IRA taxes are deferred until you take your withdrawals, so when you do pull the cash out, you never have to pay taxes on it. Contributions to 401k plans cannot be made until the following year, so money withdrawn from your 401k plan is taxed when withdrawn and is also taxed when withdrawn from an IRA.
In order to contribute to both a 401k and an IRA, you would need two separate accounts. As long as one account is not used for both a 401k and an IRA at the same time it isn’t subject to conflicting tax treatments.
Having both accounts will let you maximize your savings, this is because they each have different tax treatments.
In addition to what you have already been told, I would like to provide you with the pros and cons of 401Ks and IRAs so you can make an informed decision.
401(k) plans: Advantages
- These plans offer tax benefits at both the federal and state levels, as well as Social Security protection if you remain in the same job for several years.
- Contributions are deducted from your paycheck before taxes, saving you money on taxes now, and allowing for maximum growth potential without being taxed later.
- If your employer matches part of your contribution, you can set aside a larger amount of money for retirement.401(k) Disadvantages
- When you cash out the balance at age 55 or older and fail to satisfy the IRS’s 59 1 2 rule, you will be subject to an extra 10% penalty tax on top of any income tax.
- The maximum pre-tax contribution for 2002 is $10,500 (up from $9,000 in 2001).
- You are locked into investing a certain percentage of your pay in the plan – no matter how much you may want to keep your investments liquid!
IRA (Individual Retirement Account) Advantages
- The income limits that prevent most people from participating in 401k plans do not apply to IRAs.
- If you make early withdrawals, there is no penalty on those withdrawals, although you will still owe the income tax!
- With these plans, you can invest your money in risky stocks and mutual funds and still get a great return – if you know what you are doing.
- You can diversify your investments using 401k plans by investing in different mutual funds, which some companies do not allow, for fear of having their employees’ investments concentrated in a few stocks.
- Contributions are normally taken out after age 70 1/2. Therefore, the IRS does not consider IRA withdrawals to be taxable until the year of the withdrawal.
- Contributions to an IRA can often be made in the form of cash – no need to set money aside from your paycheck.
IRA plans can also allow you to invest in real estate, precious metals, and other collectibles, which is something that 401k plans will not allow.
Because IRAs are designed so that they may be used in retirement there are provisions that provide added flexibility on how you take advantage of them before retirement age.
Other things to Consider
- More investment options are available for 401k plans than for IRAs.
- Higher-income limits apply to 401k plans, which may make it more difficult to qualify to contribute.5. You do not get any Social Security protection with an IRA (although you can receive it if you retire early on social security).
- Additional paperwork may be required in order to establish an IRA when your income is close to the limits that make you eligible to participate in a 401k plan – this may include having the proceeds of your IRA distributed as non-taxable payments called “Roth IRA distributions”.
Contributing to Both
It is possible to contribute to both a 401k and an IRA, but you will have to split your funds between the two. You can also put enough money in each one that they would cover your annual expenses.
For example, if you are a 25-year-old single person who earns $6,000 a year (and has no children), spends $4,000 a year and your employer matches $2,000 each year for 6 years, you can contribute $15,000 to your IRA ($2,000 x 6). Some people have done the math and figured out the amounts they could put into each plan to cover their annual expenses.
So if you decide that you want to contribute $15,000 per year into a 401k and an IRA. You can do that – first use the 401k calculator to figure out how much you would have to make per year (before taxes) in order for it not to be taxed – $76,400 (that is assuming a 15% tax rate and no incentives from your employer such as matching contributions), this is a very conservative estimate. All contributions under this amount will be taxed at 15%.