IRAs and 401 (k)s share key similarities: they are both retirement plans that can help you lower your tax bill, provide tax-deferred growth, and can serve as an income source later in life. However, there are also key differences between the two options, some of which may affect your financial planning decisions.
Here’s what you need to know:
1. IRAs allow you to make qualified charitable distributions.
If you are an IRA owner or beneficiary over 70 1/2, you can send up to $100,00 from an IRA directly to a charity without including it in your income. While you won’t get a charitable deduction, you will never have to report that income on your tax return, thus your tax bill won’t increase. In addition, a charitable distribution from an IRA can be used to offset all or part of your required minimum distribution.
2. IRAs allow you to take a penalty-free distribution for higher education expenses
Typically, distributions from a retirement account taken before age 59 1/2 are subject to both income tax and a 10% early distribution penalty. However, there are some exceptions, including using your IRA to pay for higher education expenses for yourself or other family members. Note that this is only true of IRA distributions taken before age 59 1/2. If you try to do the same thing with funds from a 401 (k), you will end up with a large tax bill.
3. IRAs allow you to take a distribution whenever you want.
While funds retirement accounts are meant to be used during retirement, sometimes circumstances arise that necessitate an early distribution. Taking an early distribution from a 401 (k) plan can be complicated and dependent upon your specific plan’s rules. Access to 401 (k) funds are limited and are not guaranteed under the law.
Conversely, you can usually take a distribution from an IRA whenever you want, even if it’s early (i.e., before age 59 1/2), regardless of the circumstances. While you will owe both income tax and a penalty, if you truly need access to the funds, you know you will have this option available to you.
4. IRAs allow for aggregate RMDs between multiple accounts.
People are now more likely to be maintaining multiple retirement accounts, usually because they have switched employers. If you have more than one 401 (k) and you are over age 70 1/2, you are required to determine the Required Minimum Distribution (RMD) for each account and take the appropriate amount separately from each account.
If you have more than one IRA and are over age 70 1/2, you still have to calculate an RMD for each IRA, but you can either combine or aggregate the RMDs you take without any penalty. Doing the same thing with a 401 (k) plan would subject you to a 50% penalty!
5. IRAs allow you to avoid withholding
You can’t avoid paying taxes, but there are often deductions, exemptions, and credits that will lower you tax bill. In those instances, it doesn’t make sense to further withhold from your retirement plan, since you would essentially be giving the government an interest-free loan.
If you have an IRA, you can opt-out of withholding — an option that isn’t available to you with a 401 (k).
Questions about what plan might be best suited to your financial goals? The Robin S. Weingast & Associates team can help! Contact us today to discuss what works for you.