What are the advantages to the employer sponsored 401k plan in today’s market? How does it compare to the popular Roth IRA? Both are retirement accounts which allow your hard-earned money to grow tax-deferred, and each has different features investors should understand.
The Roth IRA
The Roth is an excellent way to save money, and is ideal for an account designated to estate planning. Contributions made to the Roth are taxed as earned income, but the money is tax free when taken out. Although favored for growth in the long term, profits are dependent on the firm managing the investments. In some cases the pre-taxed status of the money can overwhelm any potential gains.
A unique feature of the roth ira is the five year tax seasoning period. Any principle contributed to a Roth may be taken out at any time, as long as this 5 year period has passed. Note that the IRS uses tax years and not calendar years. This is not applicable to earnings, however, which are still subject to penalties if withdrawn early.
Maximum contributions are $5,000/ year for persons under 50 and $6,000/year for those over 50. Maximum eligible gross income is $177,000 for 2010 if the person is married and both of names are on the tax return. If the filer is single or head of household, the limit is $120,000 per year.
To receive tax and penalty clear distributions from a Roth account, the individual needs to be 59 ½ with the ‘five year rule’ met. Exceptions to this are withdrawals for disability, medical expenses not covered, taking cash out for a home purchase, and using the funds to pay the IRS. Penalties for early distributions are 10% plus income tax.
The 401 (k)
The immediate advantages of the 401k are the tax benefits. Money contributed is tax-deferred, and is not counted as part of taxable income for that year. Another benefit is the availability of employer matching contributions, effectively doubling the pace at which money can accumulate. Upon withdrawal, taxes are taken out as if it were regular income.
The other advantage is the annual contribution limit. The individual under 50 can put up to $16,500 per year into their account, and people over 50 are allowed up to $22,500 per year. Adding employer matching contributions brings the number up to as much as $46,000, or the equivalent of the employee’s salary.
Minimum distribution age for a 401k is also 59 ½, and there are exception allowing early withdrawals, such as for disability. However, a 10% penalty is still levied, even then. To get around this, the employee can take a loan out against their account, and pay it back with interest.
There are limitations to the 401k, such as when a person stops working, they stop making contributions. In order to continue accumulating interest, the account must be rolled over, often to a Roth ira. There is also a forced distribution age of 70 ½, and for every payment not taken out, the IRS levies a 50% penalty.
An ideal situation is to have both accounts open at once. Then, when the employee leaves their job, the funds can rolled over into the open Roth account, taking a tax hit, but continuing to grow
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