How Much Do You Know About 401(k) and IRA?

Disclosure: This post might contain affiliate links. If you click through and make a purchase, I’ll earn a commission, at no additional cost to you. Read my full disclosure here.

How much do you know about 401(k) and IRA? The general concepts are easy, but Iots of people are not very familiar with the details of these 2 types of retirement accounts, so they do not get advantage of all their benefits. In this post I will cover 12 popular misconceptions about the 401(k) and the IRA.

Quiz

In order to test our knowledge, let’s start with a quiz. These 12 questions have multiple-choice answers. Please write down your answers, e.g. in a piece of paper. You will be able to check your answers at the second half of this post. Feel free to add a comment about how many of these questions you got correct and whether something surprised you.

1. Are the 401(k) and the IRA good investments?
   1. Yes
   2. No
   3. N/A
2. Can you only deposit pre-tax money to the 401(k) and the IRA?
   1. Yes
   2. No
   3. It depends
3. Is it better to contribute to a pre-tax 401(k) (or IRA) than a Roth 401(k) (or IRA)?
   1. Yes
   2. No
   3. It depends
4. What is the maximum amount that anybody can contribute to the 401(k) in 2020?
   1. $19.5k
   2. $57k
   3. > $100k
5. Can you contribute to a Roth IRA if you have a high salary (e.g. $200k)?
   1. Yes
   2. No
   3. It depends
6. If you switch employers, then is it preferable to transfer the 401(k) balance to your new employer’s 401(k) provider?
   1. Yes
   2. No
   3. It depends
7. Can you contribute to an IRA, if you’ve max out your 401(k)?
   1. Yes
   2. No
   3. It depends
8. Can you withdraw any money from the 401(k) or IRA before 59.5 years of age without paying a penalty?
   1. Yes
   2. No
   3. It depends
9. Does it make sense to contribute to a 401(k) or IRA if you’re planning on leaving from the US soon?
   1. Yes
   2. No
   3. It depends
10. Does spreading out your contributions to the 401(k) and IRA throughout the year give you the optimal return on your investment?
    1. Yes
    2. No
    3. It depends
11. Can you open a 401(k) and contribute to it, if you are self-employed?
    1. Yes
    2. No
    3. It depends
12. Is it possible to hold precious real estate (e.g. rental properties), metals (e.g. physical gold), commodities, private placements, limited partnerships, tax lien certificates, and other sorts of alternative investments within an IRA account?
    1. Yes
    2. No
    3. It depends

Answers

1. Are the 401(k) and the IRA good investments?

Correct answer: N/A

This was a tricky question.The 401(k) and the IRA are not investments. You cannot buy a 401(k) or an IRA. Stocks, mutual funds, bonds and ETFs are investments. 401(k) and IRA are investment accounts. This means that you can buy investments (i.e. stocks and bonds) within the 401(k) and IRA.

The 401(k) that is provided by your employer has a limited set of investment options, which means that you will not be able to buy any investment that you want within those accounts. You should check each investment option that is provided in your 401(k) and pay special attention to the fees. Make sure that you only invest in low-fee options. Even the most well-known companies might not provide many good investment options within their 401(k).

The IRA stands for Individual Retirement Account. This means that you have the option to open an IRA in any investment provider that you want (e.g. Vanguard, Fidelity, Charles Schwab, etc). Each provider will offer the full set of investments that they have (e.g. if you open an IRA in Vanguard you’ll have access to all their ETFs and mutual funds).

In order to identify which funds to select within your 401(k) and IRA, you can also read my previous post “8 Critical Decisions for a Successful Investment Strategy“.

2. Can you only deposit pre-tax money to the 401(k) and the IRA?

Correct answer: No

The 401(k) has 3 different contribution options:

1. Pre-tax: Your contributions are tax-free, but your withdrawals are taxed (i.e. you don’t pay any taxes when you contribute the amount, but you pay taxes when you withdraw)
2. Roth: Your contributions are taxed, but your withdrawals are tax-free (i.e. you pay taxes when you contribute, but you don’t pay any taxes when you withdraw money)
3. After-tax: Both your contributions and you withdrawals are taxed

Each employee can decide how much money to contribute using each option (up to specific limits that will be covered by the following answers). We will explore which option is best for each employee in the following questions.

However, this does not mean that all employers offer all 3 contribution options. All employers offer the pre-tax contribution options. Most employers offer the Roth contribution option. Few employers offer the after-tax contribution option.

Within the tech space, Amazon is the only big company that does not offer the after-tax contribution option (i.e. it offers only the first two). All other big high-tech companies (e.g. Microsoft, Facebook, Google, etc) offer all 3 options.

Mega Backdoor Roth conversion

At this point you might be wondering why somebody would contribute to the 3rd option (i.e. the after-tax 401(k) ), since it is clearly worse than the other 2 options. The answer for this is the Mega Backdoor Roth. If your plan allows this, then you are able to contribute money to the after-tax 401(k) and then immediately convert it to Roth 401(k) or a Roth IRA. This means that the after-tax 401(k) essentially becomes equal to the Roth 401(k)/IRA. However, as we will see in the following questions, the contribution limit to the after-tax 401(k) is much higher than that of the Roth 401(k)/IRA. So, the Mega Backdoor Roth allows you to bypass the limit for the Roth 401(k)/IRA. This conversion is legal and supported by the IRS.

There are 2 types of IRA accounts:

1. Traditional IRA:
   1. If your family income is below specific limits that are defined by the IRS, then your contributions are tax-free, but your withdrawals are taxed (similar to pre-tax 401(k) )
   2. If your family income is above these limits, then both your contributions and your withdrawals are taxed (similar to the after-tax 401(k) )
2. Roth IRA: Your contributions are taxed, but your withdrawals are tax-free (similar to a Roth 401(k) )
   1. Eligibility: You can contribute to a Roth IRA only if your family income is below specific limits that are defined by the IRS

The 2020 total contribution limit for all your IRA accounts (traditional and Roth) has been defined by the IRS as $6k ($7k, if you are age 50 or older).

The decision about whether to contribute to a traditional IRA or a Roth IRA (assuming that you can contribute to both) is similar to the question about contributing to a pre-tax 401(k) vs a Roth 401(k) and we’ll cover it in a following section.

Backdoor Roth IRA Conversion

At this point you might be wondering why somebody would contribute to a traditional IRA, if they cannot have tax-free contributions. The answer is the Backdoor Roth IRA conversion. If you have high income, then you can contribute money to a traditional IRA (without being able to take a tax deduction for these contributions) and then immediately convert this amount to a Roth IRA. This tactic effectively allows you to bypass the income limitations for contributions to a Roth IRA. It is a legal tactic and is supported by the IRS. We will cover it in more detail in a following question.

3. Is it better to contribute to a pre-tax 401(k) (or IRA) than a Roth 401(k) (or IRA)?

Correct answer: It depends

The quick answer is that it depends on your tax bracket:

1. Low tax brackets (up to 12%): It is best to use the Roth 401(k) and the Roth IRA
2. Intermediate tax brackets (22% and 24%): It depends on your retirement income. If you expect high income in retirement, then probably you should go for the Roth 401(k)/IRA. If you expect low income in retirement, then you should probably go for the pre-tax 401(k) and the traditional IRA.
3. High tax brackets (32% or higher): It is best to use the pre-tax 401(k) and the traditional IRA (assuming that you qualify)

A more advanced advice would be to compare your current marginal tax rate (i.e. how much tax you will pay for additional $1 earned) with your expected effective tax rate at retirement (which can be calculated by dividing your total estimated taxes at retirement with your retirement income).

In order to understand the difference between the effective and the marginal tax rate, let’s assume that you are a single filer and both your current income and your expected retirement income is $100k. Based on the tax brackets, your current marginal tax rate is 24%. Your effective tax at retirement will be $18,174.50, which means that your effective tax rate will be 18.17%. In order to calculate your effective tax rate, you can use a tax bracket calculator.

Finally, if you want a very detailed answer, you can also read this Reddit article.

4. What is the maximum amount that anybody can contribute to the 401(k) in 2020?

Correct answer: > $100k

The IRS has set 2 limits for 40(1)k accounts:

1. The max contribution for all pre-tax 401(k) + Roth 401(k) contributions is $19.5k
2. The max contribution to one employer’s 401(k) plan is $57k

Source: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

Pasting from the above source regarding the 2nd limit: “Total annual contributions (annual additions) to all of your accounts in plans maintained by one employer (and any related employer) are limited.“

This means that if somebody has multiple 401(k) accounts, then they can contribute $57k * N to their 401(k) accounts (N is equal to the number of 401(k) accounts). Out of this amount, $19.5k will be pre-tax/Roth and the remaining ($57k * N – $19.5k) will be after-tax.

Some examples where this can happen:

1. You changed employers during the year
2. You work both as a freelancer and as an employee
3. You are working for multiple employers (this is typical for doctors, who work for multiple hospitals)

5. Can you contribute to a Roth IRA if you have a high salary (e.g. $200k)?

Correct answer: Yes

The IRS has set income limits that specify who can directly contribute to a Roth IRA. However, it is possible to indirectly contribute to a Roth IRA without any income restriction. This tactic is known as the Mega Backdoor Roth rollover.

In order to do the rollover, you need to have both a traditional IRA and a Roth account. It consists of the following steps:

1. Contribute some money to a traditional IRA
   1. For 2020, this contribution is limited to $6k per person ($7k for age 50 and above)
   2. This contribution will not be tax deductible
2. Rollover this amount from the traditional IRA to a Roth IRA

If you need more information, you can take a look at this guide from Physician on Fire.

I wanted to point out the following points, if you decide to do this conversion:

1. Step #1 has to be done within a calendar year (i.e. from January 1st to December 31st of one year). However, step #2 can be done until the tax filing date of the next year (i.e. until April 15th of the next year)
   • E.g. you can contribute to the traditional IRA anytime between 1/1/2020 to 12/31/2020. You can do the rollover to the Roth IRA anytime between 1/1/2020 and 4/15/2021
2. When you file taxes, you will report each step at the year that it was done. This means that it’s possible that you might report both steps in the same tax report, but they could be in different ones, e.g.
   • If you contribute $6k to the traditional IRA on 3/3/2020 and rollover on 3/5/2020, then you will report both actions in your 2020 taxes
   • If you contribute the $6k on 3/3/2020 and do the rollover on 3/3/2021, then you will report the contribution on your 2020 taxes and the rollover on your 2021 taxes
3. You need to be aware of the tax implications. You will pay taxes in the following cases:
   1. Taxes on gains: If you contribute $X to your traditional 401(k), this amount increases to ($X+$K) and then you roll it over, then you will pay taxes on the gains (i.e. on the $K). It’s best do to the contribution and the conversion without any delay in order to avoid any gains
   2. Pro rate rule: If at the end of the year (12/31) your balance on all your traditional IRAs is not $0, then some part of your conversion will be taxed. In order to avoid this, you should always make sure that the balance on your traditional IRAs is $0 on 12/31 of every year.
4. The IRA contribution limit ($6k) is specifically for the contribution. There is no limit regarding the conversion. This means that if you have $10k in your traditional IRA, then you can convert all of them at once to your Roth IRA. However, you should be aware of the tax implications mentioned above.

In order to make sure that you report the Backdoor Roth Conversion correctly to the IRS, you should check this post by The Finance Buff on “How to Report Backdoor Roth in TurboTax” (he also has posts for H&R, TaxAct, FreeTaxUSA).

6. If you switch employers, then is it preferable to transfer the 401(k) balance to your new employer’s 401(k) provider?

Correct answer: It depends

Here are some things to consider:

1. 401(k) investment options: You should always check the investment options for each 401(k) (as was mentioned in the 1st question).
   1. If the 401(k) of your new employer has better options than your old 401(k), then it would make sense to transfer the balance.
   2. However, if it doesn’t have better options, then you can keep the balance in your old 401(k). You will not be able to contribute any additional money to your old 401(k), but you should still be able to manage the money that you have there.
2. Fees in the old 401(k): You should check if you will be paying maintenance fees to the provider of your old 401(k), now that you have changed employers.
   1. While you were employed in your previous employer, they used to pay the maintenance fees, but it is possible that after changing employers, you’ll be paying those fees.
   2. For example, if you leave Amazon then you’ll be paying maintenance fees to Vanguard. However, if you leave Microsoft then you won’t be paying maintenance fees to Fidelity.
3. Check if the 401(k) account needs to be closed after some period after you leave your old employer: For example, 5 years after you leave Amazon, Vanguard will close your 401(k) account and convert your holdings to an IRA as cash.

7. Can you contribute to an IRA, if you’ve max out your 401(k)?

Correct answer: Yes

Your 401(k) contributions are independent of your IRA contributions, i.e. you can max out both accounts. Also, you can do the Mega Backdoor Roth conversion (i.e. convert from an after-tax 401(k) to a Roth 401(k)/IRA) independently of the Backdoor Roth conversion (i.e. convert from a non-deductible traditional IRA to a Roth IRA).

The only connection between the two accounts is that if you max out the 401(k) contribution, then you might not be able to deduct your full contribution to your traditional IRA.

8. Can you withdraw any money from the 401(k) or IRA before 59.5 years of age without paying a penalty?

Correct answer: Yes

Most people are aware that if they withdraw any amount from their 401(k) or IRA before being 59.5 years old, they will have to pay 10% tax penalty on the earnings of their withdrawals.

However, there are multiple ways to avoid this fee:

1. Withdraw 401(k) from current employer at 55: If you leave your employer at 55 years old, then you can withdraw any amount from your employer’s 401(k) without any penalty. This is only limited to the amount that is your employer’s 401(k) (i.e. it excludes IRAs and other 401(k) accounts), but it should be easy to rollover all of them to your employer’s 401(k) before resigning.
2. Borrowing from your 401(k): If your employer’s plan allows it, you can borrow money from your 401(k), but you’ll have to pay the amount back (with some interest) within 5 years (or within 60 days after leaving your employer). The disadvantage is that you lose the growth of the amount that you have borrowed
3. IRA withdrawals due to medical expenses, higher education expenses and first-time home purchase: There is no fee, if you withdraw from your IRA for these 3 reasons
4. Roth Conversion Ladder:
   • This is how it works:
     • After leaving your job, rollover your 401(k) to your IRA
     • Calculate how much money you will need 5 years from now
     • When you don’t have a job (i.e. you have low income), convert this amount from your traditional IRA to your Roth IRA
     • You will be able to withdraw this amount tax-free 5 years later
   • Example:
     • Years 1-5: Each year convert $50k from your traditional IRA to your Roth IRA. You will also pay the taxes for this conversion, but your tax bracket will be low, since your income is low
     • Years 6-10: Each year, withdraw the amount that you converted 5 years earlier tax-free and penalty-free
   • Additional resources: Mad Fientist
5. 72(t) Substantially Equal Periodic Payments (SEPP): I’m copy-pasting the following steps from Mad Fientist, since he has done an excellent job of explaining each step:
   1. When you leave your job, immediately roll your 401(k)/403(b) into a Traditional IRA.
   2. Determine how much you think you’ll want to withdraw from your retirement accounts every year until you turn 59.5
   3. Calculate the three possible withdrawal amounts (see this IRS document for more info) and pick the one that is closest to the number you decided in Step #2.
   4. Speak with a tax professional to ensure that your Step #3 calculation were correct.
   5. Withdraw (and pay tax on) that amount every year. Depending on the method you used to calculate the withdrawal amount, you may need to adjust the amount you withdraw every year.
   6. (Optional) If you find that you need to withdraw more money or you don’t need to withdraw as much, you can change the IRS method you use to calculate your withdrawals only once so make sure you’re happy with your change.
   7. Continue making the withdrawals for five year or until you turn 59.5 (whichever is longer). If you stop the withdrawals or if you withdraw the incorrect amount, you could face steep penalties so definitely don’t do that!

Finally, I wanted to point out that out of all the above tactics, the Roth Conversion ladder is the one that is mostly used in the FIRE community.

9. Does it make sense to contribute to a 401(k) or IRA if you’re planning on leaving from the US soon?

Correct answer: It depends

This is a very complicated question and it is best to get advice from a CPA that understands both the US tax system, as well as the tax system of your own country. I will try to provide some food for thought, but I will definitely not be able to cover all aspects of this issue.

The most important part is to identify if there is a tax treaty between US and your home country (you can find the list here). These treaties prevent the double taxation of US income, i.e. protect you from paying the tax twice (both to the US and to your home country). However, you should consider that:

1. You will probably pay the highest tax that is defined by the two countries. For example, if you would pay 25% based on US tax code and 35% based on your home country’s tax code, then your total tax will be 35%.
2. Most treaties avoid double taxation for earned income, but they do not clarify what happens with income from retirement accounts, such as the 401(k) and the IRA

Due to item #2 above, it might be possible that your home country might consider withdrawals from a Roth account (401(k) or IRA) as taxable income! In that case you might not have to pay taxes to the US, but you would pay regular income taxes to your home country!

Another topic to consider are the IRS guides for taxation of nonresident aliens. The IRS splits the income based on whether it is a) Effectively Connected Income (ECI), i.e. income earned for services performed in the US or b) Fixed or Determinable, Annual, or Periodic (FDAP) income, which includes interest, dividends, rents or royalties. ECI is taxed based on standard tax rates, however FDAP is taxed as a 30% flat rate, unless a treaty specifies a lower rate. So, if you withdraw money from your traditional 401(k) while being in your home country, there is a chance that you’ll pay 30% tax!

However, there are cases where it does make sense to fully contribute to a 401(k) and pay the tax rate, even if it is 30%. For example, let’s say that you work at a company that has a 50% match on your 401(k) contributions, such as Microsoft or Google. In that case, every year you contribute $19.5k in your 401(k) and you get a match of additional $9.75k (i.e. a total of $29.25k). If you withdraw this amount and pay 30% tax, then you will get $20,475.

So, my advice is that you should check with a CPA and a tax advisor that understands the tax codes of both countries, as this is a very complicated subject.

10. Does spreading out your contributions to the 401(k) and IRA throughout the year give you the optimal return on your investment?

Correct answer: Yes

This is the same question as whether you should do Dollar Cost Averaging (DCA) or lump sump investing. I covered this in my post “8 Critical Decision for a Successful Investing Strategy“. I’ll paste the same answer from that post.

Vanguard analysed this scenario in US, UK and Australia using multiple asset allocations (stocks/bonds: 100/0, 60/40, 50/50, 0/100) and found that for all the above combinations approximately 66% of the time it is better to invest the lump sum. The following graph from their paper shows the results:

However, an astute reader might also point out that this research ignores the cases where the stock market is overvalued. In that case, the possibility of a crash might be higher. Fortunately, the blogger A Wealth of Common Sense has done the corresponding calculations and found that when the market is really high (CAPE > 32x) then the lump sum is better 60% of the time, as is shown in the following table:

So, the end result is that it’s better to invest everything at the beginning of the year as one lump sum, instead of doing Dollar Cost Averaging (DCA).

11. Can you open a 401(k) and contribute to it, if you are self-employed?

Correct answer: Yes

If you are self-employed, then there are 3 types of retirement accounts that you can achieve the same benefit as a 401(k):

1. Individual 401(k): This is very similar to a 401(k) that is provided by an employer
   1. You have the option to open a pre-tax individual 401(k) and a Roth individual 401(k)
   2. It has the same limits as a regular 401(k)
      1. You can contribute both the employer’s portion and the employee’s portion
      2. Total contribution (for 2020): $57k
      3. Employee’s portion (for 2020): $19.5k
      4. Employer’s portion is limited to 20% of the net earnings from self-employment
2. SEP IRA: This is similar to a traditional IRA, with the exception of the contribution limit, which is the lesser between:
   1. 20% x (your business’s profit, minus the deduction for one-half of your self-employment tax), or
   2. $56k
3. SIMPLE IRA: This is similar to a traditional IRA with the exception of the contribution limit, which is the sum of:
   1. Employee contribution: $13.5k for 2020 (plus an employee catch-up contribution of $3,000 for 2019 if you are age 50 or over), limited to 100% of your net earnings from self-employment
   2. Employer contribution: 3% of your net earnings from self-employment.

Additional resources:

1. Vanguard: Compare our SEP-IRAs, i401(k)s & SIMPLE IRAs
2. Oblivious Investor: SEP vs. SIMPLE vs. Solo 401(k)
3. Nerd Wallet: Retirement Plan Options for the Self-Employed

12. Is it possible to hold precious real estate (e.g. rental properties), metals (e.g. physical gold), commodities, private placements, limited partnerships, tax lien certificates, and other sorts of alternative investments within an IRA account?

Correct answer: Yes

Most people are familiar with the regular IRAs, which can be setup as traditional or Roth IRA accounts. These accounts can only hold stocks, bonds, certificates of deposit, and mutual or exchange-traded funds (ETFs).

However, there is another type of account called Self-Directed IRA (SDIRA). These accounts can also be setup as traditional or Roth IRAs. The main difference between an SDIRA and a regular IRA is the type of investments that can be held. More specifically, SDIRAs can hold rental properties), metals (e.g. physical gold), commodities, private placements, limited partnerships, tax lien certificates, and other sorts of alternative investments. There are also some limitations, as the IRS prohibits investments, such as life insurance and collectibles (e.g. artwork, rugs, antiques, etc), alcoholic beverages, and certain other tangible personal property.

This type of account should be used only by very experienced investors, as it very easy to make a mistake that could trigger an IRS audit. Also, SDIRAs have additional fees and paperwork to setup than regular IRAs. If you want to learn more about SDIRAs, then you can start the following article from NerdWallet titled “Self-Directed IRAs: What You Need to Know“

How much did you score? Was there something that surprised you? Feel free to leave your comments below!