If you do any reading about retirement plans, you’ll often see terms like Traditional IRA, Roth IRA and 401k thrown around with carefree abandon. But what do they mean? Here we explain some of the differences.
An initial glance at the three plans reveals similarities. All three are retirement investment vehicles, designed to help you grow your money as you approach your golden years. Traditional and Roth IRAs are usually offered through financial services companies, like Voya. This means you have some flexibility to choose where your money is invested. To be eligible for either one, you simply have to be under the age of 70½ and earning some sort of income. A 401k is offered through your employer, so you will likely have fewer choices in the investments. But as long as your employer offers a plan, you’re eligible. There are also many differences:
How much can you invest?
In a Traditional IRA, you can invest $5,500 annually if you’re 50 or under, and $6,500 if you’re older. You can invest the same amounts into a Roth IRA, but there are income caps. For tax year 2015 – if you’re single and earn between $116,000 and $131,000 or married and earn between $183,000 and $193,000 per year, your upper limits may be less. If you earn more than this, you can’t invest in a Roth IRA at all. With a 401k, you can invest up to $18,000 a year and $6,000 for catch-up contributions.
Are there any tax breaks?
With a Traditional IRA, your contributions can be tax-deductible, depending on your income level and access to employer-sponsored retirement plans. 401ks also offer tax-deductible contributions. With a Roth IRA your contributions aren’t tax deductible, but if you’ve had the account more than 5 years and are 59½ or older, you can withdraw your money income tax-free.
Can you withdraw without a penalty?
With a Traditional IRA and 401k, you can start withdrawing at your discretion at 59½. Withdrawals become mandatory at age 70½. The money you withdraw is viewed as income, so it’s taxed. If you withdraw early from your Traditional IRA or 401k, you can face a 10% penalty on top of the taxes levied. A Roth IRA can offer more flexibility. If you’ve had the account more than 5 years, you can start withdrawing any time so long as the withdrawals don’t exceed the value of your contributions, and you can start drawing the investment gains at age 59½. A Roth IRA carries a 10% penalty if you withdraw before 5 years, but after that you can withdraw your money free of penalties or taxes.
Weighing them up
At first glance, IRAs can offer great flexibility. But the 401k has a knockout punch, in that many employers offer matching contributions. This is essentially free money, which you won’t want to pass up. But that doesn’t mean a 401k wins outright. In fact, a good retirement strategy often uses a mix of different plans. Talk to your financial advisor to see which ones could work for you.
This material is provided for general and educational purposes only; it is not intended to provide legal, tax or investment advice. All investments are subject to risk. We recommend that you consult an independent legal or financial advisor for specific advice about your individual situation.
The tax information herein is not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding tax penalties. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.
Securities and investment advisory services offered through Voya Financial Advisors, Inc., member SIPC.
Neither Voya nor its affiliated companies provide tax or legal advice. Please consult with your tax and legal advisors regarding your individual situation.