This note summarizes the understanding of 401k, IRA, and Roth IRA, aiming to provide some ideas for friends planning their retirement.

IRA and 401k are common retirement accounts in the U.S., both offering tax advantages but with different attributes in tax benefits and withdrawal rules. For self-employed individuals, IRA accounts or solo 401Ks can be opened at major financial institutions and insurance companies (Fidelity, Charles Schwab, BOA Merrill, etc.). The process is simple and requires no special qualifications.

Traditional IRA (Traditional IRA)

Tax Benefits: Contributions are tax-deductible and grow tax-deferred. Contributions made to a traditional IRA can be deducted from taxable income in the year of the contribution, reducing the current tax burden. The funds grow tax-deferred, but taxes are due upon withdrawal during retirement.

Contribution Limits: For 2024, the contribution limit is $7,000 (for singles). If you are over 50, you can contribute an additional $1,000.

Example: A single, self-employed individual aged 30 with a MAGI of $60,000 before contributing to an IRA. If they contribute $7,000 to a traditional IRA in 2024, their taxable income reduces to $53,000. Assuming a 6% return, annual returns are tax-deferred. With an income tax bracket of 22%-24%, contributing to the IRA could save approximately $1,500 in taxes, subject to other income and deductions.

Withdrawal Rules: Withdrawals can begin at age 59.5. Early withdrawals incur a 10% penalty. There is a required minimum distribution (RMD) starting at age 72.

Roth IRA

Tax Benefits: Contributions are made with after-tax dollars, so withdrawals (including earnings) are tax-free. Roth IRA contributions do not offer a tax deduction in the year of contribution, but investment gains within the account are tax-free.

Example: If you contribute $7,000 in 2024 and continue to contribute for 10 years with consistent gains, the account balance might grow to $150,000. If you are 59.5 years old and the account has been open for at least 5 years, the entire $150,000 can be withdrawn tax-free.

Inheritance Planning: Roth IRAs can be passed to beneficiaries (e.g., children) who can also withdraw funds tax-free. It is suitable for those expecting higher tax rates in retirement.

No RMD: Unlike Traditional IRAs, Roth IRAs have no RMD during the owner’s lifetime, although inherited Roth IRAs may have distribution requirements post-2024.

401K

Tax Benefits: Contributions are made with pre-tax dollars, reducing taxable income in the contribution year. The maximum contribution limit for 2024 is $23,000, with an additional $7,500 allowed for those over 50. Investment returns grow tax-deferred until withdrawn.

Employer Matching: Many employers offer matching contributions. For example, if your employer matches 50% of your contributions up to 6% of your salary and you earn $80,000, contributing $4,800 (6%) would result in an additional $2,400 from your employer, totaling $7,200 in contributions.

Withdrawal Rules: Normal withdrawals can begin at age 59.5. Early withdrawals typically incur a 10% penalty, though there are exceptions (first-time home purchase, education, major medical expenses).

RMD: Required minimum distributions must begin at age 72 unless you are still employed.

For Self-Employed: Self-employed individuals can set up a solo 401k at financial institutions.

Combining IRA and 401K
Both accounts can be opened and maxed out simultaneously for maximum tax benefits. Their limits are calculated separately. 401K investment options are usually limited compared to IRAs, which offer a wider range of choices but also have income restrictions. This introduction covers the basics and does not delve into detailed strategies.