So you want to save for retirement. You’ve heard good things about both 401(k)’s and IRA’s.
But you’re limited on funds. You’d like to save your money in both, but that’s not just happening. (At least not today.) So if you only have to pick one, which is it going to be?
In this post, we’ll skip all the boring, recycled facts about retirement planning and get straight to the point of addressing this question: Should I put money in a 401(k) or IRA first?
Why Either is a Good Choice
First of all, understand that for most people: You can do both. It’s very common for most middle-class Americans to be able to save their money in both an IRA and 401(k). To be sure if you qualify, check the IRS requirements here.
In addition, both options are a great choice over traditional bank accounts because they offer the unique advantage of tax-deferment.
Remember that when you save your money in a regular bank account, it’s with AFTER-tax income from your paycheck, meaning that you’ve already paid taxes on this money. On the other hand, with retirement accounts, you make your contribution BEFORE the taxes are taken out.
Why does that matter? Let’s say you have the choice to save $10,000 of earnings this year. By the time you receive that money in your paycheck, it will be approximately $7,500 because $2,500 went to taxes. But with your retirement accounts, you get to stash the whole $10,000. That’s a huge 33% difference!
Okay, so back to the original question: Where do we start saving first?
1- 401(k) Employer Matching Contributions
The first question to ask yourself is whether or not your employer offers you any sort of 401(k) matching contribution. This is money that your employer kicks-in to your 401(k) alongside your contributions.
If your employer does this, start saving your money inside your 401(k) and do everything you can to maximize it!
Seriously. Passing up employer contributions is like leaving free money on the table. It’s just plain foolish. I’m sure if your boss was walking around passing out $100 bills, you wouldn’t pass that up. So why pass up the chance to collect the same thing using your 401(k)?
According to Investopedia, on average, most employers will match anywhere between 50 cents and $1 for every $1 you contribute to your 401(k) (up to some pre-set maximum amount).
Wow! A dollar for dollar match? You’d be effectively doubling your money for doing nothing more than simply choosing to save it.
Also not to mention that, just like your contributions, this money grows tax-deferred until someday in the future when you withdraw it for retirement. Good deal!
Unfortunately for the IRA, since this is your personal plan, it is extremely rare for employers to help in any way with contributing to it.
2- Fees and Flexibility
Following employer matching contributions, the next point to consider on using a 401(k) or IRA first is that of fees and flexibility. And in this debate, usually the IRA wins.
Because you can choose which investment company to start your IRA, you’re going to find a lot less expensive options than probably what your 401(k) will offer.
For example: My go-to for investing is Vanguard. They offer lots of fund choices that carry an annual expense ratio of 0.25%. In fact, they’ve got a very popular stock market index fund that costs only 0.04% per year. This means you’re paying $4 for every $10,000 you’ve got invested. That’s almost nothing!
By contrast, the average 401(k) fund carries an annual expense of 1.0% according to the Center for American Progress. That’s more like $100 for every $10,000 you’ve got invested. Which would you rather pay?
Combine this with the fact that IRA’s don’t have any administrative fees. 401(k) plans do. Most people don’t realize it, but they’re actually also paying an additional fee to their plan administrator to simply “run” the 401(k). CNBC found that depending on the size of your company’s plan, this could be an extra 0.27 – 1.13% annual expense.
Also because you get to choose who your IRA is through, this gives you an added benefit of choosing among thousands of options. With a 401(k), most of the time your plan is limited to only the choices that your plan administrator will allow. If you don’t like those options, then you’re generally out of luck.
Finally, with IRA’s, you have a little bit more flexibility over the fund. With 401(k)’s, you have to ask for your plan administrator’s permission to take out loans or file for special withdrawals. With an IRA, since you are the boss, you make these decisions with your investment service provider.
Bottom line: After contributing as much as you need to get your full 401(k) employer match, save the remainder to your IRA.
3- How Much Do You Plan to Contribute?
After fees, the next topic to consider is how much you plan to save up every year.
This is where IRA’s fall short. As of 2018, the maximum annual contribution you can make to an IRA is $5,500 (or $11,000 for couples). That’s not nearly as much as the $18,500 you’re allowed to stash away in your 401(k).
Therefore, 401(k)’s will provide you with more room to stash your savings tax-deferred.
Bottom line: After you’ve maxed out your IRA, you should then switch back over to your 401(k) and continue to save your money there.
Do I Use a Roth or Not?
One more ingredient to make this subject just a little bit more complicated is the issue of whether or not to use a Roth-style account.
As you might already know, Roth accounts are the opposite of Traditional-style accounts. With a Roth, you pay your taxes now, the money grows tax-free, and then remains tax-free even after you’ve retired.
To Roth or not comes down to one simple question: Do you think you’ll have more expenses now or in the future?
What is this question getting at? It’s trying to identify whether you think you’ll be in a higher tax bracket now or later.
If you think you’ll have fewer expenses at retirement, then this means you’ll likely need less money, be in a lower tax bracket, and therefore the Traditional style account would be better suited for you.
But if you plan to live more luxuriously, travel, or just plain enjoy your money more in retirement, then chances are you’ll be in a higher tax bracket and the Roth makes more sense.
To find out more about the differences between Roth and Traditional style accounts, check out our full guide here.
Maximize Your Savings
Again: The best-case scenario when it comes to using your retirement plans is to max them all out as much as possible.
When you do this, it accomplishes every one of the goals we’ve discussed so far:
- Minimizing your taxes as much as possible, which translates to more money in your pocket.
- Maximum employer contributions.
- Tax-deferred or tax-free growth.
If you’re looking for some practical tips on how you can start saving more your hard-earned income, then please check out my book Save MORE, Earn MORE. Here you’ll find some proven strategies for stashing more of your money every year.
Readers – Where do you recommend to your friends that they put their money first – a 401(k) or IRA? What order or strategy do you like to use to get the most out of each one?
Photo credit: Pixabay