||Ask the Dollar Diva
What's the difference between
a 401(k) and an IRA?
Dear Dollar Diva,
Please tell me the difference between a 401(k) and an Individual
Retirement Account. The only thing I know about a 401(k) is you
can start withdrawing your money after you're 59-1/2 years old without
paying a penalty.
An IRA is a private investment funded solely by your
own money, while a 401(k) is offered through your place of work
and involves your contributions and often contributions from your
And if you get nothing else from today's column, understand
this: Anyone who doesn't take advantage of their company's 401(k)
plan has bricks for brains. A 401(k) is a pension plan. Employees
contribute to the plan through tax-deferred payroll deductions (i.e.
you don't pay taxes on the contributions or earnings until you take
the money out). This plan has two glorious features:
Each year, you can contribute as much as 15 percent
of your salary or $10,000, whichever is smaller. (If you work
for a small company the cap may be $6,000, which is still very
An employer can make matching contributions. Some
companies contribute 33.3 cents to 50 cents for every $1 the
employee donates. If an employer matches 33.3 cents to the dollar,
the employee instantly receives a 33.3 percent return
on his investment. And it's tax-deferred. If you know of a better
investment out there, please contact me immediately.
IRAs: Traditional and Roth
There are two IRAs: Traditional (the old one) and
Roth (the new one). Unless you desperately need the deduction, the
Roth makes great sense.
Generally, anyone who works or receives alimony can
contribute to an IRA. The employer has nothing to do with this account.
It is opened and maintained by the individual. Most people go to
a reputable investment firm such as Fidelity,
T. Rowe Price
and they are walked through the process of opening an account. For
most people, the maximum contribution each year is $2,000. The cap
may be lower if you have a retirement plan at work or your income
reaches certain limits. For more details on this go to the IRS
Web site, and pull up Publication 590.
One thing an IRA has in common with a 401(k) is that
the magic age to withdraw funds without penalty is 59-1/2.
This is the best thing the IRS has done for the average
taxpayer in a long time. Take advantage of this opportunity.
The basic differences between the Roth and the traditional
The Roth is not deductible.
The funds must be held for at least five years
in a Roth. If withdrawals are made prior to that, there is a
10 percent penalty on any taxable earnings withdrawn. (The amount
you contribute is not taxable.)
If you hold the funds in a Roth for at least five
years and make your withdrawals after you reach age 59-1/2,
none of your withdrawals will be taxable. You heard that right.
Neither your contributions nor the interest/dividends/capital
gains earned are taxable. Ever. Even if you die. Your beneficiary
doesn't have to pay taxes on it. Think about this. As a general
rule, at a 10 percent return on your investment, your money
doubles every seven years. How'd you like to have those returns
tax free when you retire?
Contributions can be made to a Roth after age
70-1/2 if the person is still earning income. Contributions
must stop at that age for the traditional IRA.
The maximum annual contribution is $2,000. If you
are eligible, make the contribution as
early in the year as possible (today for 1999; Jan. 3, 2000 for
the year 2000) to take advantage of the tax-free status of the earnings
on your investment.
Think about the long term on these retirement vehicles.
There is at least a 10 percent penalty on all taxable amounts withdrawn
before you are 59-1/2 years old.
However, if you find yourself in an emergency situation,
there are "Qualified Distributions" that are not subject to the
10 percent penalty. They include withdrawals taken if you become
disabled, or if you need to pay for some medical expenses, some
higher education costs or a home for the first time. You can read
about them in Publication 590 from the IRS.
A 401(k) is very sweet, indeed, especially when your
employer matches contributions. Everyone should participate to the
fullest, even if it means reducing your recreational shopping. Avoid
thinking of them as short-term savings. If you start early and let
them grow, these plans can give you a level of financial independence
that others only dream about.
-- Posted: Sept. 3, 1999