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IRA vs 401K: How and When to Choose Each

Choosing between an IRA vs 401K isn’t a matter of either-or but how to have both

Saving for retirement is an alphabet soup of confusion. Between IRAs, 401Ks, Roth IRAs and the dozen other investing acronyms, it’s a wonder anyone does any saving at all.

But in all that confusion and different ways to save are some huge opportunities for tax-free investing. In all the years I worked private wealth management, it was knowing how to get around taxes that made the rich much of their money.

There are distinct advantages and disadvantages in each of the retirement accounts available. Getting the most from your money means gaming the system to get the advantages in each without limiting yourself on the disadvantages.

I’ll start off with a quick explanation of each type of account, 401Ks and the IRA, before describing the differences between the two and how to choose the right mix. Then I’m going to reveal the strategy I use to max out my retirement investing and save thousands in taxes.

which is better 401k or ira
Which is Better? IRA vs 401K

What is a 401K?

A 401k is a retirement program set up between your employer and a plan administrator, usually a large investment firm. The plan administrator provides a list of funds in which employees can invest and then manages all the reporting.

Your employer will set some important details of the program including the matching policy and vesting schedule.

The matching policy determines how much the company will put into your account based on how much you invest. For example, your company will put in half the amount you contribute up to 3% of your salary each year. If you have a salary of $36,000 and contribute $1,080 (that’s 3% of $36,000) then the company would contribute $540 into your account.

That’s actually the most typical matching policy, a 50% match up to 3% of your salary. Some employers are especially generous, matching 100% of your contributions up to three- or five-percent but that’s an exception rather than the norm.

Understand, your company’s matching policy has no effect on how much you can contribute. You can still put in the maximum $19,000 (2019) into your 401K. The matching policy only affects how much your company will put in on your behalf.

The other important detail your company decides is called the vesting schedule. This determines when and how much of the employer match you get to keep if you leave. You will always get to keep 100% of the money you put into your 401K from your salary and any returns on it. The vesting schedule determines how much of your company’s money you keep.

Let’s look at an example 401K vesting schedule to explain it.

example vesting schedule 401k
Example Vesting Schedule 401K

There are two types of schedule here. Which applies to your 401K plan will be up to your company. In the ‘cliff vesting’ example, you only get to keep any of your company’s match contributions if you stay more than two years. Upon your three-year anniversary, if you decide to leave the company, you’ll take 100% of the employer contributions in your account.

The ‘graded vesting’ schedule is more common. You usually get the right to some of your employer’s contributions earlier compared to the cliff vesting schedule but you have to wait longer to be entitled to 100% of the contributions. For example, if you left your employer after working four years, you would take with you 60% of the contributions the company put into your account over the period.

There are two important points to remember here. First is that even though you might not have ‘vested’ or have the right to keep your employer’s contributions yet, those contributions are still being made according to the 401K matching policy. Even someone in their first year of service, if they are contributing to the program, their employer will be making matching contributions.

So there are employer contributions in your account even if you don’t have the right to them yet.

The second point is that you might want to check your company’s vesting schedule before you turn in your notice. If staying with the company for another few months means taking tens of thousands of dollars in employer contributions with you…wouldn’t that influence your decision?

When you become eligible for your company’s 401K plan, you’ll fill out some paperwork and select one of the plan administrators available. According to how much you decide to contribute, usually a percentage of your salary, that amount will automatically be deducted every paycheck and go into your account. You won’t pay taxes on it and your employer will contribute its match.

More 401K Articles You’ll Want to Read:

What is an IRA?

An individual retirement account (IRA) is a self-directed account, meaning you set it up with an investment broker or online platform. Your employer has nothing to do with your IRA and won’t be contributing to it.

You can open as many IRA accounts as you like. In fact, I have retirement accounts on three different investing sites including multiple types of accounts (IRA, SEP IRA and Roth IRA) on a single website. You can invest your IRA money in any investment available on the platform including stocks, bonds, mutual funds, ETFs, Options and even futures.

The fact that you set up multiple IRA accounts doesn’t change the maximum amount you can contribute each year though. You’re only allowed to contribute up to $6,000 (2019) into your IRA each year. That means $6,000 into one or as many accounts as you like but the total cannot exceed that amount.

You get a deduction from your income equal to the amount you contribute into an IRA each year. Since you withheld income taxes on your paycheck on the amount you contribute, this might mean you get a refund. You reduce your taxable income by the $6,000 contribution so you didn’t owe taxes on that amount afterall.

More IRA Articles You’ll Want to Read:

What’s the Difference Between an IRA and 401K?

Those are the basics of an IRA and 401K but what are the differences between the two programs? What are the pros and cons of each and how do you choose between them?

The biggest difference is that nobody is contributing to your IRA except you. That employer match into your 401K is like free money, something you won’t get with any other savings plan.

If that makes a 401K plan seem like a no-brainer, hold up. There’s a big benefit to IRA accounts as well.

With an IRA account, you get maximum flexibility to invest in whatever you like. In fact, some IRA plans will even give you a checkbook to invest in assets not available on the platform. For example, you might invest your self-directed IRA into a direct property investment.

You don’t get that flexibility with most 401K accounts. Most plan administrators limit the choices to a group of mutual funds managed by the investment company. Even if they allow investment in exchange-traded funds, it’s usually a shorter list than what you would find on an investing platform.

How much you can contribute to your 401K or IRA accounts is also a big difference. The current contribution limit for IRAs is $6,000 while you can put in as much as $19,000 (or 100% or your salary) into your 401K plan. Remember, putting more than the company match max into your 401K doesn’t get you any extra employer money, but you’ll still get the tax benefit on the money you contribute.

The final difference is that you have to decide what to do with your 401K when you leave your employer. You can either leave it with the investment company, roll it over into another 401K at a new employer or roll it into an IRA account.

You don’t have this decision with an IRA because it is always in your personal account. Your employer has nothing to do with it so leaving your job has not affect.

Is it Better to Have a 401K or IRA?

Given the choice, if it was totally either-or, I would say go with your company 401K. That employer match makes it a no-brainer. That’s free money you’re getting from your company in the match…why would you not take it?

But choosing between a 401K or IRA is rarely an either-or decision.

There’s nothing legally keeping you from having both types of retirement account. The only limitation is usually how much you have available to invest from your paycheck.

In fact, in 99% of the cases when people ask me which account they should have, my response is, “You should have both.”

Pros of 401K Investing

  • Employer match into your account
  • Comes automatically from your check

Cons of 401K Investing

  • Limited selection of funds
  • Vesting schedule means you may have to wait to have right to employer contributions

Pros of IRA Investing

  • Maximum flexibility in investment choices
  • No need to transfer account when you leave your employer

Cons of IRA Investing

  • No employer match
  • Your responsibility to invest the money and get the deduction on income taxes

How to Choose Between an IRA and 401K

Given the great benefits in each account, the question of choosing which to use becomes how to get the most from each. To answer that, you only have to determine how much total you have available to contribute to retirement investing.

Let’s look at three scenarios and how they determine the IRA vs 401K choice:

(Scenario 1) You cannot afford to max out your company match in the 401K plan. For example, in our $50,000 salary example and a 3% limit on the employer match, if you can only afford to contribute $900 instead of the full $1,500 then you would invest as much as possible in your 401K.

Invest as much as you can up to your employer match policy into your 401K account!

This gives you all the free money possible through that employer contribution. I don’t care if your name is Warren Buffett or Peter Lynch. You will never make a better return than getting that free money from the employer match!

(Scenario 2) If you can max out your employer match contribution. For example, you can contribute the $1,500 in our example above and still have some money you want to invest. The best option here is to max out your employer match and invest the rest into an IRA plan on a separate investing site.

Max out your employer match then invest the rest of your money available into an IRA.

This gets you the maximum ‘free’ money available from your employer. They aren’t going to contribute any more above the match policy. It also gives you maximum flexibility investing in the IRA account and possible access to lower-cost funds.

(Scenario 3) This last scenario is one in which you have enough available to max out both your 401K match and the contribution limit into your IRA. Keeping with our $50,000 salary example; that would mean contributing the $1,500 to max out your employer match and the $6,000 limit on annual IRA contributions…and still having money left over to invest.

Max out your IRA contributions and invest the rest into your 401K (up to the limit)

While you won’t get any more employer match beyond that 3%-of-salary limit, you will still get an income tax deduction up to the $19,000 contribution limit. That means an instant return on your money depending on your income tax rate.

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My Retirement Account Strategy to Maximize Savings

Most people will find themselves in second scenario above, not able to max out their IRA and 401K limits.

Using our example of a $50,000 salary and the 3% employer match limit, that means $7,500 total contribution into an IRA and 401K. That’s 15% of the pre-tax salary which is more than most people have available to invest. Some experts recommend trying to get to saving 20% of your income but just maxing out the employer match and your IRA limit will put you ahead of the vast majority of savers.

I’ve got a special twist on this IRA and 401K savings strategy, one that will also give you maximum income in retirement.

It starts with maxing out your employer match and putting as much as you can into an IRA, up to the limit. Then every few years, you convert some of your IRA money into a Roth IRA account.

The Roth IRA is different in that you don’t get the instant deduction off your income taxes but all the money you withdraw is tax-free in retirement. When you convert money from an IRA into a Roth account, you have to pay taxes on the contribution but will never pay taxes on any withdrawals.

The process to convert money into a Roth IRA is easy. If you have the IRA and Roth account on the same investing platform, it’s basically just a one-click transfer between accounts. You’ll get a tax form at the end of the year to tell you how much income you need to declare in the transfer.

This strategy gives you maximum flexibility in your retirement income. The money you withdraw from your 401K and IRA accounts will count as taxable income. The money withdrawn from a Roth account is 100% yours with no taxes owed.

This means you can manage how much you withdraw from taxable and non-taxable accounts to limit the amount of taxes you owe each year. For example, if your spouse is still working then your taxable income will be higher and you may want to take money out of your Roth IRA. In years when your taxable income is lower, you can withdraw from the 401K or IRA and let the Roth money grow.

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Deciding on a retirement investing strategy and between an IRA vs 401K can be confusing. I planned on writing a quick article and it turned into a 2,000+ speech without going into every detail. Taking the time to understand the differences in retirement accounts will save you thousands though and make your money grow faster. With just a little study, all the advantages in 401Ks and IRAs can be yours without any of the disadvantages.

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