401(k) Versus IRA

These common retirement tools offer various benefits for savers:

  • An individual retirement arrangement, or IRA, is a personal savings plan available for anyone who earns income and is less than 70 1/2 years old. The IRA owner can direct the custodian of the IRA - often a bank or financial institution - to use the money in the account to purchase a wide range of securities. Like a 401(k), a traditional IRA is tax-deductible; the proceeds are taxed upon withdrawal. The biggest difference between the two accounts is control: While an employer determines the available investments under a 401(k), the individual can shop around for investment funds under an IRA.
  • A Roth IRA is an increasingly popular form of investment that differs from a traditional IRA only in the way it's taxed. Money invested in a Roth IRA is taxed at the time it is invested, rather than when the money is withdrawn.
  • The 2011 tax-deferred contribution limit for a 401(k) is $16,500. For people younger than age 50, the maximum annual IRA contribution is generally $5,500, while people older than age 50 may contribute up to $6,500. The maximum catch-up contribution to the 401(k)for those over 50 is $5,500.

[source: IRS]

Penalties for Cashing Out Your 401(k) Early

For employees who are not yet eligible to withdraw money from their 401(k) (and some who take hardship distributions), if you want your money early, you're going to pay for it. All early withdrawals from a 401(k) plan are subject to a 10 percent excise tax. However, as in all aspects in life, there are exceptions to this rule. Distributions not subject to the excise tax include:

  • distributions to an employee who is 55 or older and no longer works for the employer sponsoring the plan
  • distributions to pay a domestic relations order such as child support or alimony
  • distributions to pay off tax debt (i.e. unpaid income tax)

[source: IRS]

Yet it's not just through tax penalties that an early 401(k) cash-out can wreak havoc on retirement savings. There is also the standard income tax implication. An employed person who raids his 401(k) early is likely to be in a higher tax bracket at the time of the withdrawal than a retired person who withdraws the same amount of money, simply because the retired person is likely to have less income. Additionally, by reducing the amount of money in the 401(k) account, the account holder lessens the amount of interest he can earn on the money.

Given the current state of the economy, someone who taps into his 401(k) earlier will likely have to work longer before retirement than those who hold off. A 2011 study indicates that the median household headed by a person age 60 to 62 with a 401(k) account -- many of which lost up to one-third of their value when stocks tanked starting in 2008 -- has less than one-quarter of what is needed in that account to maintain its standard of living in retirement. That includes people who have not yet withdrawn funds from their 401(k) [source: Browning].