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IRAs and 401(k)s Are Different
It can be confusing to differentiate between all the different types of retirement plans offered. The acronyms are confusing and there are different rules for each plan. We're here to distill it for you!
In essence, the difference between IRAs and 401(k)s is the party establishing the plan.
A 401(k) plan must be established by an employer. In a 401(k), employees have the option to contribute a portion of their salaries to the plan. The employer may also contribute to the employee’s account by “matching” his or her 401(k) contribution.
On the other hand, an IRA is an individual account which is not tied to your employer. You can set up an IRA through an IRA provider and make a lump sum or periodic contributions. You may also rollover 401(k) contributions to an IRA account.
IRA Type Overview
IRAs can either be a Traditional IRA or a Roth IRA. Understanding the difference is important because one may be better suited to you than the other.
In a traditional IRA, your contributions are pre-tax (or tax-deductible) for people at lower income levels. You avoid paying taxes for contributions when you put them in, but your withdrawals during retirement are taxable. For people at higher income levels, traditional IRAs do not offer any tax advantage. In 2019, if your modified adjusted gross income is more than $64,000 but less than $74,000 (single) or more than $103,000 but less than $123,000 (married couple) or less than $10,000 (married filing separately), you can only take a partial deduction for contributions to a traditional IRA. Above the upper limit, you your contributions will no longer be deductible.
In a Roth IRA, contributions are taxable (you put in after-tax dollars from your paycheck after taxes have been taken out) but they can grow tax-free. Some people in lower income brackets can get a tax credit for contributing to a Roth IRA but for most people using Roth IRAs, contributions are post-tax. Since you already paid taxes on the income contributed to Roth IRAs, qualified distributions including the fund’s earnings are exempt from taxes when you reach the age of 59½.
IRA Contribution Annual Maximum
In 2019, the combined contribution limit for IRAs (traditional IRA and Roth IRA) is $6,000 ($7,000 if you are 50 and up). This limit usually sees an increase every year because it is adjusted for inflation.
If you are employed, you are most likely saving for retirement through a separate retirement savings vehicle called a 401(k) plan. A 401(k) is a retirement account sponsored by your employer. It differs from an IRA which you may open on your own.
401(k) Type Overview
Just like an IRA, you can usually choose a traditional (pre-tax) or a Roth (post-tax) option, if your employer offers the Roth 401(k) option. For most 401(k) plans, you are contributing to a traditional 401(k). Contributions to a traditional 401(k) are made before you pay taxes on it. So, your taxable income becomes lower.
In Roth 401(k), you have already paid income tax for the contributions you made. In return, distributions from your 401(k) become tax-free when you retire.
401(k) Contribution Maximum
Employee contribution to traditional or Roth 401(k)s is subject to a $19,000 limit in 2019. This limit typically goes up every year or every other year, adjusted for inflation. Employees aged 50 and up who want to “catch up,” can contribute up to $25,000. Your employer may “match” part of your contributions. That is not included in the $19,000 max.
There’s a tax trick that can get an extra $37,000 a year into your Roth IRA. Do you know about it? We have a guide.