401K or IRA? You Need Both

By Matt Bell on 7 July 2016 0 comments

There are two primary tax-advantaged ways to save for retirement. You could contribute to a workplace retirement plan, such as a 401K plan, or open an Individual Retirement Account (IRA).

But which one should you use? In some cases, the answer may be "both." Here are three considerations as you decide which plan(s) works for you:

1. Does Your Employer Provide Matching Money?

If your employer offers a 401K plan and matches some of the money you contribute, start your retirement savings there. That's the easiest money you'll ever make.

Under a typical arrangement, your employer may contribute 50 cents to one dollar for every dollar you contribute, up to 6% of your salary. Even at the low end, that's a guaranteed 50% return on your money. So, at very least, contribute the full amount that's eligible to be matched.

At that point, you'll probably have an important decision to make. You very likely need to contribute more than 6% of your salary in order to save enough for retirement. (Do you know how much you should save?)

If so, should you simply contribute more to your workplace plan? Or, would you be better off investing those additional dollars through an IRA? Questions two and three will help you decide.

2. Does Your Plan Have What You Need?

Does your workplace plan offer the right investment choices in order for you to follow your strategy of choice? This is especially important if your employer doesn't match contributions, since it means selecting low-cost investments likely to generate strong returns is even more important.

If you're keeping it simple by using a target-date fund, it may be fine to use your 401K exclusively for your retirement savings.

But what if you're following a more involved strategy — one that includes the use of a gold fund, for example — but your 401K plan doesn't offer the necessary investment choices?

This would be one good reason make use of an IRA, where you'll have access to a wide range of investment options.

3. How Much Do the Investments in Your Plan Cost?

Even if you're keeping things simple by using a target-date fund offered through your 401K, check on that fund's fees. In particular, find out what its expense ratio is. That's the percentage of the fund's assets deducted each year to cover fund expenses, such as management and administrative costs. If your fund has an expense ratio of .5%, that means for every $1,000 you have invested, $5 is going toward these expenses.

Expense ratios vary quite a bit from fund to fund. For example, Vanguard's target-date fund for people planning to retire in 2050 charges just .16%, whereas American Funds' 2050 target-date fund charges .76%.

That may not sound like a big deal, but let's say you now have $25,000 in your 401K plan, contribute $500 per month, and earn an average annual return of 7% before expenses, no matter which fund you choose.

After 35 years, if you had used the fund charging .16%, you'd end up with more than $1,080,000. If you had used the fund charging .76%, you'd end up with about $150,000 less.

So, if the type of fund you'd like to invest in is available for a lower cost outside your 401K plan, that would be another reason to consider an IRA.

Final Factors

Keep in mind that IRA annual contribution limits are much lower than 401K plan limits — $5,500 vs. $18,000 (or $6,500 versus $24,000 for people age 50 and older). If you contribute 6% of your salary to your 401K in order to take full advantage of your employer's match and then max out an IRA, it's possible you'll still need to invest more. So, head back to your 401K plan and finish out your retirement plan investing there.

Also, while a high income will not make you ineligible for your employer's 401K plan, there are income-based eligibility restrictions for IRAs.

There's much to be said for simplicity, but depending on how you answered the questions above, using your workplace plan and an IRA may turn out to be more profitable. Yes, it'll involve a little more work than investing in your workplace plan alone. But being able to follow your strategy of choice and avail yourself of investments with lower fees could pay significant dividends down the road.

So, which is it for you? 401K or IRA?

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