Traditional 401(k) and Roth IRA Plans
In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferrals". That is, an employee's elective deferral funds are set aside by the employer in a special account where the funds are allowed to be invested in various options made available in the plan. The IRS sets a limit on the amount of funds deferred in this way, and includes a "catch up" provision intended to allow older workers to save for their approaching retirement. These limits are adjusted each year to reflect changes in the cost of living due to inflation. For tax-year 2012 this limit is $17,000 for those under age 50, and $22,500 for those 50 and over. The limits for tax year 2013 will be $17,500 and $23,000, respectively.
Employers may also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59 1/2, he or she may begin to receive "qualified distributions" from the funds in the account; these distributions are then taxed at ordinary income tax rates. Exceptions exist to allow distribution of funds before 59 1/2, such as Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).
Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement (IRA). In contrast to the 401(k) plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 1/2. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2012, individuals are limited to contributing no more than $5,000 to a Roth IRA if under age 50, and $6,000 if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly). See 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.
Read more about this topic: Roth 401(k)
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