Should I Contribute to an IRA or 401(k)?
A common issue people run into as they begin saving for retirement is prioritizing the retirement saving account options they have available to them.
This often comes down to a choice between their 401(k) and an IRA, but the same general rules apply to 403(b)s, 457s, and TSPs.
Let’s walk through these account types and discuss things you should consider when making this decision. Finally, I’ll run through a hypothetical scenario to help you with your own evaluation.
Employer-Sponsored Options
The key difference between an IRA and employer-sponsored savings plans like 401(k)s, 403(b)s, 457s, and TSPs is that your employer drives many of the options and policies in a plan at work.
The employer chooses the investment company that serves as the plan custodian.
The employer chooses whether or not they’ll allow in-service distributions.
The employer chooses whether or not they’ll provide a Roth option within the plan.
The employer drives decisions about which investment options are available to their employees which also means they effectively set the bar for expenses that will be charged to their employees for the investments they select within the plan.
Most importantly, the employer gets to decide whether or not they will make any contributions to the plan on their employee’s behalf, and this is the most important factor to consider when deciding between saving in a plan at work versus opening your own IRA.
I’m going to share several positive aspects of IRAs in a minute, but one shortfall they have compared to an employer-sponsored plan is that you won’t get any matching contributions in an IRA.
Employer contributions, whether they are a full, dollar-for-dollar match or not, represent absolutely free money.
Try not to overthink this. If your boss calls you into his or her office next week and offers to pay you more, you’re probably not going to turn them down.
So, if you’re already trying to decide where to save for retirement, why not start in the place where you’ll receive free money for doing so?
It’s a free boost to your retirement savings and it would be costly to turn it down, so if you have an employer-matching contribution to a retirement plan take that first.
IRAs
I’ve already pointed out that you’re not going to get an employer matching contribution to your IRA, which leaves them at a significant disadvantage to your plan at work, but there are a couple of advantages IRAs have over employer-sponsored plans.
The most important aspect is control.
By opening an IRA on your own, you effectively get to do all the things your employer does for you in your plan at work.
Don’t like the plan custodian at work? No worries. You can pick your own for your IRA.
Are the investment options limited or expensive at work? They won’t be in your IRA.
Does your employer limit your options for rollovers and in-service distributions? You don’t have to worry about any of that in an IRA.
And I don’t want to understate the importance of this level of control.
I once calculated the impact of nine-tenths of a percent (0.9%) difference in expense ratios on an average portfolio over the course of 35 years.
The result was $119,167.10 in lost value in the more expensive portfolio for what was effectively the same investment.
Having control matters because it allows you to hone in your asset allocation while having access to investments with competitively low expenses.
Ultimately, IRAs give investors much more control and the lack of an employer match is easily the biggest disadvantage they have compared to plans at work, but there is one more.
In 2024, you are limited to a maximum annual contribution of $7,000 ($8,000 if 50+) to an IRA.
The contribution limits for employer-sponsored plans are much higher. In 2024, you can contribute $23,000 ($30,500) to a plan at work and up to $69,000 ($76,500) of combined employee/employer contributions if your plan allows.
This means employer plans can potentially give you about ten times the saving space compared to an IRA. That is not a significant amount.
And, since I recommend that you save and invest 15% to 25% of your income for retirement, odds are you’ll need more than an IRA to get there.
Which is why I would recommend that you use both.
The Case for Both
If it hasn’t occurred to you already or maybe you aren’t familiar with the rules the IRS places on employer-sponsored plans and IRAs, I have good news for you: you can contribute to both an IRA and a plan at work.
(And this is off-topic, but if you have access to a 457 plan you can contribute to it in addition to both another employer-sponsored plan and an IRA.)
Having the flexibility to contribute to an IRA and your plan at work effectively allows you to maximize the benefits of both.
Many of you may have read my comments above about an employer match and thought to yourself, “Yeah, but my employer only matches up to _______.”
In fact, the average employer matching contribution for 401(k) plans in the United States is 4.167% of an employee’s salary each year.
So, on average, even if you made a healthy $100,000 each year only $4,166.67 would be matched by your employer. With a 100% match, your total contribution would only be $8,333.34, or 8.33% of your income.
This is far short of the 15% to 25% I recommend.
Now, I’ve already shared how employer matching contributions are the most valuable factor in making a decision between saving in an IRA and a plan at work, but that doesn’t mean you have to continue contributing exclusively to your employer-sponsored plan.
Once you’ve exhausted the employer match, there aren’t any real advantages a plan at work will have over an IRA except for the annual maximum contribution.
So, after you use up your employer match, I’d contribute to an IRA.
If you don’t have an employer matching contribution at all, I’d start with the IRA and contribute to it until you hit the annual contribution limit before moving to the employer-sponsored plan.
Once you’ve tapped out any employer matching contribution options and you’ve hit your annual max for the IRA, then go back to the employer plan until you either run out of money to save or you hit the limit in your plan at work.
A Martin Money Scenario
This is the exact procedure my wife and I used when we were first starting out in our careers.
As it so happened, we worked for the same company when we were first married. Our employer made an 85% matching contribution to our 401(k) plan up to 6% of our annual income.
In other words, for every $100 we put into our 401(k) our company would match it with an $85 contribution.
Our goal early on was to save 15% of our income. Even with our employer’s generous match, our 401(k) contributions only got us to a saving rate of 11.1%.
Since I preferred the level of control afforded through an IRA and I really wanted an option to contribute to a Roth account anyway (Roth 401(k)s were not very common then), we opened Roth IRAs to finish reaching our 15% goal.
Truthfully, the IRA contributions put us a little over 15% but it wasn’t a stretch back then to maximize the annual contribution, so that’s what we did.
Thankfully, our incomes in the first years of our careers grew more quickly than they seem to now so it wasn’t long before taking the employer match and maxing out an IRA wasn’t reaching 15% of our annual income.
So, we increased contributions to our 401(k) plans until we were back up to 15%.
This has basically been our strategy ever since, though we no longer make contributions to an IRA because our modified adjusted gross income has disqualified us.
Caveats:
- Even though I’ve walked through a scenario involving IRAs and employer-sponsored retirement plans, if you have an HSA available through your employer and your employer makes a matching contribution then it is actually more valuable than contributions to an employer-sponsored plan.
- Roth vs Traditional is another topic, but it doesn’t really change the prioritization of contributions, just the type. For more about Roth vs Traditional, read our post about Roth vs Traditional.
- Much of this information was presented to show how to prioritize or rank one account over another, but that doesn’t mean you should only contribute to one account until you max out your annual contribution, and then start on the next one. If you approach contributions that way you may miss out on some of your employer matching contributions.
- We have another post and video about prioritizing retirement accounts. Read or watch that for even more information about making the optimal choice for which retirement account to contribute to next.
