Funding your 401k vs. an IRA - Five Questions to Ask

Many workers have access to both a 401(k) and an IRA and the question comes up “which one should I fund?”

While the answer is often nuanced (like everything financial planning) and will not be the same for everyone, understanding some of the basic differences and pros and cons of each account can help you sort it out. Asking yourself these five questions can help you determine where your next dollar of retirement savings should go.

An important point – all of these comparisons assume that saving for retirement is something you have decided you should be doing now. While for most workers the decision to save for retirement is a resounding “Yes! (obviously)”, in some instances we may need to prioritize something like the need to payoff debt before putting money away for retirement.

We also don’t tackle the “Traditional vs Roth contribution” decision here, which is a broad topic that deserves its own blog.

1. Does your employer offer a 401(k) match?

The 401(k) match, or the ability for your employer to kick in “extra” money if you choose to contribute to the 401(k), is not something available in a Traditional IRA or a Roth IRA. Most of the time, you should take the free money. Let’s say you put in 3% of your salary, and your employer then also puts in a match equal to 3% of your salary. You have instantly doubled your 401(k) contribution and have that much more to invest.

Even if your 401(k) plan is not ideal with limited or expensive investment options, if it offers free money we may have to hold our nose and contribute at least enough to get the match.

2. How much do you plan to contribute?

There are limits on the amount you can contribute to both 401(k)s and IRAs, and the limits are very different.

For Tax Year 2021

The 401(k) allows for significantly higher contributions for those with the income to afford it. Even if the 401(k) investments are lacking or are not necessarily best in class, it may be our best option for significant tax-advantaged savings.

But what if you’re planning on contributing a smaller amount, $5,000 annually for example. If your employer’s 401k does not offer a match, or if you’ve met that match and want to look elsewhere for investments, an IRA may offer a wider selection of low-cost investments and more flexibility in accessing funds in an emergency.

3. How much money do you make?

Great news for high income earners: there is no income phase-out of 401(k) contributions like there is for IRA contributions. High income earners can contribute the maximum allowed to their employer plans without the risk of ineligible contributions.

For Traditional IRAs the rules are complicated. If you and your spouse both are not an “active participant” in an employer retirement plan there are no income limits on deductible IRA contributions. If you or your spouse is an active participant in an employer retirement plan your ability to deduct your Traditional IRA contribution is phased out at various income levels found here for active participants and here for spouses of active participants.

This gets more exciting if you have decided Roth contributions are the best option for you. Roth IRA income phaseout ranges for modified adjusted gross income (MAGI) are below. If your income is between the two numbers, your maximum allowed contribution is reduced. If income is above the phase out range, you are not allowed to make a Roth IRA contribution.

A single tax filer making $150,000 could have their ability to make a Roth IRA contribution eliminated, but if their employer offers a Roth 401(k) option, they could contribute up to the full $19,500 in Roth dollars if they chose to do so.

4. How disciplined are you?

401(k) plans offer the advantage of an automatic deduction right from your paycheck. Once you have enrolled and set your contribution rate you don’t need to think about saving the money, it’s done before your paycheck even gets to your bank account.

With an IRA – you must take the initiative to save the money. Are you disciplined enough to make your IRA contributions on a monthly or annual basis?

5. What are the 401(k) plan fees vs. the IRA fees?

Some 401(k) plans are great. Large plans offered through large employers, with hundreds of millions of dollars in assets across thousands of employees can secure rock bottom administration and investment expenses. Other plans can be quite costly. If your plan is smaller in size, or just happens to contain unnecessarily expensive investments, you might want to start thinking about an IRA.

At many firms an IRA can be opened with upfront expense and no maintenance fees. Furthermore, many well known brokerages allow you to buy and sell stocks, exchange traded funds and some mutual funds with $0 commission charges. If keeping costs down is a priority for you, an IRA may be your answer if your 401(k) provider is taking too much off the top.

Finally – maybe you should contribute to both

Investing in a 401(k) or an IRA doesn’t have to be an either/or decision. There is no problem putting money in both, as long as you keep an eye on the IRS rules around contribution limits, deductibility and eligibility. Here are a couple examples where someone may use both vehicles.

• A single taxpayer making $80,000 contributes 4% of their salary ($3,200) to their 401k to get the full employer match, and then $6,000 to a Roth IRA.
• A married taxpayer with household AGI of $175,000 maxes out their 401(k) by contributing $19,500, then contributes $6,000 to a Roth IRA.

Reach out to your financial planner for analysis on whether maxing your 401(k) or your IRA is the way to go. Schedule a free, 30 minute Get to Know You meeting to talk more about your specific situation and how we can work together.