Understanding IRAs and 401(k)s

Let's look into the world of IRAs, Roth IRAs, and 401(k)s, which for many are essential tools designed to help you build toward your future goals.

First off, let's clear up any confusion. While IRAs and 401(k)s might sound like a mouthful of alphabet soup, they're basically just fancy ways of saying "retirement accounts." These accounts were designed with benefits from the government to give us all a little nudge in the right direction when it comes to saving for our retired years.

What is IRA?

"IRA" stands for individual retirement account, and the keyword here is "individual”.  You are the owner of the IRA.  These are not joint accounts like your bank account may be.  To qualify to contribute to an IRA you need earned income that year.  Even if it’s just a little bit of income you can start squirreling away money for retirement.  Some semi-retired people have a small income from a hobby just and are still allowed to use IRAs for added tax savings!

Now, let's talk numbers. In 2024, you can contribute up to $7,000 to your IRA, Roth IRA or a combination between the two.  And no, unfortunately you aren’t allowed put $7,000 in each.  If you're over 50, you get a little extra: an extra $1,000 catch-up contribution. Not bad, right?

But hold your horses—there are a few rules to follow. Depending on how much money you make you and if you have a 401(k) or 403(b) you might not be able to deduct your IRA contributions from your taxes. This is often missed!   If you're married and filing jointly, you can only deduct contributions if your household income is below $123k in 2024. Make between $123k and $143k? You'll get a partial deduction. And if you're raking in over $143k, sorry Charlie, no deduction for you on the traditional IRA if you have a employer plan.

Roth IRA income limits are higher but need to know.  More about this below.

Now, let's talk flavors. There are two main types of IRAs: Roth and traditional. Roth IRAs are funded with post-tax dollars, meaning you don’t get a tax deduction that year.  The real magic happens though when you take the money out in retirement from a Roth IRA. Since you already paid taxes on the contributions, your withdrawals are tax-free! Traditional IRAs, on the other hand, let you reduce your taxes today by deducting your contributions, but you'll owe taxes when you withdraw the money down the road at whatever tax rate you are in at that time.  This can be scary depending on where you think tax rates may go in the future.

But what if you're a high roller bringing in more than the income limits? Enter the backdoor Roth IRA. This sneaky maneuver lets you stash cash in a traditional IRA, even if you can't deduct it from your taxes. Then, you can convert it to a Roth IRA, where it can grow and flourish tax-free. Make sure to learn and implement the pro-rata rule and tax filing before using the backdoor Roth IRA strategy.  You need to see if you have any other pre-tax IRA money floating around, or Uncle Sam might come knocking.

Now, let's switch gears and talk about 401(k)s. These bad boys can be used to help with taxes in a much larger volume. These are employer-sponsored retirement plans that allow you to save for retirement through automatic payroll deductions. And the best part? You can sock away a lot more cash each year—up to $23,000 in 2024, plus an extra $7,500 catch-up contribution if you're over 50.  Not to mention if your 401(k) plan allows after-tax dollars you could go above these limits if you’re a real super saver.

One of the perks of 401(k)s is that your employer might match your contributions, which is when you hear about “free money”.  

But 401(k)s do have some downsides and a few strings attached. Unlike most IRAs, you're limited to the investment options offered by your employer's plan.  They may be investments you like, but may not. There are more stringent rules of accessing your money than a Roth IRA would.

So, there you have some of the basics on IRAs and 401(k)s in a quick nutshell. Remember, these accounts can be like a Swiss Army knife for retirement planning—they come with all sorts of tools and tricks to help you build a brighter financial future. And if you're feeling overwhelmed, don't worry—that's where a West Michigan financial planner comes in. They're like the guides who can help you navigate the twists and turns of retirement savings, so you can enjoy a worry-free retirement.

Disclosure:

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy. AI (artificial Intelligence) sourced articles may be prone to error, due to the vast information they assemble from the internet. Always confirm any questions or concerns you may have with an experienced professional. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual

Stock investing includes risks, including fluctuating prices and loss of principal

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA. A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply. Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.