
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.
Contents
1.IRA
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 2024, maximum amount for the contribution is $7,000 for people who are under 50 years old, and $8,000 ($7,000 plus $1,000 of catch up contribution) for people who are 50 years old and above. The contribution should be made during January 1, 2024 through April 15, 2025 (i.e., due date of the tax return).
For reference, the upper limits before 2024 were as follows.
Under 50 years old | 50 years old and above | |
---|---|---|
2023 | $6,500 | $7,500 ($6,500 + $1,000) |
2022 – 201 | $6,000 | $7,000 ($6,000 + $1,000) |
(Reference: IRS: IR-2023-203, Nov. 1, 2023 and IRS: Retirement Topics – IRA Contribution Limits)
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.
2. 401(k)
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 2024, the maximum amount for the contribution is $ 23,000 for people who are under 50 years old and $ 30,500 ($23,000 plus catch-up contribution of $7,500) for people who are 50 years old and above (Note 1).
Note 1: 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)
For reference, the upper limits prior to 2024 were as follows.
Under 50 years old | 50 years old and above | |
2023 | $22,500 | $30,000 ($22,500 + $7,500) |
2022 | $20,500 | $27,000 ($20,500 +$6,500) |
2021 – 2020 | $19,500 | $26,000 ($19,500 + $6,500) |
2019 | $19,000 | $25,000 ($19,000 + $6,000) |
(Reference: IRS: IR-2023-203, Nov. 1, 2023 and IRS: Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits)
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.
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. Which should you prioritize contributions to, an IRA or a 401(k)?
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.
4. 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).
In the case of a 401(k), without exception, pre-tax funds are accumulated before taxes, and funds for Roth 401(k) are accumulated as after tax funds. Roth 401(k) have no income restrictions, but they can only be used if your workplace’s 401(k) plan includes a Roth 401(k) as an option (depending on your workplace, only Pre-Tax 401(k) may be available).
In the case of IRAs, Traditional IRAs are generally treated as before tax funds, but in exceptional cases they may be treated as after tax funds (Note 2). With no exceptions, Roth IRAs can be accumulated as after-tax funds, but unlike Roth 401(k), there are income limits (Note 3). Therefore, if your income exceeds the specified amount, you can only use Traditional IRA (Note 4).
(Note 2) Things get a little more complicated when a married person contributes to a Traditional IRA. First, if both spouses do not have a retirement plan at work and only contribute to a Traditional IRA, the entire amount will be pre-taxed, regardless of income, as a general rule. However, if one spouse is covered by a workplace retirement plan that includes a 401(k), and if the spouse also uses a Traditional IRA in addition to the workplace retirement plan, the modified AGI amount In some cases, Traditional IRAs may be treated as After Tax and income taxes may not be deferred. Details such as the amount are as follows.
If you are covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.
If Your Filing Status Is … | And Your Modified AGI Is… | Then You Can Take… |
---|---|---|
single or head of household | $77,000 or less | a full deduction up to the amount of your contribution limit. |
single or head of household | more than $77,000 but less than $87,000 | a partial deduction. |
single or head of household | $87,000 or more | no deduction. |
married filing jointly or qualifying widow(er) | $123,000 or less | a full deduction up to the amount of your contribution limit. |
married filing jointly or qualifying widow(er) | more than $123,000 but less than $143,000 | a partial deduction. |
married filing jointly or qualifying widow(er) | $143,000 or more | no deduction. |
married filing separately | less than $10,000 | a partial deduction. |
married filing separately | $10,000 or more | no deduction. |
If you’re not covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.
If Your Filing Status Is… | And Your Modified AGI Is… | Then You Can Take… |
---|---|---|
single, head of household, or qualifying widow(er) | any amount | a full deduction up to the amount of your contribution limit. |
married filing jointly or separately with a spouse who is not covered by a plan at work | any amount | a full deduction up to the amount of your contribution limit. |
married filing jointly with a spouse who is covered by a plan at work | $230,000 or less | a full deduction up to the amount of your contribution limit. |
married filing jointly with a spouse who is covered by a plan at work | more than $230,000 but less than $240,000 | a partial deduction. |
married filing jointly with a spouse who is covered by a plan at work | $240,000 or more | no deduction. |
married filing separately with a spouse who is covered by a plan at work | less than $10,000 | a partial deduction. |
married filing separately with a spouse who is covered by a plan at work | $10,000 or more | no deduction. |
(Note 3) For example, in 2024, you can only contribute the full amount to your Roth IRA if your modified AGI is less than $230,000 in case of married filing jointly (or less than $146,000 in case of single). And you cannot contribute to your Roth IRA at all if your modified AGI is more than $240,000 in case of married filing jointly (or more than $161,000 in case of single). In case your modified AGI are somewhere in between these numbers, you can only make a partial contribution to a Roth IRA.
The below table shows whether your contribution to a Roth IRA is affected by the amount of your modified AGI as computed for Roth IRA purpose.
If your filing status is… | And your modified AGI is… | Then you can contribute… |
---|---|---|
married filing jointly or qualifying widow(er) | < $230,000 | up to the limit |
married filing jointly or qualifying widow(er) | > $230,000 but < $240,000 | a reduced amount |
married filing jointly or qualifying widow(er) | > $240,000 | zero |
married filing separately and you lived with your spouse at any time during the year | < $10,000 | a reduced amount |
married filing separately and you lived with your spouse at any time during the year | > $10,000 | zero |
single, head of household, or married filing separately and you did not live with your spouse at any time during the year | < $146,000 | up to the limit |
single, head of household, or married filing separately and you did not live with your spouse at any time during the year | > $146,000 but < $161,000 | a reduced amount |
single, head of household, or married filing separately and you did not live with your spouse at any time during the year | > $161,000 | zero |
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 deferred 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).
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