Which Retirement Account Should I Invest In?

For people who are contemplating their investment options, what retirement account should they use?  An IRA or a 401K?  We will discuss the merits of both and arrive at a conclusion.

Some Background

For Individual Retirement Accounts (IRAs), there are two types:

• Traditional pre-tax or tax deferred IRAs.
• Roth or post-tax IRAs.

• Traditional pre-tax or tax deferred 401Ks.
•  Roth or post-tax 401Ks.

IRAs

With traditional IRAs, the money is not taxed in the year it is deposited into the IRA.  For most people, this means they get a tax deduction when they do their taxes.  Not when the money is deposited, but when they do their taxes which could be up to a year later.  The person would pay taxes on a traditional IRA when the money is withdrawn, typically at age 59 1/2 or later.

With a Roth IRA, there is no tax benefit in the year when the money is deposited.  But when you withdraw the money, there are no taxes on the original investment or the earnings.

In 2019, you can invest up to $6000 per year per individual into an IRA and an additional $1000 if the person is 50 years old or over.  Think of these limits as contribution limits.  This applies to both traditional and Roth IRAs.  If you contribute more than the contribution limit, it is considered an excess contribution by the IRA and is taxed at 6% per year until it is withdrawn or recharacterized.

Both traditional and Roth IRAs have income limits.  In the case of traditional IRAs, the limits determine if the contribution is tax deductible.  You can still contribute to a traditional IRA up to the maximum contribution limit if you are over the income limit, but the amount contributed is not tax deductible.  With a Roth IRA, the income limit determines how much you can contribute, as the contribution limit starts to decrease and go to zero at a certain income level.

See the IRA web site, https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits, for more information.

IRAs are not limited in how you invest the money.  It is up to you to decide and the investment company you are using.

401Ks

A 401K is typically provided by your employer and managed by an investment company.  The immediate advantage is your employer manages both your taxes and your 401K contributions, so if you are contributing to a traditional 401K, your taxes are reduced in each paycheck.

401Ks support traditional pre-tax, and some employers have plans that support a Roth post-tax 401K.

The biggest advantages of a 401K are:

• The limits for 2019 are $19,000 per year and an additional ‘catchup’ contribution of $6000 per year if you are 50 years or older.  Not all employers offer the catchup contribution.
• The employer offers matching contribution amounts, usually as a percentage up to a maximum percentage.  The contributions are subject to ‘vesting’ where you must work for an employer a certain number of years to earn the ability to keep the matching contributions.  Matching contributions are pre-tax.  The matching amount may be deposited per paycheck or at the end of the year, depending on the employer’s plan.

Let’ s suppose your employer offers up to 4% matching and you are making $100,000 per year, then you would earn $4,000 in matching money.  Free money, if you stay through the vesting period.

Some 401K plans have limited choices for investments.  They usually offer a limited choice of mutual funds and sometimes have restrictions of how often you can move money between funds.  Some 401K plans allow for self-directed brokerage accounts where you can buy and sell equities and other investments.  They usually do not support MLPs or options trading.

Which One to Chose?

It is pretty much a no brainer from a contribution perspective if you can contribute the maximum amount.  Always try to max out the 401K.  You want to save as much as you can, get the matching money, and invest for the long term by using low fee index funds.  The 401K allows the investor to save the most amount of money.  Almost every 401K supports low fee index funds, although you have to do your research since they are probably mixed in with high fee funds.

The higher contribution limits, higher catchup amounts, and the matching money of 401Ks will grow your retirement portfolio much faster.  Let’s do some math:

• IRAs allow $6000 a year and an additional $1000 when 50 or older.  Say you start saving at 30 and want to continue until age 60, so you can contribute 20 years at $6,000 or $120,000.  Then at 50, you start contributing $7,000 so for 10 years, so you would have contributed another $70,000.  $190,000 after 30 years, not counting compounding.
• 401Ks allow $19,000 per year and an additional $6000 when 50 years or older.  Using the same scenario, 20 years at $19,000 gives you $380,000, and 10 years at $25,000 gives you $250,000.  $630,000 after 30 years.
• Plus if you are making $100,000 a year and your employer pays 4% match, then you get $4000 per year for 30 years or $120,000.
• The total for a 401K could be $750,000 per year.

Probably the best approach for people with limited funds is to first contribute enough to the 401K to get the matching amount, then max out a Roth IRA, and then contribute more to the 401K up to the maximum.  If you (and your spouse) are under the income limits for a Roth IRA, you should contribute to the Roth IRA.  If you are over the Roth IRA income limit, then you could max out a traditional IRA and then roll it over into a Roth IRA.  There would be no tax deduction in this situation for the IRAs.

The biggest complaints about 401Ks are their fees and lack of investment choices.  I think this will have to change as the old style pensions are phased out and more people become educated on retirement investing and fees.  Fidelity and Vanguard are disrupting the retirement plan industry, and it is inevitable that the fees will come down.

Some other articles on this topic include:

• Why Should One Contribute Only Up to the Employer’s Max in a 401(k).
•  Is your 401(k) Enough for your Retirement?

 Summary

So you are contributing the minimum to your 401K to get the maximum matching amount from your employer, then what?