Ask Ash Cash: What's the Difference Between IRA and 401K?
AllHipHop.com’s resident Daily Word guru and all-around inspirational guy, Ash Cash, is back with his latest installment of “Ask Ash Cash.”
Watch the video below his response, as he offers more sound advice to readers:
Greetings and Salutations! Welcome to another addition of Ask Ash Cash, where we go in the streets and answer all of your finance and business questions. Remember you can send your video questions to Questions@AskAshCash.com or via Twitter (@IamAshCash - hashtag #AskAshCash).
With the economy still in disarray, and many people not knowing whether social security is going to be around when they retire, it is now wonder people are beginning to take their financial freedom into their own hands.
Dear Ash'Cash: What's the difference between an IRA and 401K? And, is it ever too early to get one?
If you’re working a 9-to-5, a 401k is the first thing you should be investing in; a 401(k) is a retirement plan that allows you as the worker to save money for retirement. The most advantageous part of a 401k is that you do not have to pay any taxes on the money that goes
into the plan until later. In the finance world, this is called tax-deferment. This tax benefit allows you to earn interest on money that would've went to the IRS had you not been in the plan, and allows you to pay the taxes once you take the money out at retirement, which is currently at 59-1/2 years old.
The assumption is that you will be earning less at retirement, putting you in a lower tax bracket and giving you even more savings. Most of the time, the money that you invest in your plan - or your "contribution" as it is called - is taken directly from your paycheck before you even see it. If your company is generous (as most were before the recession), they will match your contribution up to a certain amount...usually five percent.
An IRA, which stands for an Individual Retirement Account, is very similar to a 401(k). The only real difference is that a 401(k) is sponsored by your employer, while an IRA is sponsored solely by you (there are some exceptions to that rule, but I’ll explain further below). To contribute to a 401(k), you have to have a company that participates in the program, but to contribute to an IRA, the only stipulation is that you have earned income within the year you're contributing in. An IRA gives you the same tax benefits as a 401(k), which includes tax-deferment and a tax-free option. The following are different types of IRAs:
• Traditional IRA – a traditional IRA is the most common. Contributions are often tax-deductible, which means that anything you contribute is deducted from your income, and doesn’t require you to pay taxes until you withdraw. Just like the 401(k) your withdrawal at retirement is taxed as income at your current tax rate based on your tax bracket. All of the transactions and earnings have no tax implication as long as it is done within the IRA.
• Roth IRA – the contributions are made with after-tax dollars, which means that you cannot deduct the amount contributed from your income when you file your taxes. Any withdrawals that are made are tax-free, meaning you don’t have to pay any taxes on the principal or interest. Any transactions that you do within the IRA have no tax implication.
The easiest way to remember the two is that a traditional IRA gives you your tax break in the end – tax-deferred; and a Roth IRA gives you the tax break up front – tax-free.
• SEP IRA – a SEP IRA is designed for a small business or self-employed person to make retirement contributions into a traditional IRA that he/she sets up in his/her employee’s name.
• SIMPLE IRA – a simple IRA is also set up by an employer and stands for a simplified employee pension plan that allows both the employer and employee to make contributions. This is exactly the same as a 401(k) except that a simple IRA has lower contribution limits.
As to whether it is ever too early to start one, the answer is ABSOLUTELY NOT!!! You should be contributing to an IRA or 401(k) as soon as you can! A retirement account is the best way to save for the future, and with the many tax benefits you get from our dear old Uncle Sam, there’s no excuse to not invest in one.
Make sure you do further research before deciding which option is right for you. Your banker should be the best person who can answer your retirement questions (if you don’t have a banker, it's time to switch banks).