401Ks vs. Stocks (Which is Better in 2019?)
Today’s article explains the differences of 401Ks and stocks.
This is a great article for investors who are unclear on exactly how stocks get traded, and where retirement comes into play regarding stock investing.
Publicly traded companies issue ownership shares of what’s called “common stock”, and each share represents an equal ownership percentage of that company.
So when you trade stock, you are either buying or selling an ownership piece of a company.
A 401K is a type of retirement account where the stocks you trade are held. It is a part of a class of retirement accounts where investors can trade stocks, and it has special rules that regular, non-retirement do not.
What are stocks?
An investor who buys stock is purchasing a tiny ownership position in a publicly traded corporation from another investor who wants to sell it. When an investor sells stock, he sells that stock to a buyer. For a stock to trade, there must always be a willing buyer and a willing seller.
Thus, stock is simply a trading vehicle with which you can buy or sell ownership in a company.
The federal government set up two different categories for trading stocks – non-retirement accounts and retirement accounts. There are very few rules for the former, and very specific rules and restrictions for the latter.
What are 401Ks?
A 401K is a type of retirement account in which investments, including stock investing, can be made.
401K plans are specifically set up by employer only for their employees, and it is named after the section of the tax code that enables these accounts.
A 401K plan is a tax-favored account which allows employees to contribute up to $18,500 per year ($24,500 if you are over 50), and those contributions are tax-deductible. Any investment gains in the account are untaxed.
Taxes are only paid on withdrawals at retirement.
Some employers are very generous and will match all or a portion of whatever you contribute.
What are the differences between 401Ks and stocks?
When it comes to 401Ks vs. stock, the difference is that stock is something you trade, and 401Ks are accounts you trade stock in.
More importantly, however, are the differences between the non-retirement accounts that you can trade stock in and the retirement accounts.
With non-retirement accounts, you can deposit or withdraw money any time without tax consequences. If you sell stock at a profit, you will owe taxes on that profit in the year you sell it.
If you sell stock at a loss, you can deduct those losses in the year you incurred them, but only up to $3,000. Anything over that must be rolled over into future years.
401Ks have very specific restrictions. There are limits to deposits. I mentioned those limits a moment ago, but 401Ks for sole proprietors are also permitted, and those plans allow for an additional contribution of up to 20% of the entity’s profit.
However, you are not permitted to withdraw any money from 401Ks until you retire. When you do, the money you withdraw is taxed as ordinary income. However, if you withdraw money before retirement, not only do you owe those same taxes for the amount withdrawn, but you have to pay an additional 10% penalty tax on that amount that you withdrew.
There are some exemptions to this rule.
Distributions from 401Ks are exempt if rolled over into another eligible retirement plan within 60 days.
Distributions made to plan beneficiaries inherited after death are usually not subject to the early withdrawal penalty.
Disabled individuals can take distributions from 401Ks without being subject to the early withdrawal penalty. Specifically, a disabled individual is defined as someone “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”
The IRS requires proof of the disability.
Finally, distributions used to pay for medical expenses that are A) not reimbursed by health insurance and B) exceed 10% of your adjusted gross income, are not subject to the early withdrawal penalty.
Advantages of Stocks
When comparing investing in stocks for 401Ks vs. stocks in non-retirement accounts, here are the advantages of investing in stocks for non-retirement accounts:
- Flexibility on withdrawal
- Flexibility on types of trades and securities
- Tax lot choices
Here’s a video that provides differences between regular and retirement accounts.
Flexibility on withdrawals
Just how important is having flexibility on the ability to withdraw money from a non-retirement account vs a 401K?
Very important. Here’s why.
If your money is free to be moved around at will, then you have no worries withdrawing it for any reason, particularly in the event of an emergency. In those cases, you have to evaluate your tax situation to see if it makes sense to sell losers or winners, which will depend on a variety of factors.
Regardless, the only tax you potentially might owe is on the increase in value of any investment. So if you need emergency funds, it makes sense to sell stock that has appreciated the least amount.
However, if your money is in a 401K, you can still withdraw it, but get hit with significant taxes. You first must pay tax on the entire amount you withdraw, not just the amount it has appreciated.
But then you must also pay an additional 10% tax penalty for early withdrawal.
Flexibility on types of trades and securities
Non-retirement accounts have more flexibility in terms of how you can trade stocks, and even the types of stocks you can trade.
Regular stock accounts permit you to short-sell stocks. 401Ks generally do not, although some brokerages may permit it. The reason is that, if you sell short and the stock goes up, you lose money and may have to put more money into your account to cover the loss.
But you can’t do that with 401Ks. You can only contribute according to your employer’s plan’s rules.
Regular stock accounts let you trade options, whereas some 401Ks may or may not permit that.
Regular stock accounts let you trade on margin, which means you are allowed to borrow against the value of your securities to buy other securities. Margin in not permitted in 401Ks.
Regular stock accounts let you trade just about any kind of security that exists. 401Ks are far more restrictive, and may not permit you to trade more than stocks and mutual funds.
Tax lot choices
When you sell stock in a regular account, you usually have a choice as to which shares of stock you want to sell. That permits you to make your stock trades as tax efficient as you wish.
Because retirement withdrawals are taxed as ordinary income, there is no ability or need to choose which shares to sell.
Advantages of 401Ks
As far as 401Ks vs. stocks, these are some advantages to consider when contribution time rolls around:
- Tax deductible contribution
- Tax deferred growth
- Free money
Here’s a video that explains the basics of 401Ks.
Tax deductible contribution
There is a significant tax savings that comes along with contribution to 401Ks.
In the year that you contribute to a 401K plan, anything that you do contribute can be written off as a deduction on your taxes. This is a deduction that comes straight off whatever you earned.
So if you earned a salary of $50,000, and you contribution $10,000, that your taxable income is $40,000. The more money you earn each year, the more valuable the tax deduction will be.
So if you are in the 20% tax bracket, every dollar you contribute will save you 20 cents in taxes. But if you are in the 35% tax bracket, you will save 35 cents on each dollar you contribute.
That doesn’t even mention any state tax savings.
Tax deferred growth
Any appreciation your stocks have while they are in the 401K account will accrue without any taxation, as long as the money remains in the account.
You are only taxes when you withdraw money from the 401K.
Did you read that correctly? Yes, you did.
Some employers will actually match whatever contribution you make to your 401K. This is an incredible employee benefit.
Not only does this encourage you to save for retirement, but it encourages you to really save a lot for retirement. If you contribute $15,000 to your 401K, and your employer matches it, not only are you getting $15,000 in free money, but any appreciation to stocks you buy with that money is tax deferred.