As of December 31, 2018, 401(k) plans held an estimated $5.2 trillion in assets and represented 19 percent of the $27.1 trillion in US retirement assets, which includes employer-sponsored retirement plans, individual retirement accounts (IRAs), and annuities. In comparison, 401(k) assets were $3.1 trillion and represented 17 percent of the US retirement market in 2010.
As of 2016, about 55 million American workers were active 401(k) participants, and there were nearly 555,000 401(k) plans. Understanding the key differences between IRA & 401k plans may help you avoid info overload and get on the way to putting your money to work. So, let’s break down some of the key differences & keep in mind some of these differences can be costly if we think an option is available & it isn’t.
- One critical difference between IRAs and 401(k)s is the 10% penalty for withdrawals prior to age 59 1/2. People who participate in 401(k) plans with their employer have an option at age 55 not available to IRA participants: Once they are 55, if they retire or get laid off or fired, they can select one of three withdrawal options that avoid the 10% penalty on their distributions.
- Another option available to some 401(k) participants is a plan loan which if repaid while still employed with the company there is no penalty. However, if the employee leaves without repaying the loan in full, any amount outstanding is considered a distribution, is taxable and carries a 10% penalty prior to age 59 1/2. (IRA participants do not have a loan option.)
- Unlike 401K holders, IRA holders can make early withdrawals without incurring a 10% penalty for the following: higher education, the purchase of a first home and health insurance payments (in the case of unemployment).
- Withdrawals are taxable at ordinary income tax rates. For you 401(k) participants beware, withdrawals for these purposes will incur a 10% penalty if made prior to 59 ½.
However, there is a work-around to avoid the penalty as some 401(k) plans allow partial rollovers to IRA accounts while the account holder is still employed and participating. By rolling over some of the 401(k) funds into an IRA, the individual then has the option to make withdrawals for higher education, a first-time home purchase or health insurance without incurring a 10% early-withdrawal penalty. Withdrawals, however, are taxable at ordinary income tax rates.
- Some investors may find themselves in a situation in which they have no reportable income in a specific year. In this situation, they are tempted to make withdrawals from their retirement plan. Subsequently, they think since there is no income, they won’t be subject to the 10% early withdrawal penalty. Unfortunately, that penalty is still in effect for all distributions until the age of 59 ½.
Another potential pitfall is associated with medical expenses.
- The IRS allows an exception to the 10% early withdrawal penalty on both IRAs and 401(k)s when the funds are used to pay medical bills (only when those are unreimbursed expenses exceeding 10% of gross income) in the same year the distribution is made. So, it is important to make the withdrawals and payments in a timely basis (same year). Otherwise the IRS will disallow the exception, and a 10% penalty will apply.
When a person withdraws funds from his/her retirement plan, his or her AGI increases, and the 10% floor increases as well. For example, a $10,000 withdrawal increases AGI by $10,000, and the floor increases by $1,000. So, a taxpayer with an adjusted income of $50,000 prior to the withdrawal would only be able to claim a deduction if he/she had medical expenses that exceeds $6,000 (10% of $60,000). Yes, even those who do not itemize can use the exception.
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Source: Elliot Raphaelson Tribune News