This is the first post of two on the Hidden Pitfalls of IRAs and 401(k)s.
We hear a lot about them. In the world of retirement savings, the terms IRA and 401(k) are almost synonymous with the word retirement itself. According to ICI.org, as of the end of 2018 such accounts held over $16 trillion dollars, which is nearly triple the value held just two decades ago. To say they are popular would be an understatement.
Most folks know the basic similarities. For instance, they are both tax-deferred savings vehicles that are designed to help investors grow their nest egg as quickly as possible by suspending taxation in the present as long as one follows all the rules. However, there are differences between the two in terms of rules and allowances most people are unfamiliar with, including many advisors.
Violating the rules can be a nasty lesson in the differences between IRAs and 401(k)s. Get those rules mixed up and interchange them one for another and it can be very costly both in terms of the taxman and your retirement account savings plan. Let’s review a few of the differences and how making a mistake can be detrimental.
The biggest thing, and perhaps the simplest to keep in mind in terms of both of these accounts is the general rule that taking money out early, unless allowed by a rule, triggers both taxable income (which is always the case in an IRA or 401k withdrawal) as well as a 10% early withdrawal penalty. Tack on to this penalties and interest for not catching a tax mistake when made and the cost can be painful.
For the IRA, the penalty-free withdrawal age is 59.5. For the 401(k), it is also 59.5 unless you retire early between the ages of 55 and 59.5 and leave your funds in the 401k plan. You can withdraw early in this case without incurring the 10% early withdrawal penalty, assuming your plan allows for leaving the funds there after retirement.
If you make the mistake of rolling your entire 401k to an IRA in early retirement without contingency planning, you will owe the penalty tax on all withdrawals pre-59.5, unless they meet an exemption under IRS publication 590-B. This is where doing financial planning with a good retirement expert who knows their stuff would be helpful in determining exactly where and how you’ll receive income when retiring early without penalizing yourself and possibly jeopardizing your retirement.
I’ve heard, read and personally seen the fallout from advisors with many years in the industry getting these things wrong for their clients. Ask a lot of questions and do your research to double-check the advice you are getting from a financial advisor. A tax professional is a good source to verify tax-related advice on any retirement account moves involving withdrawals.
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