According to Fidelity Investments, the typical American needs to save at least 8 times his salary to retire comfortably. Workers sock away money in individual retirement accounts and 401(k) plans to help reach that goal. Both plans offer some legal protection from taxes and can shield retirement money from being used to pay off creditors in bankruptcy.
If you ever have to declare bankruptcy, the money you've saved in IRAs and 401(k) accounts may be protected from creditors, thanks to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. Before this federal law, 401(k) funds were shielded from bankruptcy, but IRA savings could be taken to pay off debts. While there's still no limit on the amount of money you can keep in a 401(k) if you declare bankruptcy, IRAs are now protected up to $1 million.
401(k) Tax Treatment
Contributions to a 401(k) are considered "deferred wages," which means they are not treated as taxable income when they go into the plan. However, they are subject to withholding for Social Security and Medicare taxes. You pay income taxes on the money as you siphon it from the account in retirement. Contributions to a 401(k) are capped at $17,500 a year, as of 2013.
IRAs and Taxes
Roth IRA contributions are made with after-tax money. Therefore, withdrawals from a Roth during retirement, including your contributions and investment gains, are usually not considered taxable. Contributions to a traditional IRA are made pretax. You can generally deduct these from your taxable income for the year you made them. Uncle Sam takes his share when you withdraw the money in retirement. As of 2013, IRA contributions are limited to $5,500.
Early Withdrawal Penalties
If you tap your 401(k) or traditional IRA before a certain age, you may have to shell out tax penalties. For 401(k) plans, the magic age is 55. Funds you take out before then are subject to a 10 percent early withdrawal penalty, unless an exemption applies. Plans typically allow you to make a "hardship" withdrawal without penalty for a serious financial need like paying medical expenses. Generally, you can't take out more than your contributions to the plan, so any investment gains or employer matching funds can't be siphoned off under the hardship exception.
With a traditional IRA, you won't be hit with an early withdrawal penalty after 59 1/2. Until then, you can avoid the penalty if you roll an IRA distribution into another retirement account within 60 days, use the money to buy a first home, or pay college costs for you or your child.
Adele Nicholas is a writer in Chicago. Since 2003, she has been a contributor to publications including Corporate Legal Times, ChicagoMag.com and InsideCounsel magazine. Nicholas holds a Bachelor of Science in journalism from Northwestern University and a J.D. from the John Marshall Law School.