"If I'm eligible to contribute to both an IRA and a 401(k), which should I choose and why?" The question is a common one. The answer depends on a number of factors that we'll explore in this article.
Before you can make a good decision about which retirement-funding vehicle is best for you, be sure you're truly ready to invest. The prerequisites: using a household budget; carrying no debt other than a reasonable mortgage (less than 25% of monthly gross income to cover the mortgage payment, property taxes, and insurance); and having an emergency fund able to cover three to six months' worth of essential living expenses.
One possible exception to the no-debt prerequisite is student loans. Typically it's best for accelerated payments on a student loan to be a higher priority than investing. But if your employer offers some level of match on what you contribute to a workplace retirement plan, here is a good approach: Contribute just enough to your workplace plan to get the match, then use any additional surplus to pay down the student loan.
Assuming these steps have been taken, the next step is to determine how much to contribute to a retirement plan. Use a simple calculator such as Fidelity's myPlan Snapshotfor some ballpark figures, or run a more detailed analysis using SMI's Retirement Planning Calculator.
Let's say you decide to set aside 10% of your income for retirement. Now you're ready for the 401(k) vs. IRA decision.
The first question that will help you make the best decision is whether your employer offers a match on a portion of what you contribute to a 401(k) plan. If so, that's the easiest money you'll ever make, so don't miss out! In a common scenario, an employer may contribute 50 cents or a dollar for every dollar you contribute up to 6 percent of your salary.
You could choose the most conservative investment option available in your plan (not that we advise doing so) and still be guaranteed a 50% to 100% return on your money! So if a match is available, contribute the full amount eligible for the match. In the above scenario, that would be 6 percent of your salary. Some 401(k) plans have vesting rules that restrict access to the money contributed by the employer until after you've worked for that employer for a certain number of years, so be sure to investigate any such rules.
What about the remaining 4 percent that you plan to invest? In most cases, we suggest putting that money into an IRA. SMI recommends opening an account with Fidelity, Schwab, or Scottrade if you plan to follow our Fund Upgrading or Dynamic Asset Allocation strategies. If you plan to implement SMI's Just-the-Basics strategy, Vanguard is our top recommendation.
First though, you need to make sure you are eligible to contribute to an IRA. No income restrictions exist regarding who can contribute to a 401(k), but there are restrictions on who can contribute to an IRA, especially if you are covered by a workplace plan (you are considered to be covered if either you or your employer contributes to the type of plans we've been discussing, or you are eligible to participate in a defined-benefit/pension-style plan).
Here's the current rule: If you are covered by a workplace plan, a fully-deductible traditional IRA contribution is allowed for married people filing jointly only if their 2013 modified adjusted gross income (MAGI) is $95,000 or less. For single people, the MAGI has to be $59,000 or less. The amount of the contribution phases out at higher incomes, and it completely disappears for married couples filing jointly with an MAGI of $115,000 or more and for singles with an MAGI of $69,000 or more.
A Roth IRA has no restrictions tied to partipation in a workplace retirement plan, but there are income-related restrictions. To qualify, your modified adjusted gross income (in 2013) needs to be less than $178,000 if you are married and filing jointly, or less than $112,000 if you are single. Here, too, there is a phase-out provision, with eligibility completely phasing out for married couples filing jointly with MAGI of $188,000 or more, and for singles with MAGI of $127,000 or more.
Assuming you qualify, the primary reason to switch from a 401(k) to an IRA for additional retirement savings is flexibility. An IRA offers virtually unlimited investment choices, whereas a 401(k) typically offers relatively few. Even if your 401(k) offers a "brokerage window," which usually provides access to the same wide range of options, you may want to opt for an IRA due to the fact that many 401(k) plans charge higher fees than you'd pay in an IRA.
If your workplace plan does not offer a match, the decision is even easier. Start with an IRA for the reasons mentioned above—more investment choices and lower fees. However, you may not be able to contribute as much as you'd like to. The IRA contribution limit for 2013 is $5,500, with an additional $1,000 "catch-up" amount allowed for anyone age 50 or older. Naturally, you can—if you're married—effectively double these amounts by opening IRAs for both you and your spouse. But if you max out your IRA options and want to invest more, you can then turn to your 401(k) plan, where the contribution limits are far more generous. In 2013, 401(k) plan participants (as well as participants of 403b or 457 plans, which cover non-profit and government employees) can contribute $17,500. Those over age 50 may add another $5,500.
What if you need access to your retirement money before you reach retirement age? With a 401(k), many plans allow you to borrow a portion of your balance and then pay yourself back with interest. However, beware that if you leave that employer for any reason, the full loan must be repaid, usually within 60 days. Hardship withdrawals are also allowed under certain circumstances, but will incur a 10% IRS penalty and, with a traditional 401(k) (as opposed to a Roth), you will also have to pay income taxes on the money. In addition, you may not be allowed to contribute to the plan for the next six months.
You cannot borrow from an IRA. If you take money out before age 59½, you will incur a 10% IRS penalty and, with a traditional IRA, you'll have to pay taxes on the money. Penalty-free (but not tax-free) withdrawals are allowed for certain hardships, qualified education expenses and first-time home purchases. One significant advantage of a Roth IRA is the ability to take out contributions (but not earnings) at any time without having to pay taxes or penalties. This allows Roth IRA contributions to serve as a backup emergency savings fund, though it's wise not to use this feature except in a true emergency.
You should never put money into a retirement plan unless you expect to be able to leave it invested until retirement. Still, it's wise to know the early-withdrawal rules just in case.
As you can see, the decision of whether to utilize a 401(k) plan or an IRA is not necessarily an either-or proposition. Both are excellent tools to help you reach your retirement goals, and they can be used quite effectively in combination.