IRAs-401ks – What’s the Difference

iras 401ks whats the difference

I bet you always thought IRA was short for Individual Retirement Account huh? Nope, it’s actually an Arraignment as weird as that sounds.

So what are they and how can you use them?

There are two types of these IRA’s, a Traditional IRA and a ROTH IRA (named after the late Senator from Delaware named William ROTH).

Traditional IRA – “Pre-Tax” Account

This account allows you to contribute pre-tax money if you don’t have access to a pre-tax retirement account within your employer. You can contribute annually: $6,000 if under age 50 and $7,000 if over age 50 based on 2020 IRS guidelines.

When you turn 59 ½, and you begin taking distributions, you pay your ordinary earned income taxes on not only what you contributed, but also the earnings growth of the account, or in other words the entire account.

You can’t take any money out of the account until age 59 1/2 or the IRS will hit you with a 10% early withdrawal penalty plus your ordinary income rate.

ROTH IRA – “After Tax” Account

This account allows you to contribute after tax money (your take home pay) and the only restriction to contributing is based on how much you make.  If you make to much, based on IRS guidelines found here IRS, then you can contribute directly to a ROTH IRA (there is a potential ‘back door’ way to contribute still but that gets a little more tricky).

If the account has been open for more than five years then the growth is considered tax free if you take a distribution after the age of 59 ½, so you only pay taxes on what you contributed each year.

The same rules apply on the taking money out prior to 59 1/2. The IRS will hit you with a 10% penalty and you pay taxes on the growth for the early withdrawal instead of getting that money tax free.

457 Deferred Compensation / 403b plans / 401k plans

Depending on where you work will dictate which kind of these retirement plans you have available to you and some of you may have access to more than one of these. The following are usually available with these types of employers:

  • Government or Municipal employers – 457 deferred comp (and in some cases a 401k plan)
  • Public Schools and certain tax exempt employers – 403b plans
  • Corporate or private jobs – 401k plans

Don’t get all wrapped up in the number names; think of it just like a penal code law book, the number just represents where it is found within the Internal Revenue code.

457 Differed Compensation

This type of retirement plan allows you to defer your compensation now so that when you leave your employer you can then take that compensation then. This means that after you leave your agency you are not subject to the 10% IRS early withdrawal penalty. If it is a pre-tax account (most are) then you will only pay the ordinary income taxes on it.

403b Plan

This type of plan allows you to out pre-tax money into a retirement plan. You are typically allowed to take withdrawals out at age 59 1/2 without a penalty, and in some cases you can take distributions if you retire after 55 (you should always check with your plan administrator to confirm your rules).

401k Plan

This plan works similarly to the 403b except oftentimes you have the ability to pick the pre-tax contributions or the after-tax ROTH contributions. You are also typically able to take withdrawals out at age 59 1/2 without penalty, but again check with your plan administrator to confirm their rules.

Matching Contributions

Some of you are fortunate enough to have a employer that matches your contribution in these plans. If they offer a match you should highly consider taking advantage of this. It is FREE money which can equates to a potential 100% return on your money. You most likely can’t find that kind of return anywhere else so you shouldn’t  throw that opportunity away.

Besides the 100% return, the companies match also grows, so as it does that, money is essentially free growth as well since it came from the employer matching funds. Note that all matching contributions are done so on the pre-tax side of things so when you start to take out withdrawals you will pay ordinary income taxes.

Contribution limits for 457 / 403b / 401k accounts in 2020 – $19,500 if under age 50, and $25,500 if over age 50 (always refer to www.irs.gov to confirm)

*Remember www.irs.gov is a great resource when it comes to learning more about each of these accounts, to include rules, definitions, and contribution limits each year!!

**Disclaimer Alert— As always, when it comes to taxes, you should consult your accountant for specific tax advice, and how each of these types of accounts can effect your specific tax situation!!!

By FinancialCop Nick Daugherty

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