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Finance and capital markets
Course: Finance and capital markets > Unit 7
Lesson 2: Retirement accounts: IRAs and 401ks401(k)s
401(k)s (and how they compare to IRAs). Created by Sal Khan.
Want to join the conversation?
- why is this called a 401k?(18 votes)
- Becuase it's described in subsection 401(k) of the Internal Revenue Code.(38 votes)
- Can someone elaborate on the concept of borrowing from a 401(k), how to pay that money back, and how that differs from an early withdrawal which would be subject to penalty. Also, would it be possible to stop participating in the 401(k) and roll it into a Roth IRA and take out the principle without penalty? 8:38(6 votes)
- In general, participants in 401(k) plans may borrower from their account. The maximum amount permitted is lesser of (a) $50,000 and (b) 50% of the balance of your 401(k) account. Generally, repayments to the plan occur via automatic deductions from your pay (performed by your employer). Repayment begins in the first pay period after the loan is made.
Unless the proceeds of the loan are used to buy a home, the maximum maturity of the loan is 5 years. If buying a home, the term of the loan can be much longer.
The primary difference between a 401(k) loan and an early withdrawal is that the loan does not trigger a tax event. Assuming you repay the loan, you will not pay any taxes on the amount of the loan or suffer any penalty. In an early withdrawal, you will pay a tax on the amount withdrawn in the year of the withdrawal PLUS a 10% penalty which is huge.
If you stop working for the employer you had when you took out the loan, the loan will normally become due in 60 days. This is true regardless of the reason that your employment ended. If you don't repay the loan in those 60 days, the remaining balance on the loan will be treated as though it were an early distribution, subjecting you to tax and penalties on the unpaid amount.
Generally, I'd recommend that people avoid 401(k) loans unless they're facing a dire financial emergency.
Generally, it is possible to roll a 401(k) account into a normal IRA and then convert the IRA into a Roth account.
These issues can be a lot more complex that what I've explained. It's a good idea to find a tax adviser if you're seriously considering a 401(k) loan or a Roth rollover.
Best,
Chris(15 votes)
- What happens if the person dies before the Traditional, Roth or 401k's can be withdrawn?(6 votes)
- You specify beneficiaries when opening the account. If it can't go to the beneficiary, it's treated as part of your estate.(2 votes)
- What about the self-employed? What are some plans for self-employed retirement accounts and how are they different?(5 votes)
- Self-employed people can use an IRA or a SEP. This is some information off of the IRS web site at http://www.irs.gov/Retirement-Plans/Choosing-a-Retirement-Plan:-SEP
SEP Contribution Limits (including grandfathered SARSEPs)
Contributions an employer can make for 2011 to an employee's SEP-IRA cannot exceed the lesser of:
25% of the employee's compensation or
$49,000
Note: Elective deferrals and catch-up contributions are not permitted in SEP plans.
For 2012, contributions to an employee's SEP-IRA cannot exceed the lesser of:
25% of the employee's compensation or
$50,000(4 votes)
- If I start investing in a 401 (k) at this job, but leave after only a few years- what happens to the money. Can I continue my 401(k) at another job?(4 votes)
- You can roll over the 401k into an IRA (you would probably want a Roth IRA)
Alternatively, your new employer might let you roll into their 401k .
But usually the first option is better because you retain more control over the money.
You have to do the rollover the right way to avoid a tax penalty. The company where you are holding the IRA will advise you how to do it right. It's very routine and not hard to do.(5 votes)
- what is a good amount of money to start saving per week? What is one thing that really helped you to save, i just need help getting started(4 votes)
- Rather than an amount, you might focus first on a percentage. When you develop the habit over a period of about... 12 weeks at say... 5%, then kick it up to 7.5% for 12 weeks, and if that's doing you good, kick it up again. Get into the habit, slowly, and the habit will do you good.(5 votes)
- Is the limit the maximum amount of money you can put towards your 401k per year?(5 votes)
- Yes. I believe the limit is $18,000, unless you are 50 years old or older, then you can put more money in to catch up.(2 votes)
- What is the difference between a 401(K) and a Roth 401(K). Witch one is better?(4 votes)
- Contributions to a traditional 401k account aren't subject to federal and state income taxes for the year during which you make the contributions. When you withdraw your accumulated contributions plus investment earnings in retirement, you'll pay ordinary income taxes at the federal and state income tax rates applicable to you at that time.
It's the other way around with a Roth 401k account. Contributions are subject to federal and state income taxes in the year you make the contributions. Withdrawals of accumulated contributions and investment earnings at retirement aren't subject to income taxes.
Which one is better depends on your situation. Here's an example I made up for another answer:
A person makes $10k/year and pays 5% in taxes. He invests into a traditional and starts saving $250/year on taxes. When he turns 59, 40 years later, he finally gets promoted and his new income lands him in the 25% tax bracket. Now, if he withdraws from his traditional, he has to give up 25% of it to taxes when he only saved 5% of it. So if he saved up a total of $200k, he now has to give $50k to taxes! (but saved merely $10k from his taxes deductions over the years). He actually lost $40k by investing in the traditional. On the other hand, if he had invested in a Roth, we can flip those numbers: he would have paid $10k in taxes over the years and saved $50k by not having any tax on his $200k when he finally withdrew, getting to keep that extra $40k instead.
Basically: if you're pretty poor now (and yet can still invest your money) and plan on getting promoted later in life, go with a Roth. If you're not that optimistic about job promotions in the future, invest in a traditional.(4 votes)
- how long can you leave your money in your 401k after you retire(2 votes)
- You have to start taking certain minimum distributions once you reach 70 1/2(5 votes)
- It sounds to me like you can use both IRAs and 401ks to "game the system" so to speak, and get into a lower tax bracket than you would without them. The way I understood this was as follows:
1. You earn some money (pre-tax income).
2. Out of that money, some is set aside for either IRAs or 401ks
3. Income taxes are then calculated and deducted from the remaining money.
4. You get your money (post-tax income).
Is this correct?(2 votes)
Video transcript
What I want to do in this video is to talk a little bit about 401(k)'s which you probably at
minimum have heard of. Just from the get-go,
just to put some structure in your mind of what this really is is it's very similar to a traditional IRA. It's very similar to a traditional IRA and the ways that they're the same is that you defer you taxes. You put money in on a tax deferred basis. Let me put it this way, you put pretax money in. The money can grow inside
of either the 401(k) account or the traditional IRA account untaxed. Let me write that, money grows in account untaxed and then you can withdraw it, you can withdraw the money. You can withdraw or start
getting distributions from the account after age 59-1/2. That's essentially when you're
going to start retiring, when you're going to need the money. When you withdraw after the age of 59-1/2 you will then pay income tax. This is what people are talking about when they talk about deferring taxes. You're not getting out of the taxes, you're just pushing off the date that you're going to
have to pay the taxes. For a lot of people this might be useful because while you are making money, you might be paying at a fairly high incremental tax rate but then once you're retired you have a much lower, you'll have a much lower, I guess you'll be in a much
lower incremental tax bracket and so your total overall
tax bill might be lower. Also, maybe something happens just in terms of what the government does, in terms of how they charge taxes. In general, if you had to pay 50 cents 20 years in the future
versus 50 cents today, just present value of money tells you that that 50 cents is going
to be worth a lot less in the future or the present value of it is a lot less. That's some reasons to defer. Of course, you're not just going to pay on what you put in, you will then also pay income
tax on what you've put in and whatever grew. You'll pay income tax on total disbursals. In both cases, you have to start taking disbursements from your account by 70-1/2. Penalties, let me write it this way. Penalties, if you don't withdraw or you don't start withdrawing
some of your funds by 70-1/2. There's some special
cases if you're working and all these type of things. Now, what's happens if you
withdraw before age 59-1/2? Before 59-1/2. So far, everything I've listed is true of both 401(k)'s and traditional IRAs. If you withdraw before 59-1/2,
you are taxed on withdrawal. On top of that, there's a 10% penalty on all the funds you receive. 10% penalty. This is what you have to think about unless if you just say, "Oh, I'm always just going to max out "my traditional IRA or 401(k)." You got to make sure they're not going to want
that money before 59-1/2 because you might be
facing this 10% withdrawal. These are all the cases that are the same. The question is why do they both exist? Why is there something
called a traditional IRA and why is there
something called a 401(k)? They both seem like a pretty good way for me to defer taxes, get earnings on my investment in a taxed deferred way and then pay it some future date and they both force me to make sure or they strongly suggest that I shouldn't take out
my money before 59-1/2. The ways that they're different, let's focus on the differences, the differences between the 2. One is 401(k)'s have a higher limit and if you're focused on 2010, but these numbers keep changing. In 2010 the 401(k) limit is $16,500 and that's for just what you contribute into your 401(k). This is for a 401(k). While the IRA limit is $5,000. This is an IRA. One; 401(k), you can just
participate with more money. Actually, in both of these cases, as you approach your retirement, after the age of 50. Let me put that in the same thing just so we're comprehensive. Another similarity is that you can accelerate or have higher, you could have higher, I guess, deposits into your account, accelerate after 50. Which just means you can put more money than these limits that I have right here. These are limits before you're 50, after 50, between 50 and 59-1/2 when you can start withdrawing. You can put a little
bit more money in that and these are constantly moving targets. The general idea is that
you can put more money inside of a 401(k). Now, the other difference is that a 401(k) tends to be organized by your employer. 401(k) organized by employer. Just, from your point of
view, that means 2 things, One is the employer will often specify the potential investments. Specifies investments. They'll actually run the
401(k) account for you. Normally it will be held by someone else but it will be for your
company, for company x. The company gets to decide
the universe of investments that you might be able to invest in. The other thing, because
it's run by the employer, the employer might match. Which means for every dollar you put in, they'll put another dollar even they might go above matching and you could actually go up to, I think the current limits
are approaching $50,000 for the total of the
employee and employer match. You can actually get a lot of, I guess you could think of it, leverage from putting in into a 401(k) if you have a very generous employer. The other difference, this is really a superficial difference because it's just what you see, is that with the 401(k)
the money will be taken out of your paycheck, you will never see it. Taken out before paycheck. While with a traditional IRA, you will take the money, invest it into a traditional IRA account and when you report your taxes it will be reported as a tax deduction and so you won't have to pay tax on it. Functionally they're the exact same thing. When you think about the pros and cons, if you have a 401(k), if the
option is available to you, it's a pretty good option. You're going to have higher limit. You're going to have a
higher limit right over here and your employer might match it. Then the other thing, and this doesn't come into plays a lot, but there's also the option of borrowing from a 401(k) without penalty. Borrowing from a 401(k) but you have to pay back
interest to the 401(k) account if you did that and you cannot do that with a traditional IRA. Now, when you're looking
at all these you're like, "Whoa! "Why would anyone ever want
to do a traditional IRA?" There's a couple of things. One; you could do both. Or the other thing is
with traditional IRAs you have much more flexibility on where you want to invest. Maybe your company says
you can only invest in us, you can only invest in
that company's stock. In traditional IRAs you
can invest in anything. Hopefully that clarifies
things a bit for you.