Prioritize Your Retirement Savings: 401k or IRA?

by Kevin on June 11, 2009

If you ever plan to retire — and I think we all do — you’ll need to save and invest some money during your career. The most popular options in terms of retirement accounts are 401k plans (through your employer) or Individual Retirement Accounts (IRA).

But which option is better? Should you put all of your money into the 401k first before anything else? Or should your 401k be your last option?

Prioritize Your Retirement Savings

Every one of you reading this article is in a different situation financially. My thoughts here are a general guideline — your situation may dictate your priorities be different. The idea here is there is an order of priority where you should set aside money. You start at the top and work your way down.

First: Your Employer’s 401k Up to Employer Match

Reasoning: Never turn down free money.

Many employers provide incentive to employees to participate in the 401k retirement plan. Some employers match 100% of what you save up to a certain amount, others offer a flat match regardless of how much you save, and others do a 50% match of whatever you put in. Generally we’re talking in terms of percentage of each paycheck or your salary — if you put in 6%, your employer will put in 3%.

Any way you cut it getting free money from your employer is the best return you can get. Your 401k may not have the best investment options or may have high costs. Yet these things can’t cut into a 50% match or 100% match enough to make you not want to get the match.

Free money. Don’t miss it.

Second: A Roth IRA or Traditional IRA

Reasoning: Better investment options and lower costs.

Let’s say your employer will match all of your 401k contributions up to 3% of your salary. You put in 3%, they’ll put in an additional 3%.

But what if you have enough room in your budget to save 10% of your salary every year? Should you put the rest of that money into your 401k?

I’m going to argue that your 401k likely is not the best place for that money. I would instead recommend putting the money into an IRA. What type of IRA (traditional or Roth) depends on your individual tax situation. If you earn a certain amount of money every year you may not be eligible to use a Roth IRA (which is funded with after-tax money). A traditional IRA works like a traditional 401k account — the money put into the account is pre-tax and lowers your taxable income.

Individual Retirement Accounts give you a lot of flexibility due to the large number of options available in the marketplace. You can get an IRA from all of the major fund companies — Vanguard, T. Rowe Price, etc. — as well as many brokerage firms and banks. You’ll need to be at least a little savvy to avoid high costs, but it really isn’t that difficult. The beautiful thing about IRAs is, assuming yours doesn’t come with any “account maintenance fees” or anything like that, then the only costs involved are your mutual fund expense ratios.  (For the record I recommend Vanguard and the low cost funds available there.)

Third: Max Out Your 401k

Reasoning: You’ve still got money left over and a 401k has a rather tall limit before it maxes out.

If you’ve put your initial 3% into your 401k and had money left over, put the rest into an IRA account. But what if you’ve got money left over after maxing out an IRA account (or two if you are married)?

You’ve got a couple of different options, but I would recommend going back to your 401k to max that out next. For 2009 the maximum amount you can set aside in your 401k is $16,500 (unless you are over age 50 — then the max is $22,000).

Why your 401k? Well, you’ve already got the account open, and your options after 401k and IRAs start to get slim and/or complicated.

Other Options: SEPs, SEP-IRA, Simple IRA, Solo 401k, Taxable Accounts, and Keogh Plans

Reasoning: You’ve still got money left over and need to put it into some sort of retirement account.

You’ve maxed out your 401k and an IRA account (or two if you are married). What options do you have left?

The answer as you might expect is it depends. If you don’t have any self-employment income (consulting, side business, etc.) then you’ll have to put the rest of your money into a regular taxable investment account with a bank or brokerage firm.

If you do have self-employment income you can sock the money away in several different accounts:

  • Simplified Employee Pension/SEP IRA
  • Simple IRA
  • Solo 401k
  • Keogh Plans

We won’t go into all the details about those types of accounts here. But if you’re to the point where you need to find another account to put even more retirement money after your 401k and IRA, congrats.

I’ve actually thought of using a SEP-IRA for my earnings from this blog since it is another pre-tax option. I haven’t made a decision on that just yet.

What are your thoughts on different retirement options?

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This past week’s PF reading » JoeTaxpayer
June 14, 2009 at 6:04 am


Lynn June 11, 2009 at 9:20 am

This year we are trying to put as much money in my husband’s 401K to maximize the tax benefits now. We have an income situation this year that disqualifies us from putting money in a roth IRA(large bonuses). I am frightened at what the tax situation is going to be next year so I am trying to max out his 401K to give us less taxable income. I have a Roth IRA that I have been contributing to and I thought about opening up a non-deductible IRA since I can’t contribute to the Roth. After looking at his 401K options, the fees are extremely low (.30%) and I just realized its better to get the tax break now.

Kevin June 11, 2009 at 8:37 pm

@Lynn: Good job keeping up with the tax situation. I’m a big fan of Roth-anything simply because in the long term I think taxes are going to go up. But if you need the tax breaks now, why not use them?

JoeTaxpayer June 13, 2009 at 2:28 pm

This reminds me of my own post titled 401(k) vs IRA deathmatch.

The expenses within the 401(k) account are key. The S&P fund in my 401(k) is at .05%/yr. On $100K, that’s $50, vs average of 1.12% or $1120.
401(k) accounts also allow loans, which can be a double edged sword, a nice second tier emergency fund, but not without risk.

Just a couple brief thoughts on this. Nice post.

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