IRA or 401k? Know the key differences between these two popular retirement plans to ensure you are saving in the right account.
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Key Takeaways:
– Similarities between 401Ks and IRAs
– Differences between 401Ks and IRAs
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Qualified charitable distributions from an IRA
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Penalty-Free Distributions for Higher Education Expenses from an IRA
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Access to IRA and 401K Funds
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Aggregating RMDs with an IRA
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Avoiding Withholdings with an IRA
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– Should I have an IRA or a 401K?
Video Transcript
JENNIFER
Hello! Welcome to our current version of Facebook Live. We’re glad you’re here today. We’re going to talk about five things that you can do with an IRA that you cannot do with a 401k plan, and we’ll compare and contrast a little bit, but there are some things you can do with an IRA that you are limited from with a 401k plan. Let’s first talk about how they’re similar.
How Are IRAs and 401Ks Similar?
JENNIFER
They’re both retirement plans and they both allow you to put money into them with pre-tax dollars. So, it’s like you never even earned the money that year when you put money into it, so you’re not taxed on it, and the money in them grows tax deferred. You don’t pay any taxes on that growth until you start taking distributions. And they’re both meant to be retirement vehicles, methods of funding or spending in future years when you retire. So, they do have a lot of similarities but there are also quite a few differences.
What is The Difference Between an IRA and a 401k?
#1 Qualified Charitable Distributions From An IRA
MIKE
Yeah. So, we’re going to go through those five things, and number one is making a qualified charitable distribution. This is something that we do with several of our clients that are just charitably inclined, and they want to give to a charity on a regular basis, on an annual basis. We have these things called a qualified charitable distribution or QCD, if you’ve ever heard of QCD, where you can give money out of your IRA. In most cases, it’s to satisfy RMDs, which is a required minimum distribution. So, the government at some point forces you to take money out of your IRA and 401k, and we’ll talk about one of the differences there in a minute. But a QCD is one way that you can satisfy that RMD as one available I guess benefit to the QCD, to the qualified charitable distribution, and you can also avoid taxes. Essentially what you’re doing is you’re giving money that you’ve not paid taxes on to the charity. The charity, being a charitable organization, is not having to pay income taxes on those funds. So, it’s kind of a win-win situation in that case.
JENNIFER
Right.
MIKE
You can’t do that from a 401k. A 401k does not allow QCDs or those qualified charitable distributions.
JENNIFER
Yes. And when that distribution is made, the check is made out directly to the charities. So, from your income tax perspective, it’s like it never happened and it can often lower your tax bill because charitable deductions are lower down on your tax return, and you don’t always get the full benefit of that.
MIKE
Yeah. More so when we increased the standard deduction during the trump administration. A lot of people that were giving and were claiming that as an itemized deduction can’t do that anymore because they’re not meeting that or surpassing, whereas a QCD is a number that you’ve essentially never paid taxes on, so you’re getting to have that deduction.
JENNIFER
Yes and you’re actually giving them more money because you can give them the money you would have paid in taxes as well, so it’s definitely, as you said, a win-win. And to be a charity, we have had people say, “Well, can I give it to my kids?” No. It has to be what is called a 501(c)3, if you want to get into the lingo, and be a properly registered charitable organization. But most people give something to charity, and so it can be a very efficient way. You do have to be 70 and a half before you can start, just to be very clear.
#2 – Penalty-Free Distributions for Higher Education Expenses from an IRA
JENNIFER
Yeah. So, the second thing we wanted touch on was taking a penalty-free distribution for higher education expenses. So, most of your access is limited to retirement plans until you turn age 59 and a half. And normally in an IRA, if you take money out before 59 and a half, you pay income taxes, but you also pay a 10% penalty. But if that money is going to be used for higher education purposes (college tuition, books, computers, legitimate college expenses for yourself or your children), you don’t have to pay the penalty. You still pay income taxes on it but you can get that money out pay income taxes and use it for that purpose. A 401k does not allow you to make any such distribution, penalty or otherwise. So, you don’t have that same access.
#3 – Access to IRA and 401K Funds
MIKE
Yep. That actually brings us to number three, which is just the distribution side, not specific to higher education. An IRA, while there may be a penalty to certain distributions, you do have access to that money whereas a 401k, that’s a possibility, but you’re really at the mercy of the plan itself and the distribution rules behind a 401k. And some of them will not allow distributions for any reason, you know, any kind of hardship situation, whereas in an IRA you really always have that option. That is something that a lot of people I think don’t realize. “I can’t touch my IRA until I’m eligible,” but that’s not true. You can access it. It is something we highly discourage because of the penalty, but in a dire situation when something happens and you need to access that money, sometimes it’s worth taking the hit on that to access that.
JENNIFER
Sometimes you have to, to pay the bills.
MIKE
Yeah. So that’s potentially a very big advantage to having an IRA over the 401k.
JENNIFER
Definitely. You can take a loan out of a 401k plan, but there are risks with that.
MIKE
Yeah, the biggest being that has to be paid back if you ever leave. So yeah. You can, which in this case, that’s an argument for a 401k because you can’t do that with an IRA.
JENNIFER
You cannot.
MIKE
You can access the funds, but you can’t take a loan on that money, but you can out of a 401k.
JENNIFER
Right.
MIKE
And pay it back just like you would, you know, any normal loan from a bank or institution. But if you ever separated service, that has to be paid back before you leave or before that 401k closes, or else you’ll be hit with that penalty and you’re paying income taxes.
JENNIFER
Yeah. And it does happen because we don’t have complete control over our employment sometimes, so that is a risk.
#4 – Aggregating RMDs with an IRA
JENNIFER
So, one of the more esoteric, lesser known rules is you can aggregate your required minimum distributions with an IRA. And what I mean by that is, if you have five different IRAs and you’re at the age where you have to take required minimum distributions, which now after the Secure Act is starting at age 72**, for each of those IRAs you have to calculate what your required distribution should be. But once you know what those numbers are, you can take that money from any of those IRAs. You could do it all from one, you could do it all from two, you could do it just for each one. An advantage to that is sometimes IRAs that have higher expenses so you might want to “waste” that one faster, or it could be you have different legacy goals for different IRAs, so there are some you want to preserve for other reasons. With a 401k whatever your required distribution is has to come out of that plan, and if you have five 401ks you have to take five distributions, which can be kind of a pain actually. And if you don’t do that, if you try to aggregate and take it out of one or two, you’ll be hit with a 50% penalty by the IRS. So, they really, really, really don’t want you to do that, to aggregate them. So, you have to be careful with those rules around that.
**2023 Update: Secure Act 2.0 has changed the RMD age. You can read more about those changes here!
MIKE
Yeah. They’re very siloed there, whereas in IRA world, the IRS is looking at you as the individual, how much do you have in an IRA and what was that balance, so that’s how we calculate the RMD, versus the 401k, where we’re looking at just the 401k. What’s in there? What needs to come out? And that 50% penalty is a big deal.
JENNIFER
It is yeah. That can hurt.
MIKE
That’s a much bigger hit than 10%.
JENNIFER
Yep.
#5 – Avoiding Withholdings with an IRA
MIKE
So, number five, the last advantage we’re going to talk about today, is avoiding withholdings. This is an interesting one, and one that that we only learned about recently. In a 401k, if you withdraw any of the money, you’re forced to take a 20% withholding. The 401k is going to automatically withhold 20% for federal taxes. So, that’s your income taxes and you do need to pay income taxes on any kind of qualified money, whether it’s an IRA or 401k and those taxes are virtually going to come out the same at the end. But what’s happening with an IRA is that you yourself or we as advisors work with our clients to try to figure out what that tax is going to be at the end of the year on that money, and we’re only withholding the amount that makes sense for them. So, we can adjust that. If they’ve overpaid taxes in another area, we can send that with zero withholdings. And in some cases, we’ve got clients that have very low income in retirement, and they are in a zero percent tax bracket or very low.
JENNIFER
So, we withhold 10% or 12% sometimes in those situations. And the opposite actually has been true. I don’t think you’ve experienced this since you’ve been here, but one client wanted to pay all of it, wanted to catch up on their taxes before the end of the year. Some people are really good at calculating exactly what they will owe at the end of the year. And we took a distribution where one dollar went into their checking account and the rest went to taxes.
MIKE
Oh, so the whole distribution?
JENNIFER
Yeah. They sent it all just on over there. It just made their life easy. It was very efficient for them. That’s what they wanted to do. So, you have complete flexibility as well as on the state side and what you withhold and some states, as you know of course, have different tax rates.
MIKE
Yeah. Whereas the 401k is just, again, going to be a 20% federal. End of story, no real changes.
JENNIFER
Yeah, so you may be loaning the government money or you know or you may be under withholding too.
MIKE
Yeah. And this is kind of a side note, but in the process of a rollover, we’ve seen this 20% withholding problematic if it’s not a direct rollover. We’ve had some clients, they will call and they want to roll over their 401k and wherever that’s housed, they just send the clients a check. The 401k is viewing that as a distribution, when in reality, within I think the 60-day window, you’re going to deposit that check directly into an IRA, the 401k doesn’t know that, so they’re automatically withholding that 20%, and now we’ve got to wait.
JENNIFER
Yes. So, it’s very important when most people roll over 401k, most of the time, it takes paperwork. There are some companies where it’s literally a phone call and you tell them what you’re going to do, and they’ll send a check to the IRA directly. But it’s very important to fill out that paperwork correctly because you can circumvent that withholding if it’s very clear to the 401k provider that it’s going directly into an IRA and the check is made out to the custodian, which in our case would be TD Ameritrade. It could be Fidelity, it could be anything.
MIKE
Yeah. Wherever that IRA is.
JENNIFER
There is so much language, you know, of the of the business that when you look at a form and you haven’t looked at it ever before. It is helpful to really get some information, get some help sometimes, and to know exactly what you’re doing and doing it right because that avoids all that mess with the taxes.
MIKE
Yep.
Should I Have a 401K or an IRA?
JENNIFER
So, they’re both great vehicles. We’re not saying never do a 401k. Absolutely use your 401k.
MIKE
That’s almost always the number one, as far as saving for retirement. We first look at that employer plan, 401k, 403b, you know, whatever it is you have.
JENNIFER
Especially up to what your company matches. After that it can be a more fluid description because we’ve been talking about traditional IRAs, that tax-deferred growth, but there are also Roth IRAs, so it could be if you have more money to invest, you might be better off, after you’ve made that contribution up to a company match, that any other savings might go into a Roth IRA or what we call a taxable account, which is a non-retirement account that you have access to whenever you want to without any kind of penalty. So, sometimes that is better. But one advantage is — we’ve touched on one, which is that you can’t get a loan from an IRA, but you can from a 401k. Another advantage is some company retirement plans allow distributions without penalties starting at age 55. And so, that’s a four and a half year gap, and if you’re actually retiring really young, that could be an advantage and a reason to leave the money into that plan at least until you’re 59 and a half.
MIKE
In a 401k.
JENNIFER
In the 401k.
MIKE
Oh yeah. I guess once you reach that 59 ½, you can take it out.
JENNIFER
Then it won’t matter because that advantage went away but there’s one other big one.
MIKE
Yeah. So, this is I guess not a super likely scenario, but it’s a really big deal, is creditor protection. There’s higher creditor protection within a 401k than there is an IRA. An IRA is accessible to just about any creditor. I don’t know a situation that –
JENNIFER
There are some state laws that will protect to some degree, but it doesn’t give that higher level federal protection, which isn’t complete protection. There are some reasons that you cannot — in the cases of being behind on child support, you can. There are some creditor situations where there is access to 401k money but it’s a very small set of circumstances.
MIKE
Yes, which is not the case with an IRA. So, if there if there is potential creditor issues or concerns, I mean if we’re if we’re looking or contemplating bankruptcy or if you’re in that kind of situation, you’re suscepting those funds to those creditors by moving it from the 401k to an IRA, and that would be a really costly mistake.
JENNIFER
It might lower your protection. For sure. So, they’re all great tools and I think, you know, that’s why when we go through financial plans with people is looking at all of these options and maximizing it and doing tax planning and seeing what’s the most tax efficient way to handle investments as well. And then you get in the whole distribution phase, but that’s a different story.
MIKE
Yeah. We wanted to make an announcement, and I might have to do a separate video because I don’t think we finalized or nailed down the specific times.
JENNIFER
Oh, our date. Yes.
MIKE
Yeah. We’re going to be doing our next webinar. We just did a social security webinar last week. Was it last week?
JENNIFER
It was last week. Seems like so long ago too.
MIKE
Yeah the next one coming up is on tax planning which a lot of, you know, where this money is all about taxes.
JENNIFER
Yeah. So, bring your coffee.
MIKE
Yes, so we’ll definitely get technical in this one. I am excited about this one, as this is maybe the nerding-out side of things, but I like all the different scenarios about this. But we’re going to post the time. I’ll make sure that it’s in the comments or in a separate post so that we have the date and time. I believe we’re looking at July 26th or 27th.
JENNIFER
Something like that. Yep.
MIKE
So, it’s like four-ish weeks away from now. So, stay tuned for that. We’ll put a registration link up so that you can register for that tax planning webinar.
JENNIFER
And yes. We would love for you to attend. And we also love feedback from this. If you have ideas of what you would like to hear us talk about or have questions about anything we talked about, because clearly all of these issues or topics you can go on a much deeper dive on the information as well as things are very specific to individuals. There’s no really blanket answer. I always laugh when I ask my CPA a question. He always says, “Well, it depends.”
MIKE
Yeah. We did one video several weeks ago and a friend called and said, “Mike, I just watched your video, and that all makes sense, but it’s a little different I think for me since I’m an S corp.” He owns a business, owns an S corp. And I was like, “Actually, yeah. It would be a little bit different for you and your situation.” So, yeah, if you have questions on anything, we’d love to help you out one-on-one, but it also gives us more ammo I guess for these videos and what information we can put out there to help other people. Other people probably have the same questions that you do.
JENNIFER
Yes, for sure. So, thanks for joining us. We appreciate it. Bye!
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