Personal Finance - Retirement Accounts - 401K and IRA
Introduction about Retirement Plans
First I will start with a brief introduction about 401K Plan. 401K is retirement savings plan in USA. Employees can elect small percentage of their salary directly going into their retirement account by deferring their income taxes until withdrawal. Employers will match their contribution up to certain percentage level. Employee can withdraw their money once they reach 59 1/2 years old, otherwise it will be early withdrawal subject to 10% penalty apart from federal income taxes. 401K contribution for the current year 2010 will be 16,500 USD. If you are 50 years older and above, then the limit will be 22,000 USD.
Apart from 401K Plan, there are Individual Retirement Accounts (IRAs) available. You and your spouse will have an option to contribute to either Traditional or Roth IRA up to 5000 USD per annum.
Both 401K and Traditional IRA are tax deferred contribution, but when you withdraw money, you have to pay taxes on your contribution and earning. But Roth IRA contribution is in the other way, it is made using after tax dollars. But when you withdraw money, you do not have to pay any taxes on your contribution and earnings.
When can you transfer money from your 401K?
Usually you are not allowed for either partial or complete transfer your money from current employer sponsored 401K plan, if you are actively employed. When you switch to a new company, then you will get a distribution kit from former employer sponsored 401K plan. You can directly transfer your assets from former 401K plan to new 401K plan or you can convert to either Rollover (Traditional) IRA or Roth IRA.
When you actively employed in the company, only you are allowed to take loans against your 410K plan. The loan installments will be paid directly from your pay check. To have hardship withdrawals, you need to meet certain conditions specified by the plan.
Over a period of time, you might have got so much of money sitting in your 401K plans. You cannot trade like your individual brokerage account with your 401K plans. They have got lot of restrictions in trading. You have to choose the given options provided in the 401K plan. If you select any growth or blend mutual funds, those funds will have some restrictions to avoid frequent trading. Also you cannot bet on shorting a stock or ETF.
You might be thinking that return on investment is very less. So you may consider switching to IRAs where you will have more control on your investments. Let it to be any IRA, Traditional or Roth, you will have full control on your investments. You can trade like any other individual brokerage account. You can buy any stocks, ETFs, mutual funds CDs or Treasuries. Also you will have an option to hedge your positions using derivatives - put options. Note that only IRA brokerage accounts are having these much flexibility. You can open an IRA in a bank as a money market saving account or IRA CDs.
If you want to transfer your money from 401K to Traditional IRA is much easier as there are no tax consequences since both plans are tax deferred plans. You can open Rollover IRA in any of your favorite brokerage firms. Usually the brokerage firms offering cheapest commission is the best choice until otherwise you are a very big trader and you need so much of flexibility and margins. TD Ameritrade, Scottrade, E Trade, Charles Schwab and Bank of America are some of the brokers offering cheaper commission for equities, ETFs and mutual funds.
If you want to transfer your money from 401K to Roth IRA, then it is a two step process. First you need to transfer from 401K to Rollover (traditional) IRA and then you have to convert from Rollover (traditional) IRA to Roth IRA. That’s how the process works in most cases.
Pros and Cons of IRA over 401K
The advantage of IRA account is you have more options and flexibility so that you can manage your money well. You will also have an option to hedge your position. In 401K plans, you cannot hedge your position. However you can sell your position and put it into a capital preservation or stable value fund provided by the plan. In bear market, you cannot do sell short with 401K plan. Even in IRA accounts, most brokerage firms will disable margin trading. But still you can bet using bear ETFs by holding cash position. You can buy Gold in IRA by buying the ETFs like GLD or IAU.
The disadvantage of IRA account is also the same flexibility it gives you. Unless you are an experienced trader, you may make mistakes in frequent trading and you may even get into speculative option trading, which may lead to losing your hard earned money.
Switching back and forth between Traditional and Roth IRA
When you convert your traditional IRA to Roth IRA, you have take the tax burden. The amount you convert will be added as a part of capital income. But if you convert from Roth IRA to Traditional IRA, you will have tax gains.
Consider the following two situations:
1. When you and your spouse are working, that may increase your tax bracket. If your spouse want to take a break for the next year, your tax bracket will come down.
2. You have got a huge bonus from your company that increased your tax bracket and if you think that the subsequent years your tax bracket will come down.
In the above two situations if you have Roth IRA, then you can convert it to Traditional IRA to lower current year taxes and the subsequent year you can convert back to Roth IRA again. It may not be a huge saving, but there is a chance of saving around 10% on taxes.
Posted on May 23, 2010
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