The IRA and 401(k) accounts are 2 of the most used vehicles for retirement savings today. According to the Investment Company Institute, as of March 2016 Americans have saved $12.2 trillion in such accounts!
The concept for both an IRA and a 401(k) account is essentially identical: investors contribute pretax dollars that grow tax-deferred and aren’t subject to taxation until the proceeds are distributed. That’s more or less where the similarities end. Some of the rules may come as a surprise. While some of the differences are benign, and will have little impact, others can have a substantial impact on retirement investors.
Below are some key points on what separates IRAs from 401(k) plans:
Exceptions to the Early Distribution Penalty
Generally, distributions from a tax-advantaged retirement plan taken prior to age 59½ are subject to both income taxes and a 10% penalty unless an exception applies. Be cautious. Certain exceptions apply to IRA investors younger than 59½, including distributions to pay for higher education, first-time home purchase expectation, and payment of medical insurance premiums during unemployment. These exceptions do not apply to 401(k) plans of investors younger than 59½.
With regard to 401(k) plans, there are strict rules about when a participant is eligible to take a distribution. A qualifying or “triggering” event must be satisfied to take a distribution, such as reaching age 59½, or separation from service, retirement, etc. With an IRA, there are no qualifying events. Instead, an investor can take a distribution at any time and for any reason, although the distribution generally will be subject to taxation and, potentially, a penalty if taken prior to age 59½.
You are only able to borrow from your 401(k) plan; loans are not permitted from an IRA. Generally the loan must be paid back over five years, although this can be extended for a home purchase. If a participant has had no other plan loan in the 12 month period ending on the day before you apply for a loan, they are usually allowed to borrow up to 50% of their vested account balance to a maximum of $50,000.
Qualified Charitable Distributions (QCDs)
This popular option allows an IRA owner or beneficiary who is 70½ or older to distribute up to $100,000 annually from his/her IRA and donate it to a public charity on a tax-free basis. QCDs do not apply to 401(k)s or any other qualified retirement plan.
Required Minimum Distributions (Part I)
Many investors own multiple IRAs and or 401(k)s from previous employers. Both account types generally require minimum distributions in the year an investor attains 70½.
RMD rules are clear: For investors with more than one 401(k) account, the annual RMD must be taken separately from each plan. On the other hand, investors who own more than one IRA must calculate the RMD separately for each IRA they own, although they can take the aggregate amount from any one or more IRAs.
Required Minimum Distributions (Part II)
As previously mentioned, RMDs must begin the year an investor turns 70½. Roth IRAs are the exception. A Roth IRA account owner or surviving spouse is never subject to RMDs. Roth 401(k) accounts are subject to minimum distribution rules. That being said, it is possible to avoid depleting designated Roth accounts due to minimum distributions. How? In the year a participant reaches 69½ (not 70½.), he or she could move or “roll” their Roth assets to a Roth IRA!