You are likely to agree that 401(k)s and IRA’s have many similarities. They are both retirement plans. Both plans can help you lower your tax bill today, provide tax-deferred growth and help provide a taxable income source in retirement.
Although long-time followers of my financial philosophy will know that tax-deferred is just a nicer way to say “tax-postponed”! You NEVER save any taxes with either one – you only postpone both the calculation of taxes (Will tax rates be higher? What will tax brackets be then?) and the eventual payment of tax.
But there are also some substantial differences between 401(k)s and IRA’s. Some are small and probably won’t impact you much, but other differences, in my opinion, can make one type of account far superior to the other. With that in mind, let’s explore seven things you can do with an IRA that you cannot do with a 401(k):
1) Have virtually unlimited investment choices.
Most 401k plans may have 2-3 dozen mutual funds or ETF’s to choose from. A rare few have 100 funds or more. But an IRA can be invested in some 10,000’s of stocks, bonds, mutual funds, IUT’s, ETF’s, SMA’s, etc.
2) Get a GUARANTEED lifetime income.
Many of my clients (both young and old) are pretty risk adverse after the market’s 50% drops in 2000-2002 and in 2007-2009. They are also feeing like after over six years with no major market declines, that we aren’t too far off from the next recession or bear market drop of 20% or more.
Most 401(k)’s have NO investment choices that offers a guaranteed lifetime income (for either just the employee or to include the lifetime of their spouse too). The only investment choice that can do that is an annuity. The annuities that I recommend to my clients that want some money in their “safe and secure” bucket, not only offer a guaranteed lifetime income with no market risk, but an income that will very likely grow most years during a 30+ year retirement.
3) Take a Distribution At Any Time.
But beware. They call it a retirement account for a reason. It’s supposed to be for your retirement! But life happens and sometimes people need to access their funds before retirement. If you are still working for the company sponsoring your 401(k) and you need some additional money, you are at the mercy of your company’s plan rules as well as the IRS Tax Code, when it comes to being able to access your money. Each 401(k) plan is different as to what loan provisions, if any, will be available to employees.
Typically, access to YOUR funds is extremely limited, especially if you’re still under age 59 ½. In such cases, you may be able to take a loan from your 401(k) and you may be able to take a hardship distribution, but neither of those options is guaranteed to you under the law. By law, loans are limited to 50% of the value of your account with a maximum loan amount of $50,000.
But with an IRA, you can typically take a distribution from your account whenever you want. There are no legal restrictions. Of course, as noted above, if you take a distribution from your plan or your IRA prior to age 59 ½, you will generally owe income taxes plus a 10% penalty, but if you really need those funds you may not have any other choices.
4) Take Distribution for Higher Education Expenses – Without a Penalty
Generally, distributions taken from a retirement account prior to age 59 ½ are subject to income tax and an additional 10% early distribution penalty.
But the tax code does provide for some exceptions to the rules. One of these exceptions is available if you use your IRA to pay for higher education expenses (college tuition, books, required supplies, a computer for school) for yourself or certain other family members. Note that this exception is only available if you take money out of an IRA prior to age 59 ½. There is no similar provision with a 401(k).
5) Avoid IRS Withholding
Remember that all qualified accounts (IRA, 401k’s, 403b’s, etc.) are only “tax-postponed”. Paying income taxes is not an option. It’s a requirement. When you take a distribution from your IRA, you can opt out entirely of withholding. This, however, would not be the case if you had a 401(k). Generally, distributions from 401(k)s are subject to mandatory withholding of 20%. There is no opt-out provision.
6) Combine RMDs Between Multiple Accounts
It is not uncommon for people to have several 401(k)s or similar plans accumulated over time through work with different employers. Similarly, many retirees have more than one IRA account. But here is the difference. If you have more than one 401(k) and you’re age 70 ½ or older, you must calculate the RMD for each of those 401(k) plans separately and you must take those RMDs separately from each plan.
However, if you have more than one IRA and you are 70 ½ or older, there is still an RMD that must be calculated for each IRA. BUT if you want to, you can combine the RMDs and take them from any one IRA or any combination of IRAs you so choose without a penalty. If you did the same thing with your 401(k) plans, you would be subject to a 50% penalty. That is true – for each 401K plan from which you did not take the correct distribution you would pay a huge penalty.
7) Make a Direct Qualified Charitable Distribution
Qualified charitable distributions (QCDs), allow IRA owners and IRA beneficiaries age 70 ½ or older to send as much as $100,000 from their IRA account directly to a charity and not include any of that donation amount in their income on their IRS tax forms. If you make a QCD, you do not get a charitable deduction, but you never added that income to your tax return in the first place That can result in a lower tax bill than if you had taken a “normal” IRA distribution and then made a “regular” charitable donation Plus, a QCD can be used to offset all or a portion of your required minimum distribution (RMD).
And you don’t have to be retired or not working for your old employer to rollover a 401(k) to an IRA. If you are aged 59.5 or older most 401(k) plans will allow for an “in-service withdrawal” WHILE you are still working at the company… and still contributing (and getting any match) to your plan!
So those are seven things you can do with an IRA that you cannot do with a 401(k). That doesn’t mean that IRAs are better than 401(k)s. They’re different. In most cases, for the reasons described above, I prefer my client’s retirement money to rollover into an IRA from a 401(k) when possible. For a few folks, 401(k)’s may be better. Maybe, on a future BLOG post, I’ll write about a few things that you can do with a 401(k) that you cannot do with an IRA.
All the best… Mark