Administrative note: This article assumes that you're familiar with the basic differences between a traditional IRA, a Roth IRA, and a 401(k). If you're not, I'd recommend IRS Publication 590–it's free, it's written in plain-English, and it's quite thorough. The only drawback is that it doesn't provide any guidance for choosing between accounts.
IRA vs. 401(k)
If we set aside the tax differences for a moment, there are some other meaningful differences between a 401(k) plan and an IRA. Specifically:
- Your 401(k) may offer a matching contribution from your employer,
- Your 401(k) probably has limited investment options, and
- Your 401(k) probably charges significant administrative fees.
Employer Match: If your employer offers a 401(k) match, that's a guaranteed, immediate, 100% return on your investment. Investment opportunities like that don't arise very often. Don't pass them up when they do.
Limited Investment Options: In most cases, 401(k) plans limit investment options to a pre-selected list of funds. Unfortunately, these lists are often populated with high-cost, actively managed mutual funds. In contrast, in an IRA, you'll have access to low-cost index funds and ETFs.
Administrative Fees: A study done by the Investment Company Institute and Deloitte Consulting found that the median employer-sponsored retirement plan charges an administrative fee of 0.72% of assets. (That's on top of the fees charged by the funds.) In contrast, most IRA providers don't charge any admin fees at all.
Taken together, those three factors lead most investment advisors to suggest the following priority for retirement savings:
- Contribute enough to your 401(k) to receive the full employer match,
- Max out your IRA to take advantage of its lower costs and better investment options,
- Go back to your 401(k) and max it out, then
- Invest via taxable accounts.
Roth IRA or Traditional IRA?
If you're eligible to contribute to either a Roth or a traditional IRA, the biggest deciding factor should be whether you expect your tax bracket during retirement to be higher or lower than your current tax bracket.
If you expect your tax rate to be the same: The commutative property of multiplication tells us that the ending value of your account will be the same whether you pay tax now (as in the case of a Roth) or later (as in the case of a traditional IRA).
That said, if you expect your retirement tax rate to be the same as your current tax rate, a Roth is generally the better choice for other reasons. Most importantly:
- Roth IRAs are not subject to required minimum distributions, thereby giving you more flexibility for planning withdrawals during retirement.
- Roth contributions (with the exception of amounts converted from a traditional IRA) can be withdrawn free of tax and penalty at any time.
If you expect a higher tax rate in retirement: It's best to contribute to a Roth. Better to pay tax now (at a lower rate) than later (at a higher rate).
If you expect a lower tax rate in retirement: It's best to contribute to a traditional IRA. Better to pay tax later (at a lower rate) than today (at a higher rate).
If you have no idea what to expect: Tax diversify. That is, do a little of both. Note: Many people do this without even realizing it when they contribute to a tax-deferred plan at work (to take advantage of a match) as well as to a Roth.
Have you opened your retirement account? Which one did you choose? What are the reasons you chose that type of retirement account? Tell us your story in the comments.