Consumption Rules

What is the difference between an IRA and a 401k?

Not much of a difference, but it can be significant in certain instances. I don’t think you can take loans from IRA’s, which is a minor detail, and you can only contribute to a Roth IRA if your income is below a certain limit (Roth 401(k) doesn’t have this restriction), but the biggest difference is the contribution limits: In 2008, for example, the limit for contributing to an IRA is $5,000 plus an additional $1,000 “catch-up” for those over 50. You can contribute the full $15,500 plus an additional $5,000 catch-up if you’re over 50 to either a traditional or a Roth 401(k), not including any employer contributions (match or profit sharing, for example). The total limit of all contributions is either $46,000 or 100% of your income. So, for example, if I’m making ~$45k a year, and I put in 6% of my salary then there would be virtually no difference between a 401(k) and an IRA, aside from difference in loan availability (which I think is a bad idea anyway). But, let’s say I own my own business and make around $300,000/year. I could set up a 401(k) (even if it’s a one-person business) and get all of the tax benefits of a 401(k), and potentially save up to $46,000 a year tax-deferred. Over 10-20+ years until retirement that could save me a lot of money.

What is the advantage of a Roth IRA vs just buying stock? Both are with after tax dollars and both can be sold at any time. I’m sure there is good reason or people wouldn’t be making such a big deal about it.

The devil is in the taxes, as with most things. With a Roth IRA, you put in after-tax money, but everything you take out is tax free, regardless of the prevailing tax rates. That means it has grown tax free and is withdrawn tax free. With normal stock the capital gains grow tax free (you’re taxed annually on the dividends), but are taxed at the capital gains tax rate when you cash out (or at the normal income rate if held for less than a year). Right now the capital gains rate is 5% for the lowest two tax brackets, and 15% for everyone else, but that is one of the Bush tax cuts that is set to expire in 2010. Who knows if that will still be in place beyond that. For example, let’s say you’ve put in $1,000,000 into your Roth…over 40 years it’s accumulated another $1,000,000 in earnings. With a Roth, you withdraw it and you keep all $2,000,000. With stock, you have your $1,000,000, but because the dividends were taxed along the way it’s only earned $960,000. That is now taxed at 15% (assuming the Bush tax cuts remain – unlikely if Clinton is elected and impossible if Obama is elected), so you’re left with $816,000, for a total of $1,816,000 – a theoretical difference of $184,000. That’s assuming the relatively low current capital gains rates, and with a complete shot-in-the-dark estimate on the effect of the dividends being taxed over time. Moral of the story – for short-term investments, the difference may be minimal, but in a 20-40 year scenario (saving for retirement) the IRA/401(k) has a huge benefit over other savings vehicles.

I am buying a home and I had thought that I would like to pull a small amount of money out of my 401k to help with my down payment. I had understood that there were some early withdrawal penalties. I spoke with the investment company that handles our plan, and they said that I cannot withdraw any money from my 401k and that I could only get a loan for up to half the vested balance. The max loan life was 5 yrs and it would have 7% interest which would be paid to myself. This loan will be deducted from my paycheck every two weeks. I looked up the plan brochure and near the back they argue that it is cheaper if I get a loan from a credit union rather than my 401k. The investment company says that some plans allow early withdrawal but mine doesn’t. The only way I could get the money is if I quit my job.

I would also argue that it’s cheaper to get a loan from your credit union. I assume yours is a traditional 401(k) and not a Roth 401(k)? (the rules are a little bit different). But there are a few things I question about the guy’s answer. A 401(k) loan is limited to 5 years except in the case of buying a home – then it can be up to 30 years (did you tell the guy what the loan would be for? That makes a big difference…). The 7% interest is paid back to yourself but what they don’t tell you is that it’s with after-tax money (in other words, that money will be taxed twice–once on the way in and once on the way out. This would essentially maximize your taxes, which is the opposite of what people normally try to do with their money). The interest you “pay back to yourself” is supposed to compensate you for the opportunity costs of taking out the loan – foregone investment income. So 401(k) loans are rarely, if ever, a good idea in my opinion.

1. This makes it nearly impossible to get any money pulled from a 401k before retirement.

That’s the point, for two reasons. 1) You’re getting a tax break on the money that you can’t get in any other type of investment, and 2) it’s a retirement savings vehicle – the idea is to have the money when you retire.

2. My company is basically incentizing employees to leave.

The Department of Labor is implicitly incentivizing you to leave, not your company. Every plan that’s “qualified” (tax benefits) has to follow those hairy, bureaucratic rules. They’re so cumbersome and confusing that it’s created a whole industry of firms like the one I work for that try to figure this stuff out.

3. I would never ever put more than the company match in a 401k. Our match is a 1 to 1 match up to 4 %.

If you’re talking about dividing up scarce resources between different investment options I concede your point, but a 401(k) is [by far] the best vehicle to save for retirement. Putting in just 4% of your salary may or may not provide you with a secure retirement.

4. I would always fill up a ROTH IRA since those can be sold without penalty at anytime for any reason.

The principal you’ve put in can be withdrawn without penalty, but your earnings are penalized the same as with other retirement vehicles.

I know that with a Roth IRA you can’t contribute more than the amount of money you earned that year. But what about a situation where say, you earned $2,000 and your spouse earned $6,000. Could you contribute $4,000 into each of the IRA’s? (Assuming we’re talking about tax year 2007)

I don’t know 100% on this one. For 401(k) plans I know it’s individual – it doesn’t matter what your spouse makes. This may be one reason why dentists often have their spouse on the payroll for bookkeeping or other things, and pay a salary. In the case of an IRA, I think it may be combined if you file a joint tax return, but I don’t know for sure.

Are 1099-INT or 1099-DIV income sources eligible for inclusion in Roth IRA contributions?

No, unfortunately it’s only “income from working” – wages, tips, commissions, etc. I wonder if you had a securities license, like the series 7 or 66, if you could somehow find a loophole to call investment gains “income.” [irs.gov] (If Huckabee’s elected, and he nails the “closed” sign on the door of the IRS, where will we get answers to these questions? I guess the new organization that would be set up to track and monitor the refunds to everyone on the first $30k of spending would have to answer them. Off the subject, Huckabee’s idea is a good one on paper, but actually implementing it is pure lunacy.)

Does it HAVE to be income from the 2007 year? or could income from a previous tax year somehow be used to max out a Roth IRA contribution?

It has to be income in the same year as the “limitation year.” I.e., if you’re maxing out the 2007 limit, only 2007 income counts.

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