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-- Posted: Sept. 3, 1999

Dorothy Rosen -- The Dollar Diva 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 employer.

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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 good.)

  • 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.

Traditional IRA

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 or Vanguard, 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.

Roth IRA

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 IRA are:

  1. The Roth is not deductible.

  2. 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.)

  3. 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?

  4. 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.

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