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Traditional IRA versus 401k: Choosing The Right Retirement Account For Your Financial Planning Goals

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You know that good financial planning requires a smart strategy for retirement savings. But with the alphabet soup of retirement accounts available, it may be hard to decide which way to go. How can you tell if you should invest in an IRA or 401k? Or both? Which one is better? Let’s explore the features of each to get you moving in the right direction.

401k

A 401k provided by your employer can be one of your best financial planning tools. 401k’s allow you to save money in a tax deferred account via payroll deductions. Here are situations where you might want to take advantage of your 401k:

  • Employer Match. If your employer matches your contribution, this is free money, and you should take advantage of it. Note that there are typically vesting rules which state how many years of service you will need to claim the entire employer match.
  • Higher limits. During 2008 you can contribute $15,500 to your 401k. If you are 50 or older, you can contribute an additional $5,000. The 2008 IRA limits are $5,000 and an extra $1,000 for catch-up contributions if you are 50 or older. The higher limits on the 401k may come into play depending on how much you plan to contribute.
  • Tax-deductible contributions. You can deduct your contributions from your taxable income in the year your contribution is made. This means that you will pay less taxes for that year.

  • Defer your capital gains taxes. The gains on your investments will not be taxed while held in your 401K..

Note that the Traditional IRA also allows for deductible contributions and defers taxes, on capital gains but there are income levels that will disallow the deductibility of IRAs if you have a plan available with your employer.

IRA

While Individual Retirement Accounts don’t offer the matching funds that some 401k’s do, there are many situations where an IRA investment makes good sense instead of, or in addition to, a 401k. Here are some IRA benefits to consider:

  • More investment options. With an IRA, you’re able to select the financial institution that holds your investments and you also have a greater variety of investment choices. You may be able to meet your ideal asset allocation much easier than in your 401k, where you are limited to the investments offered by your employers’ plan.
  • Lower expenses. Often, with greater choices come lower fees. You will be able to utilize low cost index funds that may not be available in your 401k. Lower expense ratios will likely result in a larger portfolio balance for you by the time you retire.
  • Later due date. While all your 401k contributions must be made during the calendar year, IRA contributions are not due until April 15. This later deadline gives you the time to estimate the taxes you’ll owe, calculate and make your IRA contribution, and then enjoy the opportunity to write a somewhat smaller check to Uncle Sam.
  • Immediate enrollment. There is no waiting period to set up an IRA. Employers typically require a waiting period before a new employee can enroll in a 401k plan.
  • Save for your spouse. With the use of a spousal IRA, you can contribute to both of your retirement savings. A 401k is only available for the employee.

Mint Financial Planning Tip: Find out what kind of IRA is best for you.

In this article, “IRA” refers to Traditional IRAs. If you are considering a Roth IRA, but unsure about which is right for you, check out Mint’s IRA Advisor. It’s a financial planning tool which can help you make this decision. Participation in either Traditional or Roth IRA’s could qualify you for the Retirement Savings Contributions Credit. See IRS Publication 590 for more information.

Availability of conversions. Consider as part of your long term financial planning that you may be able to convert your IRA to a Roth IRA in the future. And while rolling over a 401K to an IRA is not typically allowed until you leave your employer, there can be exceptions. Please check with your company’s plan about your specific circumstances.

Mint Financial Planning Tip: Consider leveraging the benefits of both a 401K and an IRA.

You may want to contribute to a 401k and an IRA to take advantage of their different benefits. For example, you could invest enough in your employer’s 401k plan to soak up all the matching funds that are offered. Then put the balance of your annual retirement savings in an IRA to increase your investment options and often lower investment expenses.

By understanding your tax-advantaged retirement savings options, you’re following Mint’s second Principle of Personal Finance: Making your Money work Hard for You. Any dollar you don’t pay in taxes is another dollar you can invest toward achieving the retirement lifestyle you want, sooner.

Further Reading:

Financial Planner Online Financial Planner
Personal Financial Planning Online Personal Financial Tracking