Monday, August 18, 2008

401k vs. IRA: Deciding the Best Way to Save for Retirement

I have been giving my future a great deal of thought as I face the reality that my life is bound to take a dramatic shift next fall as I graduate grad school and enter the "real world." I have been taking a look at my offer packet from the firm I will be working for and, like anyone, have taken great interest in the section entitled "Employee Benefits." This is the part where my eyes, glazed over from reading the dry code of conduct section, perk up. (This must be why they call them "perks").

I was pleased to see that my future employer offers a 401k retirement plan. But, having learned a great deal about IRAs, I often wondered which would be the better choice for me to invest in going forward?

I thought I would share what I have learned.

401k vs. IRA

-Employers often offer matching contributions to your 401k. For instance, my company offers 25 cents on the dollar for up to 6% of the employee's salary. Many company's will offer more. That is free money! (IRAs do not have this benefit)

- You can borrow money from your 401k without penalty, as long as you pay it back. (You cannot do this with an IRA)

- Typically, IRAs offer a wider variety of investment options than 401ks.
- IRAs allow you to readily open and close positions in various investments, 401k plans often only allow you to switch investments once every 3 months

- Some mutual funds will forgo their typical sales fee when investing through a 401k.

- As far as tax deductions go, 401ks and IRAs are equal, although many are confused by this.
- As discussed in my previous post, with a Traditional IRA any allowable contribution is tax deductible. In the case of a 401k, any money contributed (up to its annual limit of course) is automatically taken out of your paycheck, thus reducing the taxable income that is reported on your tax return. Therefore in effect, both are giving you a tax break on your contributions.

- The annual contribution limit for 401ks are higher than that of IRAs. In 2008 the annual limit for IRAs was $5,000 and the limit for 401ks was $15,500.
- Note: This fact could be misleading as sometimes employers place limits on employee annual contributions as well. For example, your employer could limit your contributions to 10% of your salary. If you make $50,000, then your limit would be $5,000, which then proves no benefit over the IRA.

Bottom Line:
If given the choice, invest in a 401k, as they offer more advantages to IRAs.

Free Advice :

1) Diversify your investments (do not invest solely in your company's stock, even if your plan is with your firm. It will not impress them. Lack of diversification violates the #1 principal of prudent investing)

2) At a minimum, contribute the contribution amount that your employer will match (there is no reason to turn down free money)

4) If you have the option of investing in a 401k. Do it.

NEXT: What happens to your 401k plan when you leave your employer?


Brad Wrage said...

Excellent post! Tons of info here. I foresee a book in the making.

Bruce said...

I would also suggest an investment of 15% on top of the free advice. Savings, Stocks, and on and on.