IRAs and How They Are Different From 401(k)s

IRAs, or individual retirement accounts, are very similar to 401(k)s, which I discussed here yesterday. They are also a retirement plan where you invest your money in various things such as stocks and bonds. As with 401(k)s, there are also penalties if you start withdrawing before you are 59.5. You must make regular withdrawals starting when you are 70.5 or half of your mandatory withdrawal amount will be taken as a penalty.  

So what are the differences between the two? Well, to start, the maximum contribution for an IRA is much lower than a 401(k). For 2009, the maximum amount a person under 49 can contribute is $5,000; the maximum for those 50+ is $6,000. You are not allowed to borrow money through an IRA. IRAs are run through banks and brokerage firms rather than the company you work for. This CAN (though it is not guaranteed) lead to a larger variety of investment options. You also can adjust your investments whenever you want, whereas many 401(k)s will only let you change your investments periodically. The money that you are allowed to put into an IRA is limited essentially to money that you would earn at a job (wages, commissions, bonuses, etc). Things such as dividends, profit from stock trading, money from renting property, etc. cannot be deposited into an IRA. Therefore, if you make $3,000 from a job and $40,000 from the stock market, you cannot deposit the maximum amount of $5,000. Only the $3,000 is eligible for the IRA.

Another important distinction to note is the ability to deduct the money from your taxes. When you invest money in a 401(k), the money is taken from your paycheck before you even pay income taxes. When you invest in an IRA, you put the money down on your tax form as a deduction. Depending on the amount of money you (and possibly your spouse) makes, you might only get a partial, or even no deduction. If you get no deduction, the benefits of using an IRA are drastically reduced. 

Also consider whether your employer offers a 401(k). If they are willing to match the money you put in, that might be a better choice because you'll be putting more money in, which means more money will accumulate. However, if the money would not be matched and you would qualify for the tax deduction, maybe the ability to invest in a greater variety of options and be able to change your investments at will makes an IRA a better choice for you.

What is a 401(k)?

A 401(k) is an investment vehicle specifically for retirement. The plan gives you an option between taking the money in cash (not investing) and deferring a percentage of your paycheck to the plan (investing). The money you defer to a 401(k) account is not taxable until it is withdrawn from the plan. This means that when you defer money from your paycheck, it is going into your 401(k) plan before income taxes are calculated. Also, the money that your investment generates is also not taxed until it is withdrawn. A 401(k) is not simply a savings account for retirement. This money is actually being invested - and you get to determine how. Plans can offer investments in mutual funds, stocks, index funds, bonds, etc. Not all plans will include all options. Often your employer will offer to match some of your money if you defer a certain percentage of your paycheck. I suggest you defer at least the minimum if this is offered. 

401(k)s are offered by your employer. This means that they can determine a number of factors that will impact your plan:

• They can match a percentage, all or none of the money you put into your account
  
• They choose what investment opportunities are allowed through your plan
  
• They can impose stricter restrictions on things such as how much you can contribute
  
• They can determine what you are allowed to do with your 401(k) if you ever switch jobs

There are several rules that the government has placed on 401(k) accounts as well.

• The money can only be withdrawn from the account (without penalty) if you retire, die, separate from the company offering the plan, are 59.5, if the plan is terminated or if your employer allows you to withdraw due to hardship.
  
• There are restrictions on the amount you can put in. In 2009, you can only defer $16,500 ($49,000 total when combined with the money your employer contributes). If you are older than 50, you can defer $22,000 ($54,000 total).
  
• If money is taken out prematurely, it will be taxed and there will be a 10% penalty.

Another interesting thing that 401(k)s offer is that you can take loans from it without incurring the 10% penalty. You have to pay (yourself) interest, but the interest rates are typically lower than one you would most likely get with a traditional loan. As appealing as this may seem, it is not a good idea. First off, you can't contribute any money to your 401(k) if it has a loan out. This means you are missing out not only on deferring money from your paycheck and not having to pay income tax, but you are also missing out on any money your employee would have contributed and the interest that would have compiled. Also, the money that you are paying it back with is going to be taxed twice. You are going to be paying using money that you paid income tax on. You also are also going to be taxed when you retire and withdraw your money. If you end up not being able to pay back the loan, it will be considered a premature withdrawal, and you will be charged a 10% penalty. Finally, when you have a loan taken out on your 401(k), if you change jobs, it is required that you immediately pay the loan back in full. If you are offered a more lucrative job, you will be forced to either give it up, or struggle to pay back your loan. 

Now, since you are given a choice of how to invest your money within your 401(k), how should you? To start, your company should give you different options. Obviously you should look into all the different options and consider how much you are willing to risk, how much you need to make, what the company suggests, etc. It is always a good idea to diversify. However, a good rule of thumb to invest by is this. From the time that you begin investing in your 401(k) to about 10 years before you plan to retire, you should invest aggressively. This means stocks. Over time, stocks will have the greatest return. Since you will be investing over a significant period of time, the volatility of the stock market should not affect your investment too much. When you get closer to retirement, you should move your money into safer vehicles, such as bonds.

Now 401(k) plans are not something that you should use for an emergency fund. They are NOT liquid. They are meant to be used for retirement only. It is possible to use it earlier, but you will incur heavy penalties and seriously hurt yourself in the long run. Also, you should always start investing in your 401(k) as early as possible. It is estimated that your money will double every 8 years. Putting it off will seriously diminish the amount you will have when you retire.

Your investment is insured in the sense that if your company goes under, you won't lose all that money. However, the money within the 401(k) is not insured. If you make a bad decision in your investments, there's no way to get that money back.

One big benefit of putting your money into a 401(k) is that the money never goes through you; it is automatically deposited. This way you can't take the money and use it for something else. Overall, you really should consider 401(k)s as a way to save for your retirement.