals are not taxed since you were already taxed on the money when you first contributed it. The only stipulations are that you must be at least age 59 1/2 (or dead or disabled) to make withdrawals and the account has to have been open for at least five years. Another advantage of Roth IRA’s is that you are not required to withdraw money like you are with a 401(K). No matter how old you are, you can keep your money in the account and let it grow. For a young person who is concerned about locking up their money for decades, the Roth IRA offers more flexibility than other retirement accounts.
Distributions are deemed to come first from contributions. So if you needed to, you could withdraw all your contributions without any taxes or penalties, at any time. If you withdraw more than your contributions and tap into the earnings in the account, then you will owe taxes and perhaps an early withdrawal penalty if you don’t meet the age and 5-year requirement.
Here is a summary of the differences between a 401(K) and a Roth IRA in 2013:
- Contributions Taxed? No
- Withdrawals Taxed? Yes
- Maximum Annual Contribution: 17,500 (or 23,000 if over age 50)
- Withdrawal age without penalty: 59.5
- Mandatory Withdrawals: 70.5
- Contributions Taxed? Yes
- Withdrawals Taxed? No
- Maximum Annual Contribution: $5,500 (or 6,500 if over age 50)
- Withdrawal age without penalty: 59.5
- Mandatory Withdrawals: Never
Written by Katie Leginsky, Peer Educator, Financial Wellness Program, University of Illinois Extension, 2012