5 Things You Can Do With an IRA That You Can't With a 401(k)
IRA or 401(k)? Know the key differences between these two popular retirement plans to ensure you are saving in the right account.
Individual retirement accounts (IRAs) and 401(k)s share many similarities. Both are retirement plans; both can help lower your tax bill today, provide tax-deferred growth, and provide an income source in retirement.
There are, however, many differences between IRAs and 401(k)s. Some are benign and won't have much impact, but other contrasts can make one type of account far superior to the other in particular situations. With that in mind, we'll explore five things you can do with an IRA that you can't with a 401(k).
1) Make a Qualified Charitable Distribution
Qualified charitable distributions allow IRA owners and IRA beneficiaries age 70½ or older to send up to $100,000 from their IRA account directly to a charity without including any of that amount in their income.
You won't get a charitable deduction if you make a qualified charitable distribution. However, by never adding the income to your tax return in the first place, it often still results in a lower tax bill than if you had taken a "normal" IRA distribution and made a "regular" charitable contribution. In no case would your tax bill be higher.
As a bonus, you can use your qualified charitable distribution to offset a portion or all of your required minimum distribution after your required beginning age.
2) Take a Penalty-Free Distribution for Higher Education Expenses
Distributions taken from a retirement account before age 59½ are generally subject to income tax and an additional 10% early distribution penalty. The law does, however, provide for several exceptions to this rule. One such exception is available if you use your IRA to pay for higher education expenses (i.e., college tuition, books, required supplies) for yourself or other designated family members, such as your children. Again, this exception is only available if you take money from an IRA before age 59½.
These exceptions do not, however, apply to 401(k) accounts, and if you try to withdraw funds early, you will wind up with a bigger tax bill than you bargained for. Some brilliant and well-educated people, including lawyers and CPAs, have gone to tax court to argue this point, and they have yet to walk away the victor: don't make the same mistake they did.
3) Take a Distribution When You Want
The purpose of a retirement account is to save money for just that: retirement.
However, life happens, and sometimes people need access to their funds sooner than planned. If you are still working for the company sponsoring your 401(k) and need some additional funds, you're at the mercy of your plan's rules and, to an extent, the Tax Code when accessing your money. Fund access is typically minimal, especially if you're still under 59½. 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 legally.
In contrast, if you have an IRA, you can typically take a distribution from your account whenever you want, with no restrictions under the law whatsoever. Of course, as noted above, if you take a distribution from your plan or your IRA before age 59½, you will generally owe income tax and a penalty, but if you really need those funds and there is nowhere else to turn, what choice do you have?
4) Aggregate RMDs Between Multiple Accounts
Today, it's not uncommon for people to accumulate several 401(k)s or similar plans over time through their work with different employers. Similarly, many retirees have more than one IRA account (some even have ten or more)!
If you have more than one 401(k) and you're age 73 or older, you must calculate the RMD (required minimum distribution) for each 401(k) plan separately and take those RMDs from each plan individually.
In contrast, if you have more than one IRA and you're 73 or older, an RMD must be calculated for each IRA; however, you can combine (or aggregate) the RMDs and take them from any IRA or combination of IRAs you choose without a penalty.
If you accidentally took the same approach with your 401(k) plans, you'd be subject to a 50% penalty for each plan from which you did not take the appropriate distribution.
5) Avoid Withholding
Paying your taxes is not optional; it's a requirement. You may, however, have a very low or even non-existent tax bill after applying all of your available deductions, exemptions, credits, etc. Alternatively, you may have withholdings from other sources, such as a pension, or make estimated tax payments sufficient to cover your tax bill. In such cases, there's no reason to have any further amounts withheld from your retirement account distributions. Doing so would give the government a tax-free loan until you filed your taxes and received your refund.
If you have an IRA, you can avoid this entirely; when you take a distribution from your IRA, you can opt-out altogether of withholdings. This, however, is different with a 401(k). In general, distributions from 401(k)s eligible for rollover are subject to mandatory withholding of 20%. There is no opt-out provision. After all, it isn't called "strongly suggested withholding."
So there you have it: five things you can do with an IRA that you can’t do with a 401(k).
Does that mean IRAs are better than 401(k)s? No, of course not. They're different. For some people, IRAs are better, while others will benefit more from a 401(k).
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