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401k or IRA: Which Should You Fund First?

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One of the questions that many people have as they plan for retirement is whether they should fund a 401k or an IRA first. And, of course, the answer depends on what you are trying to accomplish with your retirement fund.

IRAs and 401ks have some different advantages and disadvantages, and it is up to you to determine what is most likely to be the best course of action for you. As you try to figure out what to do with your retirement money, here are some things to consider:

The Employer Match

Your employer match is one of the most important considerations when deciding which type of account to fund first. If you have a 401k and an IRA, you might want to consider funding the 401k first if there is an employer match. You don’t have to max out the 401k, but you don’t want to leave money on the table, either. If your employer offers a 50% match up to 5% of your income, you can get a pretty good chunk of free money.

If you make $45,000 a year, 5% of your income is $2,250. If you put that $2,250 in, your employer match will be $1,125. That’s not too shabby, considering it’s free money. That boosts your annual contribution up to $3,375.

Once you’ve got your employer match covered, you can decide whether it’s worth it to put unmatched money in your company’s 401k. If your plan has high fees, or if your plan has options you aren’t happy with, you can put the some of the money in an IRA that you create yourself, using low-cost investments that you like. After you max the IRA out, if you have some money left over for retirement investing, you can reconsider whether you want the unmatched funds in your company’s 401k.

Flexibility

Often, you have more flexibility with investment options when you use an IRA. With a 401k, you are limited to what the employer offers, although you can always ask to have certain investments added to the plan. And, because you can open an IRA for a non-working spouse, it’s possible to double what you save as a couple for a year, since you can max out your IRA and your spouse’s IRA. However, even doubling up, you won’t be able to contribute as much to your IRAs as you could to one 401k each year.

You should also consider the flexibility of withdrawal options. With a 401k, you can borrow against your account, but if you don’t repay the loan, things can get really pricey really fast. Additionally, you have to pay tax penalties. With a Roth IRA, you can withdraw your contributions (but not the earnings) when you want. A traditional IRA also has some flexibility when you withdraw for some expenses. The 401k, on the other hand, has an interesting option that allows you to withdraw money if you retire after 55 — no penalty (but the money is still taxable).

Tax Situation

Naturally, you will need to consider the tax situation. In the past, if you wanted to withdraw money tax free in retirement, you concentrated mostly on the Roth IRA, paying taxes on your income now. However, if your employer offers the relatively new Roth 401k, you may not have to make that choice.

If you would rather have the tax benefits now, in the form of a deduction, you can contribute more to a traditional IRA or a traditional 401k.

Ideally, you would be able to max out a 401k and an IRA in a year. However, most of us won’t be maxing out all of our retirement accounts; we have to choose between them. With a little thought and planning, you can divide up your retirement contributions in the way that will benefit you the most.

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10 Responses to “401k or IRA: Which Should You Fund First?”

  1. DIY Investor says:

    Vesting may also be a consideration. Some employee matches aren’t vested until after a certain amount of time.

    • Strebkr says:

      Good point about the vesting, but if you don’t put put any money in there isn’t vesting money to grow. You can’t go back and put money in.

      Even the unvested portion still grows, its just not yours until a certain amount of time.

  2. sophomore says:

    If anyone is interested in the geeky details of IRAs, you can pick up IRS Publication 590 and read all about it.

  3. Eddie says:

    Every January,I cut 401k contributions down to the matching fund level until I’ve got a Roth funded.Then ratchet the 401 back up as high as I can stand for the remainder of the year.

    • tbork84 says:

      That’s the point that I would like to be at someday soon. Right now I am able to hit my company’s generous match and fully fund my Roth, but I am still not able to increase the amount I contribute to my 401k enough to get close to maxing it out.

  4. Grant says:

    My employer only offers a 401K so I contribute to that to the extent to get the match and then max out the Roth IRA. Can you really beat the versatility and effectiveness of a Roth IRA! That wasn’t incorrect punctuation, it was rhetorical. But, on that note, does anyone have ideas about trying to get their employer to offer a Roth 401K? This would allow me to increase my Roth contributions for retirement since an IRA is capped at 5K. I’ve requested it from the administrator of the plan, but outside of this I feel like I have no alternative. Why don’t more employers offer both Roth and Traditional 401K choices? I don’t think it would be administratively much additional work. My prior employer offered both and now I regret taking that for granted. Any answer would be appreciated.

  5. zapeta says:

    I don’t have a 401k, so it makes the choice easy for me. If I had one with employer match, I’d fund at least that percentage. You should also find out how long it will take to become vested in the employer match. In some cases, it might be 5 or more years before the employer match money is actually yours, and if you leave the job before the time is up you forfeit the money.

  6. skylog says:

    the “by the book” advice is to contribute to your 401k to get the match, then revert to max out your IRA, then go back until you max your 401k.

    this is what i do, but not every plan works for every person. investment options, bad plans, tax…etc…all of that has to come into play.

  7. mincho says:

    This was a helpful article. My question to anyone who can answer is —

    What if it takes 5 years to be fully vested in your company’s 401k plan? You can take 25% of the company’s contribution if you leave after the 1st year. If you plan to leave within 1-2 years, what is better – 401k or IRA?

    Thanks!


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