Reader Question: IRA vs 401k

November 26, 2012 — 20 Comments

Have a question about money? Send it to me and you could be the next featured reader question. Check out this great one from Julia:

I recently paid off all my debt, now I’m looking to increase my investing beyond my company-sponsored, traditional 401K.

I understand the tax advantage of a Roth – I must’ve read it 50 times while researching this topic.

I don’t understand the difference between 401K and IRA. It looks like the biggest difference is options: 401K is more restricted in how I can invest, whereas IRA has a smaller contribution limit.

It seems like everybody recommends Roth IRA over Roth 401K and I don’t understand why.

Let me add this: I’ve had a traditional 401K for several years and I generally don’t pay any attention to it. I know what I’m contributing; I know that the growth rate has reasonably matched the market in general; and I occasionally get a notice that my allocations have changed, so I guess somebody is managing it. If I’m being perfectly honest, I will never have the interest or patience to learn about investing – my brain doesn’t work that way (seriously, I think I could learn brain surgery faster than I could learn investing). And for that, the idea of picking my own investments intimidates the hell out of me. And if I’m not bothering to pick my own investments, than what difference does it make in how many funds there are to choose from?

So, what exactly is the advantage of an IRA (compared to 401K)?

This can be a very confusing topic and I cover some of it when I explain how to start investing. However, let’s go a little more in depth to fully answer the questions.

Julia has done the right thing by investing in her 401k while paying off her debt so she can start building her nest egg. If you have access to a 401k, you should at least invest enough to receive the match from your employer while paying off debt. You can increase contributions when the debt is gone.

IRA vs 401k

IRA stands for an “individual retirement account” and is basically a retirement account that anyone can open (some income restrictions). All you need to invest in an IRA is an earned income, and you can invest up to $5,000 per year ($6,000 if over age 50). You contribute to an IRA after you pay taxes, but then you can deduct the contribution amount at the end of the year – thus, lowering your tax bill. Basically, you get to invest tax-free but you’ll get hit with taxes when you take it out for retirement.

The 401k is also a retirement account, but you can only open one if your employer offers it. The federal government offers an equivalent account called the Thrift Savings Plan (TSP) and non-profits offer the 403b which are both similar to the 401k. These accounts offer a much higher maximum contribution than the IRA at $17,000 and $22,300 if over the age of 50. Typically, 401k contributions are taken out of your check before you receive any money.

So the first difference between the IRA and 401k is maximum contribution, the second difference is how you fund them, and the third difference is where you invest the money. The IRA allows you a very wide choice of investments – from stocks, ETFs, and mutual funds all the way to real estate and even cattle! However, the 401k only allows you to invest in what the company offers. Typically, your employer will have a fund administrator (such as my favorite, Vanguard) and they’ll work together to determine your investment options.

What’s Roth got to do with it?

Now that we have the differences out of the way, let’s add in a new element – the Roth designation. The “Roth” is basically a tax law named after its chief legislator, Senator William Roth. The Roth designation allows you to invest in an account after taxes, but receive the entire amount of money tax free when you retire!! That means any earnings, dividends and all appreciation will be your’s, tax free! If you haven’t figured it out yet by the number of exclamation points, Roth = awesome.

Roth’s were originally attached to IRAs, giving you a second option for your type of IRA. You can open either account separately, and you can have both open at once. Next, congress attached the Roth designation to 401k’s, allowing you to have the same tax advantage with your company 401k – if your company offers it.

The other huge advantage of a Roth is your ability to take contributions out both tax and penalty free, after a period of five years. Some people will use the Roth IRA as their medium term account for purchases in the 5-10 year range. You can’t do this with a traditional IRA or 401k – you get hit with taxes and typically a 10% penalty.

Just tell me where to put my money

I generally recommend starting with your matched account (401k) and investing enough money to receive your company-sponsored match since it’s basically free money. Most 401k accounts will offer a “name your retirement date” type fund where they’ll automatically adjust the holdings (stocks vs bonds) based on how long you have until retirement. This is a good place to start. If your company offers a Roth 401k, I’d take that over the regular 401k.

After you’ve reached your match, feel free to take your contribution all the way up to 10-15%+ based on how you’re doing financially. If you have more debt, you may want to contribute less so you can pay off debt.

Next, start your Roth IRA and try to get it to the max of $5,000 per year. If you have extra money after that, continue increasing your 401k contributions.

Note 1: Make sure you have your emergency fund (3-6 months expenses) before maxing out your Roth IRA.

Note 2: IRA and Roth IRA eligibility start to phase out as your income increases so check that out.

Is it really this easy?

Yes and no; there are many different directions to head based on your personal situation. For example, if you think your taxes are higher now than they’ll be in 30 years when you retire, you probably don’t want to do a Roth. However, I don’t know of anyone who thinks that. Also, if you’re a high earner but fall within the contribution limits, there may be some advantages to forgoing the Roth and investing in a 401k so you can lower your adjusted gross income. Either way, study up some more so you’re comfortable with your investment decisions.

The important part is to start investing today so your money can grow on itself. Check out this post to see how long it will take you to reach your first million.

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20 responses to Reader Question: IRA vs 401k

  1. Whoever asked that question–thanks a lot!! I needed to hear this. I did not understand the difference between a 401K and a 401K Roth. I think I need to go look at my funds and do some Rothing.

    On the other hand, you said, “Some people will use the Roth IRA as their medium term account for purchases in the 5-10 year range.”Ok, I hope this is not a dumb question, but would you recommend using the Roth IRA for saving up for a car? I hate paying a car bill and I want to save money up for when I buy my next car. BTW, I don’t buy a car every three years. I keep a car till it is near death. 🙂

    • Bethany – great idea to buy the car with cash… car payments are the best way to stay broke :). If your car purchase is 5+ years you can use a Roth, but if it’s less than that I’d just stick with a high yield savings account. Typically, if you open a Roth IRA, at least some of the money will be invested in the stock market (but you do make the decisions – could do bonds too) and any time you invest in the market, you introduce risk. If you only have a few years, the market could drop at the beginning and you may not even recover your initial investment by the time you need it in a couple of years. Stick with safe investments such as the savings account for anything less than five years. I write a post on this topic too… thanks for the idea!

  2. You recommend placing money in a 401-k after maxing out your IRA, is there any reason (beyond the higher allowable)?

    • Scott – I actually recommend contributing enough to your 401k to receive the employer match (if your company offers one) and then moving to the Roth IRA (if you fall within income limits). I really like the Roth IRA because it’s more flexible and allows you to withdraw the money totally tax free at age 59 and a half. It also allows you pull money out for other qualifying reasons.

  3. Thank you for your post! Since working full time last year, I have a lot of questions on 401K! Thanks for all the answers!

  4. That clears more than a few things up for me and I’ll be sure to share this with my husband as well.

  5. Dan – You really need to get busy on that book. This kind of information is what I and everyone else needs. You need to share in one compact place, like a book. OK I am stepping down off my soapbox now. I just want you to know that I need information like this post has and I look to them. You explain them in a way that even I can understand. 🙂

    • Cheryl – I feel like you think I should write an ebook :). Seriously though, I’m honored by your feedback and will continue writing this type of posts because people find them helpful. Thanks!

  6. There is another type of investment we have been discussing – a 529. I understand it doesn’t have the income limits of the IRA’s. Thanks for explaining the Roth part of an IRA.

    • Leora – great question. The 529 is a college savings plan comparable to the ESA (educational savings account), and I’ll add this to my list of reader’s questions and try to get to it pretty soon. Thanks for the idea!

  7. I loved the way you broke these down to the basics. It makes these seem much more approachable and understandable for the everyday person. Great job answering the questions. :)))

  8. I like reading these kinds of posts because I know that although I am only in my early 20’s, I need to start thinking about and seriously planning for retirement. Thanks for all the wonderful knowedge shared here!

    • Kelly – glad you enjoyed it… if I had a time machine, I’d definitely go back a few years and tell my younger self to get more serious about investing 🙂 You can never start too early.

  9. There is such a need for financial education such as you’re providing. Save now, or regret it later.

    • Jeannette – thanks for stopping by. It really is sad how few people know the basics of the money… but it’s not surprising because it’s not really taught anywhere! Save now, save now, definitely save now!

  10. This is why I like to hire people who are really gifted in this area LOL My creative head explodes sometimes when I think of figures.

    • Lisa – thanks for stopping by and leaving a comment! It definitely takes a nerdier type of mind like mind to enjoy this kind of stuff! My head explodes when I get lost in design and creativity land 🙂

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