So you want to save for retirement, and you’ve heard good things about both 401(k)’s and IRA’s.
You’d love to save your money into both types of retirement accounts. But unfortunately, that might not be possible.
First, there’s the big question: Are you even eligible? Maybe you work at a place that doesn’t offer a 401(k) plan. Or maybe you have no idea if you qualify to open an IRA.
Next, if your finances are anything like most American households, then there’s only so much money to go around. Your paycheck is only so big, and you might only be saving somewhere around 10 percent of it. There might be enough to spread around.
Finally, there’s the debate of what’s best for you and your money. Do any amount of searches in Google for IRA vs 401(k) plans, and you’ll soon find that the jury is always out. Some people absolutely love IRA’s over 401(k)’s, while other people will fight tooth and nail to convince you that the opposite is true.
With so many differences of opinions, who’s right and who’s wrong? And what are you supposed to believe?
In this post, we’re going to skip past all the boring, recycled facts about retirement planning and get straight to the point of addressing the big question: Should I put money in a 401(k) or IRA first?
By the end, you’ll have a better understanding of what questions you need to first ask yourself, and how your answers will shape which plan is truly the best place for you to save your money.
First Thing to Know – Either is a Good Choice
Before anything else, let’s address the first question regarding eligibility for the retirement plans.
It will be helpful for you to know that it’s very common for most middle-class Americans to be able to save their money in both an IRA and 401(k). Generally for:
- A 401(k) plan, your employer simply has to offer one.
- An IRA, you get set this up yourself with any major financial service provider (and is no harder to do than setting up a regular bank account).
To be sure if you qualify due to your income level or employment status, you can check the IRS requirements at this link here.
Above all else, both a 401(k) and IRA are a great choices for your retirement savings 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!
So given the choice between the two retirement plans, where’s the best place to start?
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.
Bottom line: If you’re employer offers 401(k) matching, you’re definitely going to want to start contributing to the 401(k) plan. Contribute as much as you need to in order to get the full matching benefit!
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, route the remainder of your savings into your IRA.
3- How Much Do You Plan to Contribute?
After fees, the next topic to consider is how much money you plan to save every year.
For most people only saving about 10 percent of the median Amercian income of approximxatley $60,000, this works out to $6,000 per year. So points 1 and 2 above are enough to take care of this.
But what if you earn more money than that, and therefore have more money to go around?
What if you’re a super saver, and you go above and beyond your peers by saving 25% or even 50% of your income in an effort to hit those financial freedom goals much sooner?
This is where the IRA’ will fall short. Although it’s great for flexibility and usually lower in fees, the maximum amount you can contribute is quite a bit less than your employer plan.
As of 2020, the maximum annual contribution you can make to an IRA is $6,000. That’s not nearly as much as the $19,500 you’re allowed to stash away in your 401(k). Even if you plan to put money in both your IRA and your spouse’s IRA, that’s still only $12,000 altogether.
Plus, remember the first thing we said: Both plans are good because they offer tax-deferment. Regular brokerage and savings accounts with after-tax money can’t do that.
Therefore, you’re going to want to go back to your 401(k) and start increasing your contribution levels.
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 building up your nest egg, you’re going to want to max out your retirement savings accounts 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
I don’t think you really get a choice. The money you’ve allocated to go into your 401(k) will go right in. You’ll never see that money in your wallet and never get a chance to decide.
Personally, I don’t think there’s any reason to touch an IRA unless you’ve already maxed out your 401(k), you have excess savings and you’d rather lower your taxable income, or you recently received a small cash windfall and you’d rather put it away long term rather than paying taxes on it.
I myself don’t have an IRA, but I contribute 25% of my paycheck to my 401(k). If me and my business partner decide to dissolve a business that we own (that we haven’t done anything with in a long time), then I’ll be getting roughly $6,000 that most of will go into an IRA.
Ultimately, it really doesn’t matter where you save that long term retirement money as long as you save as much as you can.
ARB–Angry Retail Banker
There could potentially be a difference between an IRA and a 401k in regards to asset protection. That might be something to keep in mind.