One of the most important things my father taught me about managing money is investing for retirement. Based on his advice, I opened an IRA at age 19 and have been investing ever since. When I first started investing, I was eligible for an IRA, but I was in the USAF and we did not have a 401(k) plan. It wasn’t until I was in for about two years that the military had an equivalent plan, the Thrift Savings Plan (TSP).
At that point, I wasn’t earning enough money to fully max out my IRA and contribute to the TSP. I had to decide which investment plan was the best for me. Since I didn’t receive a “company” match to my TSP, I chose to invest in a Roth IRA. (Why choose Roth over Traditional IRA?).
IRA vs 401k – Finding the Best Retirement Plan for You
In my current situation, I have a 401(k) plan with my employer, and I have the option of investing in an IRA plan as well. I face the same question a lot of people face: where should I invest my retirement funds – in a company 401(k) plan, or in an IRA? Let’s take a look at the pros and cons of both accounts, then you can use this information to make the best decision based on your needs.
Employer Sponsored Retirement Plans, including 401(k) Plans: There are a variety of employer sponsored retirement plans, including 401k, 403b, 457, 401a Plans, and Thrift Savings Plan. For continuity, we will use the term 401k. Please see the IRS page for more info on related retirement plans.
Company sponsored 401k plans are similar to Traditional IRAs as far as taxes go – contributions are invested before taxes are withdrawn, which can lower your adjusted gross income (AGI), giving you a tax break now. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal. There is also the possibility of investing in a Roth 401(k), although not all employers offer this option. The maximum annual 401k contribution amount is the same for both traditional and Roth 401k plans..
A distinct benefit in favor of 401(k) plans is a possible company match, which is essentially free money for employees. My current company offers a 401(k) match of up to 1.5% of my pay. It isn’t very much, but it is free money and I take advantage of every penny of it!
Individual Retirement Arrangement, or, IRA: There are two main types of Individual Retirement Accounts: Traditional and Roth. (I have chosen not to focus on SEP IRAs, SIMPLE IRAs, or other forms of IRAs as they are not applicable to everyone).
- Traditional IRA: The main benefit of a Traditional IRA is that the money can be fully or partially deductible, depending on your situation. The money is invested before taxes are withdrawn, which can lower your AGI, resulting in an immediate tax break. The invested money will be taxed when withdrawn at retirement age, and there are stiff penalties for early withdrawal (barring certain exceptions).
- Roth IRA: Roth IRAs are non-deductible, which means you use post-tax money to fund your account. However, the distributions made during retirement age are tax exempt, which is the main reason people invest in a Roth IRA. As with the Traditional IRA, early withdrawals may incur stiff penalties. Learn more about Roth IRA withdrawal rules here.
- For both IRAs: These are individual investments, meaning there are no company matches. There may be certain tax or eligibility restrictions for Traditional or Roth IRAs based on your income, filing, and marital status. The IRA contribution limits can also vary based on age and other factors.
Pros and Cons of 401(k) Plans and IRAs
401(k): The biggest benefit of a company 401(k) plan is the possibility of having your company match a portion of your contributions. Free money is something you shouldn’t pass up, especially when it will compound over time. On the downside, some company 401(k) plans may have a limited selection of funds to choose from or may have higher investment fees than you would have if you invested on your own. Your investment options will be limited to whichever funds are in the company plan, which can be detrimental if your plan consists primarily of funds with high expenses.
IRA: With IRAs, all investment responsibility lies with the individual. He or she must decide where to invest, how much to invest, etc. This can be overwhelming for some people, but there is always the option of paying someone to manage your funds. The benefit of controlling your investment is the flexibility of deciding where to invest: funds, stocks, bonds, ETFs, etc. the possibilities are limitless. The other benefits of IRAs include controlling your tax diversification options by investing in a Roth IRA for tax free withdrawals, or investing in a Traditional IRA to lower your AGI and current tax obligations.
Where Should You Invest?
Only one of these types of retirement plans involves the possibility of free money – the company 401(k) plan. If your company offers a match, it is probably in your best interest to invest in a 401(k) plan at least to the point of receiving the maximum company match. It is hard to pass up free money!
After you have put in enough money to get the match, I would consider investing in a Roth IRA if you are eligible. Roth IRAs are beneficial because you will be able to withdraw this money tax free in retirement. Doing this diversifies your future tax liabilities by having a taxable and non-taxable retirement funds.
If you have enough money to invest for the full company match, and max your Roth IRA, then you should consider investing more money in your 401(k) plan. This will ensure you maximize your retirement contributions, and diversify your tax obligations both now and in retirement.
On a personal level, I max out my IRA at the beginning of the year, using money from my savings account. Then I contribute to my 401k via payroll deductions. I contribute enough to get the company match and a little on top of that. My goal is to increase it until I can max out both my IRA and my 401k plans. My goal is to funnel as much money as possible into my retirement accounts while I am young and able to do so!
Always Research Your Investment Options Before Investing
These recommendations are based on common situations. You should always ensure your investment decisions are based on your needs and the amount of risk you are willing to take. The most important thing is to get started and keep investing. Your future is worth it!