The U.S. government offers tax breaks on qualified retirement savings plans such as individual retirement accounts and 401(k)s. A traditional IRA and a 401(k) provide a tax deduction for contributed funds, but you are taxed at your marginal rate on all withdrawals. Roth IRAs don’t provide a tax deduction on contributions, but do allow tax-free withdrawals of contributions and earnings. A 401(k) is sponsored by an employer, who can augment employee contributions. You must earn at least as much compensation as the amount you contribute to any of these plans.
The Internal Revenue Service limits 401(k) employee contributions, and the limits are subject to change. As of 2013, the limit was set at $17,500. Employers can kick in company money to raise the total contribution to $51,000. For employees aged 50 or older, a “catch-up” contribution is allowable to $5,500. The maximum contribution is based on compensation up to $255,000.
The contribution limits on IRAs are $5,500 for individuals below age 50 and $6,500 for everyone else. The IRS imposes no income caps for traditional IRAs except if you are also covered by a workplace retirement plan, or have a spouse who is. For this situation, the limit on modified adjusted gross income for singles begins at $59,000 and tops out at $69,000. For married couples, the limit range is $178,000 to $188,000.
The IRS curtails Roth contributions for singles with a modified adjusted gross income range of $112,000 to $127,000, and for married couples with a range of $178,000 to $188,000.
IRA contributors may be eligible for a federal retirement savings contribution credit of up to $2,000 per couple if their modified adjusted gross income doesn’t exceed $59,000. The limit for individuals is $29,500 for a $1,000 credit. The saver’s credit is not available for 401(k) contributions. The credit is a dollar-for-dollar reduction of your tax bill, which is more valuable than a tax deduction.
To escape penalties, you must be at least 59 ½ before you withdraw money from your 401(k) or traditional IRA. You must pay income tax at your marginal rate on all withdrawals from these two plan types.
Roth IRAs have different withdrawal rules. You can always withdraw the contributions you've made tax-free, since you've already paid taxes on them. You’ll owe taxes and penalties if you withdraw earnings before the Roth plan reaches its fifth birthday or you reach age 59 ½. Otherwise, you can withdraw earnings tax-free.
Required Minimum Distributions
As long as you’re living, you do not have to take a distribution from your Roth IRA.
If you own a traditional IRA or a 401(k), you must begin taking distributions soon after reaching age 70 ½. You must take your first distribution by April 1 of the year following your 70 ½ birthday. You take subsequent annual distributions by December 31, starting with the year after you attain age 70 1/2. You use actuarial tables in IRS Publication 590 to figure your minimum distribution amount.
If you own both a traditional IRA and a 401(k), you must separately figure the required minimum distribution from each. If your fail to take the minimum distribution, it will cost you a 50-percent excise tax on the amount not withdrawn.
Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com.