Administrative note: This article assumes that you’re familiar with the basic differences between a traditional IRA, a Roth IRA, and a 401(k). If you’re not, I’d recommend IRS Publication 590–it’s free, it’s written in plain-English, and it’s quite thorough. The only drawback is that it doesn’t provide any guidance for choosing between accounts.
IRA vs. 401(k)
If we set aside the tax differences for a moment, there are some other meaningful differences between a 401(k) plan and an IRA. Specifically:
- Your 401(k) may offer a matching contribution from your employer,
- Your 401(k) probably has limited investment options, and
- Your 401(k) probably charges significant administrative fees.
Employer Match: If your employer offers a 401(k) match, that’s a guaranteed, immediate, 100% return on your investment. Investment opportunities like that don’t arise very often. Don’t pass them up when they do.
Limited Investment Options: In most cases, 401(k) plans limit investment options to a pre-selected list of funds. Unfortunately, these lists are often populated with high-cost, actively managed mutual funds. In contrast, in an IRA, you’ll have access to low-cost index funds and ETFs.
Administrative Fees: A study done by the Investment Company Institute and Deloitte Consulting found that the median employer-sponsored retirement plan charges an administrative fee of 0.72% of assets. (That’s on top of the fees charged by the funds.) In contrast, most IRA providers don’t charge any admin fees at all.
Taken together, those three factors lead most investment advisors to suggest the following priority for retirement savings:
- Contribute enough to your 401(k) to receive the full employer match,
- Max out your IRA to take advantage of its lower costs and better investment options,
- Go back to your 401(k) and max it out, then
- Invest via taxable accounts.
Roth IRA or Traditional IRA?
If you’re eligible to contribute to either a Roth or a traditional IRA, the biggest deciding factor should be whether you expect your tax bracket during retirement to be higher or lower than your current tax bracket.
If you expect your tax rate to be the same: The commutative property of multiplication tells us that the ending value of your account will be the same whether you pay tax now (as in the case of a Roth) or later (as in the case of a traditional IRA).
That said, if you expect your retirement tax rate to be the same as your current tax rate, a Roth is generally the better choice for other reasons. Most importantly:
- Roth IRAs are not subject to required minimum distributions, thereby giving you more flexibility for planning withdrawals during retirement.
- Roth contributions (with the exception of amounts converted from a traditional IRA) can be withdrawn free of tax and penalty at any time.
If you expect a higher tax rate in retirement: It’s best to contribute to a Roth. Better to pay tax now (at a lower rate) than later (at a higher rate).
If you expect a lower tax rate in retirement: It’s best to contribute to a traditional IRA. Better to pay tax later (at a lower rate) than today (at a higher rate).
If you have no idea what to expect: Tax diversify. That is, do a little of both. Note: Many people do this without even realizing it when they contribute to a tax-deferred plan at work (to take advantage of a match) as well as to a Roth.
Have you opened your retirement account? Which one did you choose? What are the reasons you chose that type of retirement account? Tell us your story in the comments.
Mike as always a good insightful post. I would add one thing. Several studies have shown that the single biggest factor in retirement success is the amount saved. I agree that there are many 401(k) plans with high cost, mediocre funds. Even in such a plan, there are often one or two choices with enough merit to warrant participation.
If someone is going to go the Roth IRA route as mentioned in your post they need to have the discipline and the abiltiy to contribute on a consistent year-in and year-out basis. One great feature about a 401(k) plan is automatic payroll deduction feature. If their 401(k) has a Roth feature so much the better.
Roger Wohlner´s last post ..Its 2010 Now What?
Hi Roger.
As you know, I’m in complete agreement about the significance of how much you invest rather than just how you invest. And you’re right: Automatic contributions (whether to a 401(k) or IRA) are a great way to make sure you don’t fall short of your goals.
Mike Piper´s last post ..How to Choose ETFs for Your Portfolio
Thanks for the post Mike, it’s helpful as my wife and I plan on doing more investing this year. Currently I’ve got a 401k through my work that doesn’t have a match, and the investments available in the plan aren’t that great. So when we start investing this year we’ll be looking at Maxing out a Roth IRA, and then maxing out the 401k at my work..
Thank you for hosting my guest post, Peter. :)
Sounds like a good plan to me.
Mike Piper´s last post ..How to Choose ETFs for Your Portfolio
I don’t get a 401k or any program from work so set up my own Roth IRA and maxed it out and hopefully can do so in the second year to get a nice jump on it.
A very timely article for me as I’m working up my own retirement plan right now. I’m going your balanced approach of taking the match, IRA and then back to the 401k. Always sound advice Mike. I’m actually reading your book on Small Business taxes right now! Fantastic.
Hi Paul.
Thanks for buying one of my books and thank you for the compliment.
And just for reference, I’m always very interested to hear what readers think. So if you have any suggestions for improvement for next year’s edition, feel free to shoot me an email. :)
Mike Piper´s last post ..How to Choose ETFs for Your Portfolio
I continue to caution people that in today’s dollars it would take over $2M in pretax accounts at retirement to create enough income to top off the 15% bracket. If you believe Social Security will still be there when you retire, you should adjust this number to take it into account. Either way, this is a huge number. Average retirees now are nowhere near this. Are we in Lake Wobegon, where 20 or 30 years out we will all be well above average?
Indeed. That’s a big part of why all the talk about Roth conversions this year has made me somewhat uncomfortable. I worry that many people will go overboard with tax-free accounts rather than tax-deferred.
At the same time, given the ever-changing nature of tax rates, I see a benefit to tax diversifying. For example, for an investor aged 30 right now, how possible is it to predict with a meaningful degree of accuracy what tax rates and tax brackets will look like in 30-35 years?
Fantastic post.
I never thought about the fees associated with my 401k, since it is employer based.
Something to look into.
I recently converted a decent-sized traditional IRA to a Roth for the very reason listed in the post. I took about a $2000 hit in taxes last year, but I can’t imagine the money I’ll be saving in retirement.
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PBS did an interesting Frontline piece last year titled “The Retirement Gamble” in which they focus on 401k and mutual fund costs. Perhaps the most important issue that the video sheds light on is the power of compound returns (and conversely, fees).
Jack Bogle, the founder of Vanguard, gives the following example. Let’s say you invest in a fund that earns a 7% return over 50 years, but there is a 2% annual fee. At the end of 50 years, that 2% fee will have eaten away nearly 2/3 of your returns.
Personally, I think this up-front, lump-sum, 50 year investment analogy is unrealistic. But it does provide a simple example of how detrimental fees are.
I have a ROTH ira because 401 K is not offered.
I’m in a unique situation where I am a partner in a small consulting firm. In the past, my company did not have a retirement savings plan, so I maxed out my traditional IRA. For 2013, we set up a SEP IRA. Having maxed out my SEP, I wanted to put money into a traditional traditional as well. But when I started running preliminary numbers in TurboTax, I came to realize that my income allowed for only a portion of the traditional IRA contribution to be tax deferred. As a result, I will be going with a Roth this year.
In addition, I’m of the field of thought that some level of tax diversification is prudent. So putting a small portion of my retirement savings in a Roth seems like a good idea.