How a 401(k), a Traditional IRA and a Roth IRA Really Work, in Twelve Questions

The most popular retirement account in America is named after a subsection of the tax code. Think about that. In any other walk of life, you would call a thing a Plan or a Fund or a Nest Egg. Congress called it 401(k), the way a hospital might name its emergency room Wing 4(b), and then millions of working people were expected to love it.

They do, mostly, once somebody explains what is inside. The machinery is simpler than the names make it sound. There are accounts you get through a job, accounts you open yourself, and two ways of arranging the tax, and almost everything else is detail. What follows is twelve questions that people really ask, answered in plain terms. This is general information about how the accounts work. It is not advice for your own situation, and where a number changes from year to year, I tell you to check the IRS rather than guess.

Two kinds of account

1. What is the difference between an employer plan and an individual account?

An employer plan is set up by your employer, and you take part through your job. A 401(k) is the best known; a similar plan at a nonprofit or school is a 403(b), and government workers often have a 457 plan. Contributions usually come straight out of your paycheck.

An individual retirement account, or IRA, is one you open yourself at a bank, brokerage or other financial institution. Your employer is not involved. You decide where to open it, how much to put in, and what to invest it in, within the limits the law sets.

You can have both. Plenty of people contribute to a 401(k) at work and also fund an IRA.

2. What is a 401(k), exactly?

It is an employer-sponsored savings plan, named for section 401(k) of the Internal Revenue Code, which Congress added in the Revenue Act of 1978. You choose a percentage of your pay to contribute, the employer sends it to the plan, and you pick from a menu of investments the plan offers. The history of how it grew from a technical provision into the main retirement vehicle for working Americans is told in From Savings Banks to Roth Accounts, a Timeline of How Americans Learned to Save.

Two features matter. First, the traditional version takes contributions before income tax, which lowers your taxable pay now. Second, the money grows without being taxed year by year, and is taxed when you take it out. Many plans also offer a Roth version, which works the other way, as described below.

3. What is a traditional IRA?

A traditional IRA is an individual account in which contributions may be tax-deductible, meaning you may subtract them from your taxable income, and growth is not taxed until withdrawal. At withdrawal, the money is generally taxed as ordinary income.

I say "may be deductible" on purpose. Whether you can deduct a contribution depends on your income and on whether you or a spouse are covered by a plan at work, and the thresholds change. The IRS publishes the current rules, and your tax preparer can apply them to your case. Contributions that are not deductible are possible too, and they have their own bookkeeping.

4. What is a Roth IRA?

A Roth IRA is the mirror image. You contribute money you have already paid income tax on. There is no deduction now. In return, if you follow the rules, qualified withdrawals in retirement, including all the growth, are not taxed. It was created by the Taxpayer Relief Act of 1997 and named for Senator William Roth of Delaware.

There are also income limits on who can contribute directly to a Roth IRA, and they change. Some employer plans offer a Roth 401(k) option that has no such income limit for participants, because the rules for employer plans are different. The two choices, traditional or Roth, are set side by side in Pay the Tax Now or Pay It Later? Traditional and Roth Accounts Side by Side.

The tax and the employer

5. When is the tax paid, and why does it matter so much?

The tax is paid now or later, and that is the entire difference between the two main flavours.

• Traditional: you skip the tax on the way in and pay it on the way out.
• Roth: you pay the tax on the way in and skip it on the way out.

Which is better depends on whether your tax rate will be higher now or in retirement, and nobody knows what the rates will be in thirty years, since they are set by Congress. If your rate is the same in both periods, the two choices give the same result in simple arithmetic. The bet is on the difference. Many people split the risk by holding both kinds.

6. What is an employer match, and what is vesting?

An employer match is money your employer adds to your account when you contribute. A typical arrangement might match a share of your contribution up to a limit set by the plan, though what a given employer offers is entirely up to that employer and is described in the plan documents. A match is not guaranteed by law. Many employers do not offer one.

Vesting is the schedule on which employer contributions become fully yours. Your own contributions are always yours from the start. The employer's money may vest gradually over a number of years, a "graded" schedule, or all at once after a set period, a "cliff" schedule. If you leave before you are fully vested, you may forfeit some of the employer's contributions. When you are weighing a job change, check the vesting schedule in the plan's summary, since it can be worth real money.

The match is one reason that people who can afford to contribute enough to receive it are often counselled to do so. It is the closest thing in finance to an immediate return, but what is right for a given household depends on its circumstances.

7. Who can open an IRA, and are there limits on contributions?

In general, you can contribute to an IRA if you have earned income, such as wages or self-employment income. There is a yearly limit on what you can put in across your IRAs, and it is set by law, often with an additional allowance for people age 50 or older. The Roth IRA also has the income limits mentioned above.

I am not going to quote the dollar limits, because they are not fixed. They are adjusted from time to time, partly by formulas that account for inflation, and partly when Congress changes the law. The honest way to get the current number is to go to IRS.gov and look at the retirement plans pages for the year you are in.

Taking money out early

8. What happens if I take money out early?

This is the question that causes the most trouble, so read carefully. For most retirement accounts, withdrawals before age 59½ are subject to an additional 10 percent tax on top of any ordinary income tax that applies. If you withdrew $10,000 from a traditional account at 45, you would generally owe income tax on that $10,000 and a $1,000 additional tax. The purpose is to discourage using retirement money for current spending, and it works.

Roth IRAs follow a different logic. The money you contributed, the principal, can generally be withdrawn at any time without tax or penalty, because you already paid tax on it. The earnings are subject to the rules: to withdraw them tax-free, you generally must be at least 59½ and have held a Roth IRA for at least five years, with some exceptions.

A hypothetical, kept simple: if you put $20,000 into a Roth IRA over several years and it has grown to $26,000, you can generally take out up to your $20,000 of contributions without tax or penalty. Touching the $6,000 of growth before the rules are met can trigger tax and the 10 percent addition. Check the current rules before acting.

9. Are there exceptions to the early-withdrawal penalty?

Yes, a number of them, and they are specific. The law provides exceptions for certain situations, which have included the death or disability of the account holder, a series of substantially equal periodic payments, certain unreimbursed medical expenses above a threshold, and, for IRAs, up to a lifetime limit for a first-time home purchase and for qualified higher education expenses. The list has grown over the years, and the details, including who qualifies and how the withdrawal is reported, change.

Two cautions. An exception from the 10 percent additional tax does not necessarily excuse the ordinary income tax on a traditional account. And claiming an exception correctly requires paperwork. The place to find the list in force today is the IRS website, and a tax professional is the person to ask about your facts.

The better plan, as a general matter, is not to depend on the exceptions at all. That is one more reason to hold a separate cash reserve, as argued in Why the Emergency Fund Comes Before Every Other Money Goal You Have, so that a bad month does not turn into a tax bill.

Rollovers, required withdrawals and changing limits

10. What is a rollover?

A rollover is a move of retirement money from one account to another without paying tax on it. It usually comes up when you leave a job. You can often move a 401(k) to an IRA or to your new employer's plan.

There are two methods. In a direct rollover, the money goes from one institution to the other without passing through your hands. That is the simplest and the safest. In an indirect rollover, a check is made out to you, and you have a limited window, 60 days in general, to deposit the full amount into another qualifying account. If you miss the window, the amount is generally treated as a withdrawal. For distributions from an employer plan paid directly to you, the plan is generally required to withhold 20 percent for federal tax, which means you would have to make up the difference from your own pocket to roll over the whole amount. For that reason, direct rollovers are preferred.

11. What are required minimum distributions?

You cannot leave money in a traditional retirement account forever. The law requires you to begin withdrawing a minimum amount each year starting at a certain age. These are called required minimum distributions, or RMDs. The amount is calculated from your account balance and your life expectancy according to IRS tables, and the withdrawal is taxed as ordinary income in the case of a traditional account. The point of the rule is simple: the government gave you a tax deferral and intends to collect eventually.

The starting age has been changed by Congress more than once, so I will not state it. It is a good example of why you should look at IRS.gov rather than at a friend's memory. Missing a required distribution carries a tax penalty on the amount you should have withdrawn. A Roth IRA, by contrast, has no required distributions during the original owner's lifetime, which is one reason people with a long horizon like it.

12. Why do the annual limits keep changing?

Two reasons. One is indexing. Many of the limits are adjusted in steps to keep up with inflation, so the number tends to drift upward over time. The other is legislation. Congress changes the rules from time to time, and major retirement bills have raised limits, changed ages and added exceptions.

The practical lesson is that any article that quotes a precise limit is probably out of date a year later. Do not trust a figure from a blog post, including this one. Check the IRS website for the year you are in, and when you make a real decision, ask a qualified adviser who knows your facts. That is not a dodge. It is the only responsible answer.

A few more things worth knowing

Investment choices are separate from account types. A 401(k), a traditional IRA and a Roth IRA are containers. What goes in them, stocks, bonds, funds or cash, is a separate decision. People sometimes think a Roth IRA is an investment, and it is not. It is a tax wrapper.

Fees matter inside the container. The expenses charged by the investments you choose, and sometimes by the plan itself, reduce your return every year, and over decades the effect is large. The arithmetic is worked in Compound Interest Year by Year, the Arithmetic That Rewards the Patient Saver, where a 1 percent annual fee takes nearly a quarter off a thirty-year result.

Your beneficiary designations matter. The name you put on the account's beneficiary form generally controls who receives it, regardless of what your will says. Check it after a marriage, divorce or birth. It is a five-minute task that prevents a terrible mess.

None of this replaces the basics. Retirement accounts reward the saver who has first covered an emergency reserve and dealt with high-rate debt. Putting money into a locked account when you have no cushion invites the early-withdrawal penalty described above.

Why a conservative should care

The deeper reason these accounts matter has nothing to do with the tax code. A person who owns an account has a stake in the economy, a claim on the future and a reason to care whether the currency holds its value and whether the government keeps its books. An American with a retirement account in his own name is harder to persuade that wealth is something other people have. That is why the sensible conservative position is not to wring hands about the tax treatment but to encourage ownership: more people holding more of their own money, in their own names, answerable to nobody. You can see what the alternative looks like by checking the national debt clock.

The case in brief

1. An employer plan such as a 401(k) is set up through your job, and an IRA is an account you open yourself; you can have both.
2. Traditional accounts skip the tax on the way in and tax withdrawals later; Roth accounts tax you now and generally leave qualified withdrawals untaxed.
3. Employer matches are not guaranteed, and employer money may vest over time, so read the plan's schedule before you change jobs.
4. Withdrawals before age 59½ generally carry a 10 percent additional tax, with specific exceptions, and Roth contributions can usually be withdrawn without tax or penalty.
5. Rollovers are safest when done directly, required distributions are set by law, and every limit and age should be checked at IRS.gov because they change.

What you can do: this week, find your workplace plan's summary, look up its match and vesting schedule, and check the current contribution limits at IRS.gov.