IRAs and 401 (k)s share key similarities: they are both retirement plans that can help you lower your tax bill, provide tax-deferred growth, and can serve as an income source later in life. However, there are also key differences between the two options, some of which may affect your financial planning decisions.
Here’s what you need to know:
1. IRAs allow you to make qualified charitable distributions.
If you are an IRA owner or beneficiary over 70 1/2, you can send up to $100,00 from an IRA directly to a charity without including it in your income. While you won’t get a charitable deduction, you will never have to report that income on your tax return, thus your tax bill won’t increase. In addition, a charitable distribution from an IRA can be used to offset all or part of your required minimum distribution.
2. IRAs allow you to take a penalty-free distribution for higher education expenses
Typically, distributions from a retirement account taken before age 59 1/2 are subject to both income tax and a 10% early distribution penalty. However, there are some exceptions, including using your IRA to pay for higher education expenses for yourself or other family members. Note that this is only true of IRA distributions taken before age 59 1/2. If you try to do the same thing with funds from a 401 (k), you will end up with a large tax bill.
3. IRAs allow you to take a distribution whenever you want.
While funds retirement accounts are meant to be used during retirement, sometimes circumstances arise that necessitate an early distribution. Taking an early distribution from a 401 (k) plan can be complicated and dependent upon your specific plan’s rules. Access to 401 (k) funds are limited and are not guaranteed under the law.
Conversely, you can usually take a distribution from an IRA whenever you want, even if it’s early (i.e., before age 59 1/2), regardless of the circumstances. While you will owe both income tax and a penalty, if you truly need access to the funds, you know you will have this option available to you.