Retirement accounts: IRAs and 401ks
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.