Financial bloggers often portray the traditional IRA vs. the 401(k) plan as a debate, as if one plan is better than the other.
In truth, they’re very different plans, and they fill very different needs. If you can, you should plan to have both.
This is especially true if your 401(k) plan is fairly restrictive. A lot of them are. They charge high fees and offer very limited investment options. A traditional IRA is often the best strategy to work around those limits.
Let’s take a deep look at both plans, and particularly at where each stands out. I think you’ll agree having both makes a lot of sense. It’s one of the best strategies to supercharge your retirement savings, especially for early retirement.
How the Traditional IRA Works
Here are the basics:
IRA contribution limits. You can contribute up to $5,500 per year, or $6,500 if you’re age 50 or older. Contributions must be made out of earned income only. That means wages, salary, commissions, self-employment income, or contract income. It does not include income from unearned sources, like pensions, Social Security, or investment income.
For example, if you earn $40,000 in 2018, and only $4,000 is from earned sources, your IRA contribution will be limited to no more than $4,000.
Age restriction on contributions. Contributions to a traditional IRA can be made only up until age 70 ½. If you still have earned income after that age, you can instead make a Roth IRA contribution. There is no age limit for Roth IRA contributions. The only requirement is that you have earned income.
Spousal IRA provision. If you’re married filing jointly, and either you or your spouse has earned income, and the other doesn’t, you may be eligible to make a spousal IRA contribution. The only requirement is that the spouse with earned income must have sufficient earned income to cover contributions to both plans.
Required Minimum Distributions (RMDs)
Like every other retirement plan – other than the Roth IRA – traditional IRAs are subject RMD rules. When you turn age 70 ½, you’re required to begin receiving distributions from the plan.
The distributions are generally based on your remaining life expectancy. And because that expectancy reduces as each year passes, the percentage distributed from your plan will increase slightly. In theory, the purpose is to exhaust the plan within your lifetime, providing the IRS with its expected tax revenue.
Tax Deductibility of Traditional IRA Contributions
For most taxpayers, the contributions made toward a traditional IRA will be fully tax-deductible. This is always true when neither you nor your spouse are covered by employer-sponsored retirement plan. What’s more, there’s no income limit on the tax deductibility of a traditional IRA contribution if neither of you is covered by an employer plan.
If either of you are, tax deductibility may be either limited or eliminated completely.
The tax deductibility of a traditional IRA contribution when you or your spouse are covered by an employer plan is based on your modified adjusted gross income (MAGI). That’s basically your adjusted gross income for tax purposes, with certain modifications.
If you are covered by an employer-sponsored plan, you can still make a contribution to a traditional IRA. But the tax deductibility of that contribution will be determined by the following MAGI levels:
- Single or head of household, contribution fully deductible up to a MAGI of $63,000; deduction phases out up to $73,000, beyond which it completely disappears.
- Married filing jointly, or qualifying widow(er), fully deductible up to a MAGI of $101,000; deduction phases out up to $121,000, beyond which it completely disappears.
- Married filing separately, contribution phases out up to a MAGI of $10,000, beyond which it completely disappears.
The numbers are different if you are not covered by employer-sponsored retirement plan, but your spouse is. In that case, the tax deductibility of your IRA contribution is subject to the following MAGI limits:
- Married filing jointly, fully deductible up to a MAGI of $189,000; deduction phases out up to $199,000, beyond which it completely disappears.
- Married filing separately, contribution phases out up to a MAGI of $10,000, beyond which he completely disappears.
Other IRA Tax Considerations
Investment income tax deferral. Whether or not your contributions to a traditional IRA are tax-deductible, the investment earnings you accumulate in the plan are always tax-deferred. That means you can invest without worrying about tax consequences. Tax-deferred investment income is worth having, even if your contributions aren’t deductible. Your investment nest egg will grow much faster with tax deferral than it ever will without.
Your investments will continue to grow on a tax-deferred basis until you begin making withdrawals.
Taxability of IRA withdrawals. You don’t begin paying taxes on IRA until you begin taking withdrawals. You can take withdrawals beginning at age 59 ½, which will be subject to ordinary income tax.
If you made any contributions that were not tax-deductible, usually due to the income limitations described above, that portion of the distribution will not be taxable.
For example, if you have $100,000 in an IRA account, which is comprised of $60,000 in accumulated investment income, $30,000 in tax-deductible contributions, and $10,000 in nondeductible contributions, then 10% of any withdrawal will not be subject to income tax.
In that situation, if you made a withdrawal from the account of $10,000, $9,000 will be taxable. The remaining $1,000 will not ($10,000 X 10%). This is what’s referred to as the IRS pro rata rules. You won’t be able to declare that the first $10,000 withdrawn from the plan specifically represent your nondeductible contributions.
Early Withdrawal Treatment
If you withdraw funds from a traditional IRA before you turn 59 ½, you’ll be subject to ordinary income tax on the distribution, plus a 10% early withdrawal penalty.
For example, if you’re in the 12% federal income tax bracket, and you make a $10,000 early withdrawal from your plan, you’ll have to pay $2,200 in tax. That’s comprised 12% in ordinary tax, plus the 10% early withdrawal penalty.
However, the IRS does have a list of exceptions to the penalty. However, you will still be required to pay ordinary income tax on the amount withdrawn.
Tradional IRA Investment Options
Self-directed investing. One of the biggest advantages with an IRA – traditional or Roth – is that you have complete control over the account. That means you can create your own portfolio, choose the investments that make it up, and buy and sell securities on your own timetable.
Account Trustee. You’re free to choose any trustee platform you want. You can choose any of the following trustees to hold the plan:
- A bank, particularly an online bank paying high interest rates
- Investment brokerages, like Scottrade, E*TRADE or TD Ameritrade
- Managed funds or investment accounts
- Mutual fund or exchange traded funds (ETF) families
- Robo-advisors, like Betterment, Wealthfront or Ally Invest
- Peer-to-peer lending platforms, like Lending Club or Prosper
- A real estate investment trust (REIT)
- Crowdfunding platforms, like Peerstreet, Fundrise and RealtyShares
Investment options. There’s more good news here. You can hold just about any type of investment in a traditional IRA that you choose. The IRS has a very short list of prohibited investments, and their generally not the kind you would buy anyway.
As for what type of investments you can hold – just use your imagination! Mutual funds, ETFs, target date funds, individual stocks and bonds, certificates of deposit, options, gold, foreign currency, and real estate investment trusts.
A traditional IRA is the virtual antidote to a 401(k) plan with limited investment options.
The Roth IRA Conversion
No discussion of a traditional IRA would be complete without mentioning the Roth IRA conversion. The conversion is available for both IRA and 401(k) plans. But it’s generally easier to do it with an IRA since it’s a completely self-directed plan. While some employers do permit IRA conversions while you are still employed, most will require that you remain in the 401(k) until your employment is terminated.
Why do a Roth IRA conversion? The Roth IRA has the lone distinction (along with the Roth 401(k), Roth 403(b), etc.) of providing tax-free income in retirement. It works much like a traditional IRA in that income within the plan is tax-deferred. It also has the same contribution limits.
But contributions to a Roth IRA are not tax-deductible. However, when you turn 59 ½, and if you have been in the plan for a minimum of five years, distributions can be taken tax-free. That includes distributions of both your contributions and your investment earnings.
One of the big advantages with a Roth IRA conversion is that there’s no limit on the amount of retirement money you can convert to a Roth. You can build up the Roth account much more quickly by doing a conversion of say, $100,000 from an IRA or 401(k), than by annual contributions of $5,500.
This is why Roth IRAs, and Roth IRA conversions from other retirement plans, have become so popular.
The Tax Implications of a Roth Conversion
The down side of the conversion is that you will pay tax on the amount converted. The good news is there is no early withdrawal penalty, even if the conversion takes place before 59 ½.
This is the summary version of a Roth IRA conversion. I go much deeper into the topic on my Roth IRA conversion article.
How the 401(k) Works
Here are the basics of the 401(k):
401(k) contribution limits. For 2018, the 401(k) contribution limit is $18,500, up $500 from $18,000 in 2017. The catch-up contribution of $6,000 remains the same. That means if you’re 50 or older, your contribution can be as high as $24,500 for the year.
Employer matching contribution. Many employers, particularly large ones, offer some sort of matching contribution. For example, if they offer a 50% match, and you make a 10% contribution, the total contribution will be 15%.
According to the Society for Human Resource Management (SHRM) 42% of companies match dollar-for-dollar on 401(k) contributions. If you make a 10% contribution, and your company will match 100%, your total contribution will be 20%.
Employer matching contributions are subject to vesting provisions. Vesting refers to the time it takes before the employer match is considered to be permanently yours. Depending on the vesting schedule used, it can take anywhere from two years to six years before you become 100% vested in the employer match.
In theory at least, combined contributions to a 401(k) plan from you and your employer can be as high as $55,000 for 2018.
401(k) funding method. One of the big advantages of a 401(k) plan is the ease of funding it. Since it’s employer-sponsored, your contributions are made by automatic payroll deductions. This is one of the simplest ways to fund any investment program, making it an easy path to wealth building. All you need to do is select your contribution percentage, and let the contributions flow into your account. If your employer offers a matching contribution, it will generally be made as your contributions are.
Tax Deductibility of 401(k) Contributions
Your contributions to a 401(k) plan are fully tax-deductible. What’s more, employer matching contributions are not taxable in the year received. Given the amount of contributions permitted under the plan, this can result in a substantial tax deduction.
Tax deferral of investment earnings. Just as is the case with the IRA, and virtually every other tax-sheltered retirement plan, investment earnings accumulate within the plan on a tax-deferred basis. That means you can invest without regard to income tax consequences. This is a powerful compounding advantage, since a 10% return on investment will actually be 10%. It won’t be reduced down to 7% if you’re in a 30% marginal tax bracket, as would be the case with a taxable investment.
Taxability of 401(k) withdrawals. Neither your plan contributions nor the investment earnings on the plan are taxable during the accumulation phase. You are eligible to begin making withdrawals from the plan after turning 59 ½. Ordinary income tax must be paid on the distributions, which will include both contributions and investment earnings.
Early 401(k) withdrawals. If you take distributions from a 401(k) plan before reaching age 59 ½, you will not only have to pay ordinary income tax, but also a 10% early withdrawal penalty. But as is the case with IRAs, the IRS has a fairly long list of exceptions to the early withdrawal penalty. Though you will still have to pay ordinary income tax on the amount withdrawn.
Other 401(k) Plan Features
401(k) plan investment options. Generally speaking, your options will be limited to those selected by your employer. The employer will choose the account trustee, and often the investments that will be available for the plan. For example, the employer can have the plan administered by a mutual fund company, which would limit your investments to the funds offered by that company. In more liberal plans, the trustee may be a diversified investment broker. If that’s the case, you may have investment options similar to those offered in a self-directed IRA.
Yet another disadvantage of an employer-sponsored plan is fees. There will generally be an annual fee charged by the plan administrator. You may also be locked in the certain other fees, such as mutual fund load fees.
As a participant in the plan, your options will be limited to the fees charged and investments available within the trustee program.
401(k) loan privileges. This is a benefit available for 401(k) plans that cannot be done with an IRA. Loans are permitted under IRS guidelines, though not all employers offer them.
Under IRS regulations, you can borrow up to the lesser of:
- The greater of $10,000 or 50% of your vested account balance, OR
Now it’s important to understand that the amount you can borrow from the plan is based on the vested balance, not the total balance. For example, if your plan has $50,000, which is comprised of $20,000 in investment earnings, $20,000 in contributions by you, and $10,000 in non-vested contributions by your employer, your base for calculating the loan amount will be $40,000. Since you can borrow 50% of this amount, the maximum loan will be $20,000.
Required Minimum Distributions (RMDs) on a 401(k)
As you might expect, these are required on 401(k) plans, just as they are on traditional IRAs. You must begin taking distributions no later than age 70 ½. The distributions are based on your remaining life expectancy, which means the percentage distributed will increase slightly each year as you age.
Your 401(k) Plan May Offer a Roth 401(k)
An increasing number of 401(k) plans are now offering a Roth 401(k) option. This has become especially common among large employers.
Alternatively, you can split the contribution between the traditional and Roth portions of your 401(k).
This will probably be well advised. Just as is the case with a Roth IRA, contributions to a Roth 401(k) are not tax-deductible. If you contribute the full $18,500 to the Roth portion of your 401(k), you won’t get any help on the tax side. That can cause a serious budget squeeze.
The withdrawal provisions for the Roth 401(k) are similar to a Roth IRA. You can begin taking penalty free withdrawals from the plan once you reach age 59 ½, and have been in the plan for a minimum of five years.
If you participate in a Roth 401(k), the employer will carry separate balances for both the traditional and Roth portion of the plan.
What’s more, any employer matching contributions on the Roth portion must be deposited into the traditional portion. This is the maintain the separation between pretax contributions (the employer match) and actual Roth contributions (your contributions). The net result is that the employer contributions, residing in the traditional side of your plan, will be taxable on distribution. The Roth distributions will not be taxable.
Other Roth 401(k) Features
Roth 401(k) RMD rules. Unlike a Roth IRA, a Roth 401(k) is subject to RMDs beginning at age 70 ½. However, this won’t affect your tax situation, since those distributions will be tax-free anyway. The only negative is that RMD’s will deplete the account, reducing future account growth.
The Traditional IRA vs. the 401(k) Plan – The Advantages of Each
Comparing the two programs side-by-side, here’s a summary of the advantages each provides.
- You choose the plan trustee.
- Self-directed investing – you can invest in anything you choose, or even choose a third-party investment management option.
- You can set up a spousal IRA for a nonworking spouse.
- Traditional IRAs are easier to do a Roth IRA conversion with, since you have full control over the account.
- Very high contribution limit.
- Employer matching contributions, making your total annual contribution even higher.
- Ease of contributions through automatic payroll deductions.
- 401(k) loan provision.
- Your 401(k) may come with a Roth 401(k) provision.