401(k) or IRA? Where Should You Put Your Money?
by Jason Dean
Although there are other retirement plans for people in niche markets (Keogh plans for self-employed people; 403(b) plans for employees of not-for-profit enterprises), the 401(k) and Individual Retirement Account (IRA) are easily the most popular investment vehicles for retirement savings. These two plans are open to the vast majority of Americans who work for employers and have “earned income.” But with two plans, a pair of questions immediately come to mind:
- Which is the better plan?
- Can you have both?
Question #1 depends on your situation. First of all, while almost everyone with earned income is eligible to have an IRA, 401(k)s are employer-sponsored retirement plans, and therefore, they’re not available to self-employed individuals. If you own your own business and want to set up a 401(k) for yourself and your employees, speak with a financial-services representative, but you may find that an IRA can suit your needs just fine.
An IRA is just what the letters stand for — an individual retirement account. It is an account, not an investment — you put investments in it, just like you put money in your savings account. There are very few limitations to what you can put in your IRA: Stocks, bonds, mutual funds, cash, and almost any other investment product you can think of are eligible to go in your IRA.
There are two types of IRAs:
- Traditional IRAs
- Roth IRAs
Both types of IRA allow you to deposit up to $4,000 per year into your account, which you can then use to buy stocks, bonds, mutual funds, and other investments. The difference between the two types of IRAs is in their tax treatment: Contributions to traditional IRAs are tax deductible, while contributions to Roth IRAs are not. But when you reach Age 59.5 and begin making withdrawals from your traditional IRA, you have to pay taxes on the withdrawals as if they were income, whereas withdrawals from your Roth IRA are 100% tax free!
So now we have a new set of questions:
- Which is the better IRA, traditional or Roth?
- Can you have both?
Once again, the question of “which is better” depends on your situation. Many people need the tax deduction now, so they prefer traditional IRAs. But others prefer putting “after-tax money” into Roth IRAs and letting it compound, tax-free, until they’re ready to withdraw it at Age 59.5.
So can you have both a 401(k) and an IRA? How about a traditional IRA and a Roth IRA? All three? The answer: The only legally permissible combination of retirement accounts (at least those mentioned in this article) is a traditional 401(k) and a Roth IRA. You can’t have a traditional 401(k) and a traditional IRA, nor both kinds of IRAs. Sorry!
So let’s say you have the 401(k) and a Roth IRA combination: Where should you put your money? Well, the good thing about 401(k)s is employers often provide a matching contribution. Sometimes employers agree to a 100% match, and other times its as low as 50%. Also, they usually have a maximum they’re willing to match — i.e. 7% of your salary.
The conventional wisdom is you should always contribute up to the maximum your employer is willing to match — otherwise you’re throwing away free money. But once you reach your employer’s match limit, it is often a better idea to begin contributing to your Roth IRA instead. This is because the downside of 401(k)s is they offer a limited selection of investment products, determined by the administrator (i.e. Edward Jones or another financial-services firm) that’s been hired by your employer to manage your plan — you don’t get the total freedom that an IRA allows you, and you might be steered into making investments you otherwise wouldn’t.
In summary, here is some advice you can bank on:
- If your employer provides a contribution match, enroll in your company’s 401(k) plan. If your employer doesn’t provide a match, then you might want to skip the 401(k) and open either a traditional IRA or Roth IRA — but be sure to develop a savings plan and stick to it! One of the best things about 401(k)s is they’re automatic.
- If you have a 401(k) with an employer match, don’t even think about contributing to a Roth IRA until you have reached your employer’s match limit.
- Once you reach your employer’s match limit, put additional retirement savings in a Roth IRA.
- Develop a plan for savings and stick to it. The power of compound interest is an amazing thing. Saving just a little extra here and there can easily lead to a millionaire’s retirement, and with a Social Security crisis looming, there’s never been a more important time to save than now.