Today’s topic is IRA and 401(k). As you might have already known, both are retirement savings and have certain tax benefits. The biggest difference between them is that anybody who have earned income can make contributions to IRA, while contributions to 401(k) can be made only when his/her employer set up the program for its employers. Also, maximum amount of the contributions is quite different.
Followings are more detailed explanations.
IRA is an abbreviation for Individual Retirement Account. If you have an earning income, you can open an account with the financial institution of your choice, which could be either bank or brokerage firm. Once you open an account, you can contribute up to maximum allowed amount every year. The maximum allowed amount will be set by IRS each year. If you are married, as long as your spouse has earning income, both can contribute to respective IRA account even if you do not have any earning income.
In case of 2020, maximum amount for the contribution is $6,000 for people who are under 50 years old, and $7,000 ($6,000 plus $1,000 of catch up contribution) for people who are 50 years old or older. The contribution should be made during January 1, 2020 through April 15, 2021 (i.e., due date of the tax return).
Similarly, in case of 2019, maximum amount for the contribution is $6,000 for people who are under 50 years old, and $7,000 for people who are 50 years old or older. Since the deadline for the contribution is April 17, 2020 (Note 1), you still have a few month left to contribute (as of today), even if you had failed to do so during 2019.
Note 1: Although April 15, 2020 was the original deadline for federal tax filing as well as tax payment, such deadlines have been extended for three months to deal with coronavirus (see “IRS Notice 2020-18: Relief for Taxpayers Affected by Ongoing Coronavirus Disease 2019 Pandemic“). And in line with such extension, the deadline for the 2019 IRA contribution has been extended to July 15, 2020.
You can mange the funds contributed to your IRA account any way you want. For example, you can invest to Certificate of Deposit, Stocks, ETF, Mutual Fund, etc.
(Reference：IRS: Retirement Topics – IRA Contribution Limits)
401(k) is formally called as “Defined Contribution Plan”, but it is commonly called as 401(k) as its rules are regulated in section 401(k) of the Internal Revenue Code. In case of 2020, the maximum amount for the contribution is $ 19,500 for people who are under 50 years old and $ 26,000 ($19,500 plus catch-up contribution of $6,500) for people who are 50 years old or older (Note 2). Brokerage firm which handle your 401(k) are selected by the employer, and you cannot use other financial institutions. Also, investment options are pre-selected by your employers, and you have to chose within such limited options.
Note 2: If you are classified as “Highly-Compensated Employees”, in some case you might not be able to enjoy the benefits of maximum amount. That’s because although it is possible to contribute up to the maximum amount ($19,500 or $26,000 depending on your age) in 2020, portion of the contribution might be refunded in 2021 and such refunded portions are counted as your income earned in 2021. This happens when your employers fails to “non-discrimination testing”. If you are one of highly-compensated employees and subject to this rule, your employer would explain about it. So, you do not need to know at this point, but if you are interested, you can find explanation in IRS’s website. (See IRS: Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits)
Although I am omitting the explanation here, there are similar systems such as 403 (b) Plan (for non-profit organizations such as schools and hospitals) and 457 (b) Plan (for government officials). In addition, self-employed people can use the similar system called Self-employed 401 (k) (Solo 401 (k)).
3. Traditional IRA/Roth IRA, Traditional 401(k)/Roth 401(k)
To further classify, there are Traditional IRA and Roth IRA as well as Traditional (Before-tax) 401 (k) and Roth 401(k). Generally speaking, money deposited to Traditional IRA or Traditional 401(k) accounts will be regarded as Before Tax contribution (Note 3), while money deposited to Roth IRA or Roth 401(k) are regarded as after tax contribution.
Note 3: For people contributed only to Traditional IRA, entire contribution will be treated as before tax contribution regardless of the amount of AGI. For those who contribute to both of retirement plan offered by employer (incl. 401(k)) and Traditional IRA , depending on the amount of AGI, money contributed to Traditional IRA might be regarded as after tax contribution, partially or wholly. For detailed explanation, see the following site: IRS: 2020 IRA Contribution and Deduction Limits Effect of Modified AGI on Deductible Contributions if You Are Covered by a Retirement Plan at Work
When before tax contribution is made, the money will not be counted as income of the year of the contribution. In other words, amount of money contributed to IRA or 401(k) will be deducted from the gross income of that year, and as a result, the amount of the income tax of the corresponding year will become lower to that extent. However, when the money is withdrawn, it will be counted as income at that point, and principal (amount you originally contributed), interests and capital gains are all subject to tax in such year, i.e., payment of tax will be deffered until then.
When after tax contribution is made, there is no tax benefit in the year of the contribution because the money is counted as gross income of the year earned. Upon withdrawal, no tax will be imposed in case of Roth IRA and Roth 401 (k), i.e., you can withdraw principle, and amount increased due to interests and capital gains. In case of after tax traditional IRA, withdrawing principal is tax free but withdrawal of amount increased due to interests and capital gains are taxable.
Since contributions to Roth IRA are subject to income restrictions, if amount of your income exceeds certain level, contribution to Roth IRA is not allowed (Note 4). Roth 401 (k) has no income restriction, but it cannot be used if the employer does not offer Roth 401 (k).
Note 4: For example, in the case of 2020, contributions can be made to the Roth IRA only if the modified AGI is less than $ 206,000 / single $ 139,000 for married filing jointly. (Reference: IRS: Amount of Roth IRA Contributions That You Can Make for 2020)
4. Which of IRA and 401(k) you should contribute first?
If your employer offers you 401 (k) plan, you can contribute to both 401 (k) and IRA. If you have sufficient fund, from the viewpoint of improving retirement funds, you might feel safe if you contribute to both. But if you have limited fund, I think it is better to decide the priority, while considering the following points:
- Does your employer match to you contribution if you contribute to 401(k)? → If yes, your first priority is to contribute up to 401(k) amount you can fully receive such employer matching.
- If you contribute to 401(k), will IRA be treated as Before Tax contribution? → If you or your spouse enroll to 401(k) or other form of employer sponsored retirement plan, depending on the amount of modified AGI, your contribution to Traditional IRA might be treated as after tax contribution wholly or partially, depending on t eh amount of modified AGI. If that’s the case, I recommend to contribute to 401(k) first, and if you still have enough fund even after contributing full amount to 401(k), consider if you want to contribute to IRA on after tax basis.
- Does your employer pay the account maintenance fee for the 401(k)? → Not all, but some 401(k) plan charge plan administration fee based on the balance of the 401(k) account. Most of IRA accounts do not charge any maintenance fee. Therefore, if the 401(k) participants have to pay account maintenance fee, you might be better off putting money to IRA first.
（Reference: IRS: IRA Deduction Limits）
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