Saving for retirement is a critical and worthy goal. But given the different features and benefits of the various types of individual retirement accounts IRAs) and 401(k) plans, choosing the best for you and your situation can be challenging. In some cases, the process is easier because you can narrow down your choices by eliminating the plans for which you are ineligible. In this article, we'll look at different scenarios and the factors to consider when you are faced with choosing among investment accounts.

Key Takeaways

  • One primary difference between a Roth and a traditional IRA is when you pay taxes on your contributions—either when you make the contributions (Roth) or in retirement (traditional).
  • If you can only invest in one type of retirement account, your money may grow fastest in a company-sponsored 401(k) plan that matches a percentage of your contributions.
  • If your company 401(k) doesn't offer a match, look at the plan's investment options, fees, the accessibility of your money, and the availability of free investment advice before deciding between the plan and IRAs.
  • Individuals who can invest in all three types of retirement accounts should also consider how to get the maximum match, how to divide funds between IRAs to avoid taxes, and how to divide up contributions throughout the year.
  • In deciding which accounts to fund, you should also factor in your age and expected retirement date and your plans for your accounts—funding your retirement, say, or leaving them for your loved ones.

Roth IRA vs. Traditional IRA

Contribution limits for both a traditional IRA and a Roth IRA are the same for tax year 2019. You can contribute up to $6,000 plus an additional $1,000 if you turn 50 (or are older) by the end of the tax year. If you are eligible for both types of IRA, making the choice usually depends on when you want to pay taxes—now or in retirement.

With a traditional IRA, you can claim a tax deduction for the year in which you make a contribution. A traditional IRA is fully deductible if neither you nor your spouse participates in a retirement plan at work, or, if you do, if your income is less than $74,000 for an individual filer or $123,000 if you file jointly. However, once you start withdrawing money in retirement, those distributions are subject to income taxes.

With a Roth IRA, your contribution isn't tax deductible, but qualified Roth distributions are free of taxes and penalties. What constitutes "qualified"? You can't take distributions from a Roth in the first five years after opening the IRA, and one of the following must also hold true:

  • You have reached the age of 59½.
  • You are disabled.
  • You are using the distribution to buy a first home (lifetime limit: $10,000).
  • You have died (your beneficiary receives the distributions).

To help you decide which IRA to invest in, look at your current tax bracket compared to your projected tax bracket during retirement and try to choose according to which plan results in lower taxes and more income (granted, determining this may not be an easy thing to do).

What If You Can Contribute to a 401(k) or an IRA?

It may be that you are eligible to make traditional IRA or Roth IRA contributions as well as salary deferral contributions to a 401(k) plan, but cannot afford to contribute the maximum to the 401(k) plan and the IRA at the same time. You must decide what is most beneficial to you—to make one, two, or all three work. Some of the following concepts can also apply if you have the option of contributing to both a traditional 401(k) and a Roth 401(k).

Let's look at Casey, who works for Company A and is eligible to make a salary deferral to Company A's 401(k) plan. Casey's annual compensation is $50,000, and he can afford to contribute $2,000 each year, which he has decided to put into one account to avoid excessive fees. Therefore, Casey must decide whether it makes better financial sense to contribute to the 401(k) or to an IRA.

If There Is a Company Match

If Company A provides a matching contribution on Casey's salary deferral contributions, the 401(k) will be the better choice. Below is a look at the growth of his accounts over a 10-year period, assuming a matching contribution of $1 for each $1 Casey contributes, up to 3% of his salary. This means that Casey will receive a matching contribution of $1,500 ($50,000 x 3%). In 10 years, his 401(k) would grow significantly faster than an IRA.

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If There Isn't a Company Match

If Company A isn't making matching contributions to the 401(k) plan it offers, Casey will need to consider the following questions in deciding whether or not to invest in the 401(k):

Which investment choices are available? Large corporations typically limit investment choices to mutual funds, bonds, and money-market instruments. Smaller companies may do the same, but are more likely to allow self-direction of investments, allowing a participant to choose among stocks, bonds, mutual funds, and other available investments, similar to the investment options available in a self-directed IRA. If investments in the 401(k) are limited, Casey may do better if he contributes to an IRA, which would provide a broader range of investments from which to choose.

What are the applicable fees? One hot-button issue is the fees that are charged to 401(k) accounts. These are not as visible as the fees that are charged to an IRA, leading many participants to believe that 401(k) fees are minimal to non-existent. Casey would need to research the fees that apply to his company's 401(k) plan and compare them with the operational and trade-related fees that apply to the IRA.

Are the 401(k) funds accessible? While retirement savings are intended to accumulate until retirement, situations sometime arise that leave a participant no choice but to make withdrawals or take out a loan from their retirement accounts. Generally, assets in a 401(k) plan cannot be withdrawn unless the participant experiences a triggering event. However, if Company A's plan has a loan feature, Casey could take a loan from his account and repay it within five years (or longer, if the loan is to be used for the purchase of a principal residence). IRA assets can be withdrawn at any time. However, except for a rollover contribution, the amount cannot be repaid to the IRA.

What's the cost of professional management? If Casey isn't proficient in investment management or doesn't have the time to properly manage his plan investments, he may need the services of a professional investment advisor to make sure his asset allocations are consistent with his retirement goals and objectives. If Casey's employer provides those services as part of its employee benefits package, Casey won't incur an additional cost to have a professional manage his investments. This perk may not be available for an IRA unless an employer extends such services to assets outside of its employer-sponsored plan.

These points are worth considering, even if matching contributions are being made to the 401(k) account. But without a match, the answers to these questions may lead Casey to conclude that the savings benefits of an IRA outweigh those of a 401(k).

What If You Could Contribute to All Three?

Now, let's take a look at TJ, who can afford to fund her 401(k), a traditional IRA, and a Roth IRA. If she can afford to contribute the maximum permissible amounts to all his accounts, then she may have no need to be concerned with how to allocate her savings. But let's assume TJ can afford to save only $7,000 for the year. The points of consideration for Casey (above) may also apply to TJ. In addition, TJ may want to consider the following:

Getting the maximum match. If a matching contribution is being made to the 401(k) plan, consider the maximum amount that needs to be contributed to the plan in order to receive the maximum available matching contribution. If, for example, TJ's compensation is $80,000 per year and the matching contribution formula is $1 for $1 up to 3% of compensation, she will need to contribute at least $2,400 to her 401(k) plan in order to receive the maximum available matching contribution of $2,400.

Choosing between IRAs. If TJ puts $2,400 into his 401(k), she'll have $4,600 left over for her IRA contribution. She will have to do the math (or check with her tax advisor) to find out how much of her traditional IRA contributions would be tax deductible and factor that into herdecision to choose a Roth IRA, a traditional IRA or a contribution that's split between the two. Whatever she decides, her total contributions to both IRAs cannot exceed the limit for that tax year.

Which to fund first. It is usually best to make contributions to the retirement accounts early in the year, or a little each month—beginning early in the year so that the assets can start accumulating earnings as soon as possible. Consider how matching contributions are made, too. Some companies contribute the amount in one lump sum at the end of their tax-filing deadline, while others contribute amounts throughout the year. If the latter applies, it's better to make salary deferral contributions to the 401(k) early in the year.

Your modified adjusted gross income and your tax filing status may limit the amount you are able to contribute to a Roth IRA.

Other Points to Consider

In addition to the points listed above, you should consider other factors, such as:

Age and retirement horizon. Your retirement horizon and age are always important points of consideration when determining proper asset allocation. However, if you are at least age 50, participating in a plan that includes a catch-up contribution feature can be an attractive choice, especially if you are behind in accumulating a retirement nest egg. If that describes you, choosing to participate in a 401(k) plan with a catch-up feature can help to add larger amounts to your nest egg each year. IRAs have catch-up features, too, but you can add only $1,000, not $6,000, to your contribution.

Purpose of funding a retirement account. While retirement accounts are usually intended to finance your retirement years, some people plan to leave these accounts to their beneficiaries. In that case, you have to think about whether you want to leave tax-free assets to your beneficiaries, and whether you want to avoid having to take required minimum distributions (RMDs) that will lower the balance in your accounts. Roth IRAs and Roth 401(k)s allow you to pay the taxes you would otherwise owe when you make the initial contributions. For Roth IRAs, the RMD rules do not apply to the IRA owner, which allows for a larger balance to be left to beneficiaries.

Certain government entities offer special retirement plans for employees.

The Bottom Line

For those who are eligible to fund multiple types of retirement accounts and have the money to fund them all, choice is not an issue. For those who don't have money to fund multiple accounts, choosing the best option(s) can be challenging.

In many instances, it boils down to whether you prefer to take the tax breaks on the back end with Roth IRAs, or on the front end with traditional IRAs. The ultimate purpose of the account, such as retirement versus estate planning, is also an important factor. A competent retirement planning advisor can help people facing these issues to make practical choices.