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InVESTING MADE SIMPLE

IRA or 401(k)?

By David S. Reinders, CFP
Sound Mind Investing

CBN.com"If I can afford to contribute to either a 401(k) or my IRA but not both, which should I choose and why?" The question is a common one, and the answer depends on your specific situation. One is not inherently better than the other. Both provide tax-deferred growth, and traditional IRAs have the same tax deductibility as 401(k)s.

However, there are differences that should be considered in determining which option makes the most sense for your particular situation. Let's take a look at these differences.

Control

With an IRA, you are in control. You control which financial institution your IRA is with, if you want to move it, and where you would move it to. With a 401(k), these decisions are at the sole discretion of your employer. Here, the advantage goes to the IRA.

Investment Options

IRA's are not investment specific—many different types of investments are allowed within them. Your investment choices usually depend on the financial institution you place your IRA with. For example, if you open your IRA with a bank or savings institution, you'll likely end up in a savings account or CD. These are typical bank products, and will usually return about 5% per year.

If you open it with an insurance company, you may end up in a fixed or variable annuity. These are the products that insurance companies manufacture. A fixed annuity is low risk and a typical return might be 6%-7%, depending on market conditions. Variable annuities have sub-accounts that are managed like mutual funds; however, due to the higher fees, the net returns to investors are not quite as good. For most people, opening an IRA with a bank or insurance company is probably not the best option.

If your IRA is with an investment company, like Fidelity or Vanguard, it will likely be in mutual funds. Investments in a 401(k) plan are usually also in mutual funds. While the stock market generally averages about a 10%-12% return, performance can vary widely, so be careful in picking your investments.

In terms of investment options, neither the 401(k) nor IRA is a clear winner, as both can be invested in mutual funds and get market returns.

However, while a 401(k) plan may offer only 6-10 different investment options, with an IRA your options can be virtually unlimited depending on what provider you use. The IRA is clearly more flexible, as you could have a much wider selection of funds to choose from.

Rules of the Game

The rules for participation, contributions, and withdrawals are what truly distinguish an IRA from a 401(k). Much has been written about the strengths and weaknesses of the three types of IRAs—deductible, non-deductible, or Roth, so we won't focus on that here. Just realize that your 401(k) vs. IRA comparison can change dramatically depending on which type of IRA you are eligible for. (Relatively few workers have access to the new Roth 401(k) plans at this point, but as they become more widely available, they'll add another element to the 401(k) vs. IRA debate. Check out the Roth 401(k).

If your employer offers a 401(k) plan, you can participate, provided you meet the eligibility requirements of the plan. These requirements usually include age, length of service, and number of hours worked, to name a few. Contact your plan administrator for details regarding your specific plan.

So far IRAs have held the upper hand in our comparison, but here that begins to change. One major advantage of the 401(k) is that you are generally able to contribute 15% of your pay, up to $16,000 per year in 2008. With special "catch-up" contributions, people age 50 or above can add an additional $5,000 for a total of $21,000. Compare that with the maximum $5,000 contribution allowed for an IRA in 2008, with a $1,000 additional catch-up for those 50 and above. If you have serious saving to do, 401(k)s offer a clear advantage here.

The trump card of the 401(k) plan is employer matching. Not all employers match contributions, but those that do offer a huge benefit. For example, if your employer matches 25% up to 3% of your compensation, that means that your employer will add $0.25 for every dollar you contribute up to that earnings limit. That means that you are immediately 25% ahead, an advantage that clearly tips the scales heavily in favor of the 401(k). If your employer's 401(k) has any type of matching, you should always try to contribute at least enough to take full advantage of the matching provision. Only after you've reached the matching ceiling should you consider an IRA alternative. Also, make sure you understand any vesting rules that may apply to the matching funds in your 401(k).

Two other advantages of the 401(k) include the ability to borrow against it in most plans, and the favorable creditor protection it provides. While generally it is a bad idea to borrow from your 401(k), and it is not advised except in a true emergency, it is still an advantage, as you can access the money without paying penalties.

With an IRA, there is no borrowing provision, and early withdrawals are hit with a steep 10% penalty. Also, if truly bad times were to hit, many states allow creditors to take your IRA assets, but not your 401(k) money.

Regarding withdrawals, both are subject to premature distribution penalties of 10% if taken out prior to age 59½. For example, if someone withdraws $20,000 prematurely from their IRA, the tax penalty will be 10%, or $2,000, plus federal and state income taxes. Someone in a high federal tax bracket in a state like California may end up paying 45% to 50% of the amount withdrawn for penalties and taxes.

However, with a 401(k) plan, there are often hardship provisions such as death, disability, or severe financial hardship, in addition to the loans mentioned above. Check with your plan administrator for the details of your plan. 401(k) plans are often a bit more flexible in this regard. (Roth IRAs are a little more flexible in this regard.)

Summary

When deciding between your 401(k) and an IRA, make sure you have all the facts about both your employer plan and the IRA options available to you. If your plan has a matching provision, you'll almost always want to focus there until you reach the matching limit, regardless of the specific investments offered by the plan.

If no matching is offered, or for contributions made beyond the matching limit, look at the specific investments offered within the plan. Do they meet your investment needs, or do you need the flexibility of an IRA? Does your company plan only offer load funds? If so, you will likely want to maximize your IRA options outside the plan to avoid these fees.

This decision is not an "all or nothing" proposition. For many, the best course may be to contribute to your 401(k) up to the matching limit, and then fully fund an IRA. If you have the ability to save even more, additional contributions to the 401(k) would be in order. Both are excellent tools to help you reach your retirement goals, and can be used in combination as your financial circumstances change.


In our Sound Mind Investing newsletter, we try to regularly emphasize why we are here serving you in this way: We want to help you to have more so you can give more to share the good news of Christ's love with the world.

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