401(k) vs IRA — Complete Comparison for the CFP Exam

A 401(k) plan is a defined contribution retirement savings plan sponsored by an employer. Employees can elect to defer a portion of their salary into the plan, often with the employer providing a matching contribution. The deferred amount grows tax-deferred until retirement.

Key features include pre-tax contributions (reducing current taxable income), potential employer matching (a significant benefit), and a range of investment options, typically mutual funds. Understanding contribution limits, vesting schedules, and loan provisions are crucial for the CFP exam.

Contribution Limits: For 2024, the employee contribution limit is $23,000. Those age 50 and over can contribute an additional $7,500 as a "catch-up" contribution, for a total of $30,500. The combined employer and employee contribution limit is $69,000, or $76,500 for those 50 and over.

A Traditional IRA allows individuals to save for retirement on a tax-deferred basis. Contributions may be tax-deductible, depending on income and whether the individual (or their spouse) is covered by a retirement plan at work.

Deductibility Rules: If neither you nor your spouse is covered by a retirement plan at work, you can deduct the full amount of your Traditional IRA contributions. If you *are* covered by a retirement plan, the deductibility of your contributions may be limited based on your modified adjusted gross income (MAGI). The specific MAGI thresholds change annually, so consult the IRS guidelines for the relevant tax year. If your income exceeds the threshold, the deduction is phased out, and eventually, no deduction is allowed.

Example: If you are covered by a retirement plan at work and your MAGI is above the upper limit of the phase-out range, you cannot deduct your Traditional IRA contributions. This is an important area for exam questions.

A Roth IRA offers tax-free growth and withdrawals in retirement, provided certain conditions are met. Contributions are made with after-tax dollars, but qualified distributions in retirement are tax-free.

Income Limits: Roth IRA contributions are subject to income limits. If your modified adjusted gross income (MAGI) exceeds a certain threshold, you cannot contribute to a Roth IRA. These limits change annually and are lower than for Traditional IRA deductibility. Consult IRS publications for the current year's limits.

Backdoor Roth: The "backdoor Roth" strategy allows high-income individuals who are ineligible to contribute directly to a Roth IRA to contribute to a Traditional IRA (non-deductible) and then convert it to a Roth IRA. There are no income limits for Roth conversions. However, the pro-rata rule must be considered if you have other traditional IRA balances.

A Roth 401(k) is offered through an employer-sponsored plan, similar to a traditional 401(k), but contributions are made with after-tax dollars. Qualified distributions in retirement are tax-free, mirroring the Roth IRA.

Key Differences: Roth 401(k) plans do not have income limitations for contributions, unlike Roth IRAs. Also, Roth 401(k)s are subject to required minimum distributions (RMDs), while Roth IRAs are not (during the original owner's lifetime). Finally, Roth 401(k) contribution limits are significantly higher than Roth IRA limits.

Exam Relevance: Understand the tax treatment of contributions and distributions for both types of accounts, as well as the impact of RMDs.

SIMPLE (Savings Incentive Match Plan for Employees) and SEP (Simplified Employee Pension) IRAs are retirement plans designed for small business owners and self-employed individuals.

SIMPLE IRA: A SIMPLE IRA allows both the employer and employee to contribute. Employees can elect to defer a portion of their salary, and the employer must either match employee contributions (up to 3% of compensation) or make a non-elective contribution (2% of compensation for all eligible employees). The 2024 employee contribution limit is $16,000, with a $3,500 catch-up contribution for those age 50 and over.

SEP IRA: A SEP IRA allows the employer to contribute to traditional IRAs (SEP IRAs) set up for each employee. Only the employer contributes; employees cannot make contributions. The employer contribution is discretionary each year, up to 25% of the employee's compensation, with a maximum contribution of $69,000 for 2024.

A 403(b) plan is a retirement plan for employees of public schools and certain tax-exempt organizations. A 457(b) plan is a deferred compensation plan for state and local government employees and employees of certain tax-exempt organizations.

403(b) Plans: Similar to 401(k)s, 403(b) plans allow pre-tax contributions, tax-deferred growth, and often include employer matching. The contribution limits are the same as for 401(k) plans: $23,000 for 2024, with a $7,500 catch-up for those 50 and over.

457(b) Plans: 457(b) plans can be either governmental or non-governmental. Governmental 457(b) plans offer unique features, including the ability to make contributions up to twice the regular limit in the three years prior to retirement (subject to certain conditions). 457(b) plans may also allow for distributions upon separation from service, regardless of age, without penalty.

Individuals may participate in multiple retirement accounts (e.g., a 401(k) and an IRA). However, it is crucial to understand how contribution limits and deductibility rules apply across all accounts. For example, contributing to both a 401(k) and a Traditional IRA can impact the deductibility of the IRA contributions.

Highly Compensated Employee (HCE) Rules: 401(k) plans are subject to non-discrimination testing to ensure that the plan does not disproportionately benefit highly compensated employees (HCEs). HCEs are generally defined as employees who own more than 5% of the company or earn more than a certain amount (indexed annually). The actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test are used to determine if the plan is discriminatory. Failure to pass these tests can result in corrective distributions to HCEs.

Exam Tip: Understand the definition of an HCE and the purpose of non-discrimination testing in qualified retirement plans.

The CFP exam frequently tests knowledge of retirement accounts, including contribution limits, eligibility requirements, tax implications, and distribution rules. Expect questions that require you to calculate deductible IRA contributions, determine Roth IRA eligibility, and compare the features of different retirement plans.

The following table summarizes key features: