401(K) and IRA: How to Pick the Best Retirement Plan?

Living in retirement successfully will depend upon making the right financial choices. Many people want to know if they should invest in a 401k plan or an IRA. Both the 401(K) and the IRA (Individual Retirement Account) are ways to save money for purposes of retirement. But occasionally, it is sometimes used for major purchases such as the college education of a child or a down payment on a house. The principal difference between the two is quite simple. A 401(K)s are retirement saving plans offered through your employer, and an IRA is self-directed or a plan you set up on your own, with the help of a bank, mutual funds or other financial agency. There are people that have no option for savings but to open an IRA. If an individual is self-employed, owns a business or freelances, he or she may not have access to opening a 401(K). You generally need to be employed by a company that offers a 401(K) savings plan to have one.

There are some differences between the 401(K) and the IRA. Some people have both because of one of the major differences between the plans. A 401(K) may have a maximum savings amount or a maximum percentage of your salary that you can place in an account. You might be limited to a 10% contribution of your salary, and as of this year, the maximum tax-free amount you can place in a 401(K) is $16,000 USD. This will adjust each year if inflation occurs. Benefits to the 401(K) that the IRA doesn’t have are employer-matching programs.

Most often employers offer to match some or all of what you invest in your 401(K). This may be either half of you invest or six percent of your salary. If you invest 6% of your $100,000 USD salary per year, that’s $6000 USD, a company might completely match that $6000 USD investment, giving you $12,000 USD total in investments. This money is not taxable unless you withdraw it, and you may be able to avoid taxes on it entirely if you spend it on certain allowable expenses.

Non-taxable IRA contributions are lower than those for people who invest in their 401(K). Within this year, for instance, you could claim up to $5000 USD of your income as nontaxable if invested in an individual retirement account. Sometimes people invest their taxed income in a Roth IRA. Since it has already been subject to tax, it isn’t taxed when it is removed. It can be slightly more challenging to remove money from your independent retirement account without paying heavy fines, but it may be slightly easier to change the way your invested money is distributed.

Money in 401(K)s and IRAs may be diversified into stocks, bonds, and mutual funds. If you don’t like how something is performing, usually you can change the way your money is distributed more easily in an IRA. Some 401(K)s limit the number of times per year you can make changes. On the other hand, some 401(K)s have caught on and now allow employees to actively manage their investments on a regular basis.

You can generally funnel more money into IRAs than a 401(K), though you get less tax benefit from it. Yet the advantages of the 401(K) are many: chief among them is the employee-matching program, which might double the money you invest. However, if you plan on retiring early, you may need to use both types of savings accounts to boost the amount of money available to you when you retire. Many people who have larger incomes and larger amounts of money to invest use a combination of 401(K) investments and Roth IRAs.

Some Relevant Issues on 401(K) Retirement Plan

401(K) as we know is a retirement plan where employees make contributions from their pretax earnings. Employers may make matching or nonselective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. The fund will accumulate and free of tax up until it is withdrawn.

The IRS rule states, “Invest as much as you can in 401k investment plan for your retirement. The deferred tax element of the plan means you don't pay income tax on it until you actually withdraw, which saves you money in the long term.” However, there lot of issues on this type of retirement plan that should be addressed such as the following.

What are the advantages and disadvantages of 401(K) Retirement Plan?

The 401(K) plan has many advantages. First, since the employee is allowed to contribute to his/her 401(k) with pre-tax money, it reduces the amount of tax paid out of each pay check. Second, all employer contributions and any growth in the capital grow tax-free until withdrawal. The compounding effect of consistent periodic contributions over the period of 20 or 30 years is quite dramatic. Third, the employee can decide where to direct future contributions and/or current savings, giving much control over the investments to the employee. Fourth, if your company matches your contributions, it's like getting extra money on top of your salary. Fifth, unlike a pension, all contributions can be moved from one company's plan to the next company's plan (or to an IRA) if a participant changes jobs. Sixth, because the program is a personal investment program for your retirement, it is protected by pension (ERISA) laws. This includes the additional protection of the funds from garnishment or attachment by creditors or assigned to anyone else, except in the case of domestic relations court cases dealing with divorce decree or child support orders (QDRO - qualified domestic relations orders). Finally, while the 401(K) is similar in nature to an IRA, an IRA won't enjoy any matching company contributions, and personal IRA contributions are subject to much lower limits.

If there are advantages, there are, of course disadvantages associated with this plan. First, it is difficult (or at least expensive) to access your 401(K) savings before age 60 (59 1/2 to be exact). Second, it doesn’t have the luxury of being insured by the Pension Benefit Guaranty Corporation (PBGC). And the Third is, employer matching contributions are usually not vested or do not become the property of the employee until a number of years have passed. The rules say that employer matching contributions must vest according to one of two schedules, either a 3-year "cliff" plan (100% after 3 years) or a 6-year "graded" plan (20% per year in years 2 through 6).

What happens to your 401(K) if you change/leave/lose your job?

You have three options:

1. Keep your money in your former employer's 401(K): You have to have a vested amount of at least $5,000 in your account to choose this option. Also, you have to be under the plan's normal retirement age. If your vested account balance is under $5,000, you may be forced by the employer to take a distribution. Speak to your HR Department for details about forced distribution.

2. Roll the money over into a new 401(K): If you choose this option, make sure that the check is written directly to the new 401(K) account. There is no grace period for this option. If the money comes to you before it is placed in the new account, you will be charged the income tax and 10% penalty fine.

3. Cash out: you can withdraw the money in your 401(K). However, if you are under the age of 59.5, the income tax and 10% penalty fine will apply. If you are 55 years or older, you can begin tapping into your 401(K) and the 10% penalty will not apply. It doesn't matter if you left the job or were fired or retired. However, you will still have to pay the income taxes on your withdrawals.

Check with your HR Department for details and specifications for these conditions.

What happens to your 401(K) if your company goes bankrupt?

If your company goes bankrupt or is bought by another company, the contributions made to a 401(K) plan are held in trust by an independent custodian. Your employer does not have access to these funds. So, whatever the circumstances, the money in your 401(K) account remains yours.

What happens to your 401(K) if you leave the USA country?

Your status (Resident/H-1B or other visa/Citizen etc.) in the US at the time of contribution to the 401(K) and at the time of withdrawal is considered. It is best to consult a competent accountant or immigration lawyer about this matter. You have three options:

1. At the time of leaving, if the amount vested in your account is more than $5,000, you can leave your 401(K) money in your former employer's plan.

2. You can take the lump-sum payment of the money in your account. You will have to pay the taxes and penalties associated with early withdrawal.

3. You can directly rollover the amount in your 401(K) account into an Individual Retirement Account or IRA. Please remember, your Social Security Number is always valid (whether you live in the US or abroad), however, your finances and investments here are affected by various factors including your status in the US and how often you visit or live in the US among other things. It is best to consult experts in the field before making these important decisions.