IRA vs. 401(k): How to Choose

Weighing the choice between putting money in an employer-sponsored retirement account such as a 401(k) or a self-directed savings vehicle like a Roth or traditional IRA? Here’s the abridged answer:

• If your employer offers a 401(k) with a company match: Fund your 401(k) up to the point where you get the maximum matching dollars, then consider an IRA. If you max out the IRA for the year, return to the 401(k) and resume contributions there.

• If your employer doesn’t offer a company match: Skip the 401(k) at first and start with an IRA. After contributing up to the limit, fund your 401(k) for the pre-tax benefit it offers.

Need more details? We’ve broken down the key pros and cons below:

Hats off to you if you have the means to max out both a 401(k) and an IRA. If not, this detailed IRA versus 401(k) road map will help you prioritize your retirement savings dollars.

Again, your first step depends on whether your employer matches your contributions to your workplace savings account.

1. Contribute enough to earn the full match. Check your employee benefits handbook. If you see that your employer matches any portion of the money you contribute to the company 401(k) plan, do not bypass this opportunity to collect your free money.

A company matching program is one of the biggest benefits of a 401(k). It means that your employer contributes money to your account based on the amount of money you save, up to a limit. A common arrangement is for an employer to match a portion of the amount you save up to the first 6% of your earnings.

Even if a 401(k) has limited investment choices or higher-than-average fees, carve out enough money from your paycheck to get the full company match, as it’s effectively a guaranteed return on those dollars. Also note that employer contributions don’t count toward the 401(k) annual contribution limit.

2. Next, contribute as much as you’re allowed to an IRA. Depending on which type of IRA you choose — Roth or traditional — you can get your tax break now or down the road when you start withdrawing funds for retirement.

• A traditional IRA is often the preferred choice for those who favor an upfront tax break. Contributions may be deductible, though if you are also covered by a 401(k), that deduction may be reduced or eliminated based on income. See the IRA limits to determine whether your deduction will be affected.

• A Roth IRA is a good choice if you’re not eligible to deduct traditional IRA contributions, or if you’d rather pay taxes upfront on your contributions in exchange for tax-free withdrawals in retirement. Roth IRA eligibility is not affected by participation in a 401(k), but it may be affected by your income. Again, you can see the latest thresholds for Roths on the IRA limits page.

3. After maxing out an IRA, revisit your 401(k). Even after you’ve gotten the employer match — and even if your investment choices are limited, which is one of the main drawbacks of workplace retirement plans — a 401(k) is still beneficial because of the tax deduction.

The money you contribute to a 401(k) will lower your taxable income for the year dollar for dollar. And don’t forget about the added benefit of tax-deferred growth on investment gains.

1. Contribute to an IRA first. Not all companies match even a portion of employee retirement account contributions. When that’s the case, choosing an IRA — and contributing up to whatever amount IRS rules allow for your situation — is generally a better first option.

Why start with an IRA? One of the biggest benefits of an IRA is that it offers access to a virtually unlimited number and type of investments, giving you much more control over your investment options: You can bargain-shop for low-cost index mutual funds and ETFs instead of being restricted to the offerings in a workplace retirement account, and you can avoid paying the administrative fees that many 401(k) plans charge.

2. After maxing out IRA benefits, contribute to your 401(k). Here again, the tax deferral benefit of a company-sponsored plan is a good reason to direct dollars into a 401(k) after you’ve funded an IRA.

Only in the worst cases — a retirement account with truly crummy, high-fee investment choices and high administrative costs — would it be advisable to completely avoid your company plan. Be sure to revisit the rules about combining contributions to a 401(k) and a traditional IRA. If your income passes certain thresholds, your ability to deduct traditional IRA contributions may be reduced or eliminated. If you aren’t eligible for a traditional IRA deduction, you may still be eligible for a Roth IRA.

Even if you’re not eligible to deduct your traditional IRA contribution, you can make nondeductible contributions and still benefit from tax-deferred investment growth.