Retirement planning takes a lot of thought and calculation to do it right.
It’s important to know what all your options are, as well as their benefits and drawbacks. One popular option that people have is the 401(k) or IRA retirement plan.
However, there can be confusion between these two plans since they feature characteristics similar to rules and regulations regarding contribution limits, eligibility requirements, types available, and tax treatment.
To help you decide which one may suit your needs best, we will discuss who controls the 401(K) versus an IRA retirement plan in detail below!
Types Of IRAs
There are two main types of IRAs are:
Traditional IRA
Contributions to a traditional IRA may be tax-deductible, meaning the amount of money you contribute to the account is taken from your taxable income.
This depends on your income level, filing status, and whether or not you are enrolled in a workplace retirement plan.
The funds placed within the account will grow without having any taxes imposed on them until it is time for withdrawal.
At this point, the money will become taxed as it is pulled from the account.
Roth IRA
A Roth IRA is an Individual Retirement Account (IRA) in which contributions are made with post-tax dollars, meaning that money has already been taxed.
While these contributions cannot be deducted from your taxes like other retirement accounts, the withdrawals you make during retirement are completely tax-free, provided that certain conditions and rules have been met.
This makes a Roth IRA an incredibly attractive option for individuals seeking to save for their future.
401(k) Tax Treatment
When it comes to 401(k)s, you can allocate a portion of your wages or earnings into a retirement account.
These funds are often put towards different bonds and mutual funds.
Nevertheless, the tax implications may vary depending on the kind of 401(k) plan you have.
Traditional 401(k)
- Pretax contributions: The money you contribute to your account is made before any income taxes are removed, which can decrease your taxable income for the year.
- Tax-deferred earnings growth: As your balance builds over the years, it increases tax-deferred, meaning you will not be required to pay any capital gains taxes on investment income earned. This means that your money can accumulate and grow without being reduced by taxation, allowing you to maximize the return on your investments.
- Distributions are taxed: Any money taken out of retirement accounts during retirement is subject to taxes at the individual’s income tax rate.
Roth 401(k)
- After-tax contributions: Contributing to a Roth 401(k) requires using post/after-tax dollars, meaning your taxable income remains unaffected when you contribute. In contrast, contributions to a regular 401(k) are made pretax and reduce your taxable income.
- Tax-free earnings growth: When your balance has been invested for a prolonged period, you won’t be subject to any taxes on your retirement returns.
- Tax-free distributions: When withdrawing from a Roth 401(k) during retirement, an account holder is not required to pay any income tax as long as they are 59½ years of age or older and their account has been open for at least five years. These tax advantages benefit those who diligently contributed to a Roth 401(k) throughout their working life, allowing them to access that money without fearing hefty taxation. If you have obtained employer contributions thanks to a matching program, they must be assigned to a different account, and taxes are applied once disbursed.
Eligibility
You must pay income taxes during the tax year to contribute to an Individual Retirement Account (IRA).
This income generally refers to money generated through employment, such as salary, wages, bonuses, or self-employment income.
Additionally, any compensation from conducting a business as a sole proprietor or independent contractor may be considered when determining eligibility for contributing to an IRA.
Income from investments, Social Security, unemployment payments, annuities, and pensions are not eligible for Roth IRAs.
Additionally, there is a limit to the amount of income that can be used when applying for a Roth IRA.
Filing a joint tax return as a married couple allows you to contribute to an IRA for your spouse, even if they do not have any earned income.
Contributions can be up to the lesser of two times the annual contribution limit or your combined income in that tax year through what is known as a “spousal IRA.”
To participate in a 401(k) plan, you must have an employer that offers one.
Generally, those aged 21 and above with at least 12 months of employment are eligible to contribute.
Employers can make their own rules in the plan document, but they cannot be more stringent than what is required by law.
Contribution Limits
The Internal Revenue Service (IRS) determines the maximum amount that can be contributed each year to both Individual Retirement Accounts (IRAs) and 401(k)s.
This limitation ensures that individuals cannot exceed the yearly contribution limits set by the IRS, thereby restricting how much they can save annually in either of these retirement accounts.
IRA Contribution Limits
If you are under 50, the contribution limit for an IRA in 2022 is $6,000 and will rise to $6,500 in 2023.
Those aged 50 and older can contribute an extra $1,000 as a catch-up contribution in 2022 and 2023; this applies to traditional and Roth IRAs.
For the 2022 year, you may only add what you earned in income to your contribution.
Consequently, if your total earnings are $4,000, that is the most you can contribute for that year.
401(k) Contribution Limits
For the upcoming year of 2022, individuals are eligible to contribute up to a maximum amount of $20,500 to their 401(k) plan.
This limit increases in 2023 and then becomes $22,500.
Additionally, those aged 50 or over can make an extra catch-up contribution of up to $6,500 in 2022 ($7,500 in 2023), which gives them more financial flexibility for retirement planning.
In 2022, the total amount of contributions from both employee and employer cannot exceed $61,000 (or $66,000 in 2023).
This is equal to 100% of the employee’s salary. The catch-up contribution does not have any effect on this limit.
Which Is Right For You?
It’s encouraging to know that you don’t have to decide between an IRA and a 401(k) – you can invest in both!
It is possible to open both an IRA and a 401(k) if you meet the requirements, though many people do not have enough money in their budgets to fully fund both of these retirement accounts.
Prioritize taking advantage of your employer’s match when investing in retirement.
For example, if your company matches 50% of your contributions up to 5% of your salary, that equals a 50% return on investment. If your income is $50,000 a year, save 10% – $5,000 – to take advantage of the full employer match.
Controlling Your 401(K) And IRA Retirement Plans
In conclusion, the key difference between 401(K)s and IRAs is who controls the money.
With a 401(K), the employee’s employer will oversee how their contributions are invested and managed.
On the other hand, an IRA is an individual investment account; employees will ideally manage it or have someone else manage it, such as a financial adviser.
Despite the main differences between these two retirement savings vehicles, they offer tax benefits to save money and be used strategically to build a secure future.
Understanding what differentiates each plan’s purpose and who is ultimately responsible for your savings can help you decide which is right for you and your financial goals.
Taking an active role in planning your retirement can pay off handsomely in the long run.
