Should you use an IRA or a 401(k) to save for retirement? Here's how to make the most of both

As the internet would say, "Why not both?"


Red or blue? "Star Wars" or "Star Trek"? Britney or Christina? In these polarizing times, it seems we're constantly asked to pick sides. But retirement investors, it seems, are happy to have it both ways. Recent data from Fidelity indicates that more than 2 million investors on the brokerage's platform are saving for retirement in both an individual retirement account and their employer's 401(k) plan — a 12.5% increase from this time last year.

Investing in a 401(k) or an IRA comes with many of the same benefits, so if you're investing solely in one or the other, don't worry — you're not doing anything wrong. But there are some differences in what the two savings vehicles offer, and depending on your financial situation, it may make sense to invest in both.

The basics of retirement savings accounts

The traditional versions of the 401(k) and IRA accounts both work the same way: You contribute pre-tax money to the account, which reduces your taxable income for the year you contribute the money. You won't pay taxes on your money until you begin withdrawing it in retirement.

The other major flavor of these vehicle, a so-called "Roth" account, throws the tax situation in reverse. You fund these accounts with after-tax dollars, but from there, your account grows tax-free. You won't pay any taxes on the money you put in or the money you earn when you take it out in retirement. The after-tax status of your Roth money also means that you can withdraw your contributions from a Roth 401(k) or IRA any time without paying a penalty.

What is the difference between Roth and traditional IRAs

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401(k) advantages: Size and free money

One of the major benefits in favor of a 401(k) is that you can contribute much more on an annual basis. Savers under the age of 50 can contribute up to $19,500 in a 401(k) in 2020, compared with a $6,000 limit for IRA accounts.

Generally, the more money you make, the less you may be able to contribute to a Roth IRA or the smaller your potential tax deduction from a traditional IRA, if you're able to take a deduction at all. For single filers, the amount you can contribute to a Roth IRA begins to phase out for people with incomes of $196,000. And if you're covered by a workplace retirement account, you can't take a tax deduction on a traditional IRA if you're a single filer with more than $75,000 in income.

But even if you couldn't come close to hitting the contribution limit on either account, the 401(k) becomes a no-brainer if your employer offers a match, meaning that it agrees to mirror an employee's contribution to the account up to a certain percentage of their salary.

"Typically, I encourage everyone to contribute to their 401(k) first, if the company offers a match," says Rick Vazza, a certified financial planner and founder of Driven Wealth Management in San Diego, California. "Contributing at least the match amount allows them to essentially get an immediate pay raise. Tough to beat that!"

IRA pluses: cost and flexibility

There's no arguing with free money, but 401(k) plans do come with a few drawbacks. For one, you'll have to choose from a roster of pre-selected mutual funds. Depending on your firm, these may be a selection of index funds, a suite of target-date products (which grow more conservative as you near your retirement date), or actively managed funds, which typically come with higher expense ratios in exchange for managers running the show.

Maybe the funds in your plan will have good track records; maybe they won't. Hopefully, you'll be able to build a low-cost, diversified portfolio from your options. Either way, you'll be paying for the management fees on the mutual funds you hold, plus a fee to whatever company manages your firm's plan — which can range from 0.37% to 1.42% of assets in your account.

What is a 401(k) match and how can you take advantage of it?

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An IRA gives you much more control over what you invest in and what you pay for investing. These accounts, which you can open in minutes at an online brokerage, allow you to invest in just about any asset class the broker offers, including stocks, bonds, mutual funds, and exchange-traded funds.

"At a bare minimum, one should contribute to their 401(k) to receive their employer's match," says Brian Fischer, a CFP at Evensky & Katz in Miami, Florida. "After that, it's really a matter of preference."

If your 401(k) plan is saddling you with expensive, mediocre mutual funds, consider investing just enough to get the match and plunking the rest in an IRA, where you can build, say, a broadly diversified portfolio of low-cost ETFs.

The risks and benefits of dual accounts

Harnessing the advantages of both types of accounts comes with one major drawback — complicating your investment picture. "We generally suggest clients keep things as simple as possible," says Kristin McKenna, a CFP and managing director of Boston, Massachusetts-based Darrow Wealth Management. "It's harder to manage multiple accounts, particularly for DIY investors. Since the accounts are separate, setting an asset allocation at the portfolio level is now a manual exercise."

If keeping track of multiple accounts isn't your jam, it may make sense to stick with your 401(k), especially if your employer offers a generous match and good roster of investments. But if you don't mind mixing things up, consider signing up for a service that will keep track of your investments for you. By linking your accounts to a free service such as Personal Capital, you'll be able to view your overall investing picture across multiple accounts, including high-level breakdowns (such as your overall portfolio's allocation to stocks and bonds), and ones that drill further down, such as your allocations to domestic vs. international stocks.

And splitting things up can help you diversify the tax status of your investments, particularly if your employer doesn't offer a Roth 401(k). Having a traditional 401(k) and a Roth IRA, for instance, means you'll have accounts with both pre-tax and post-tax dollars. "In retirement, that can give you flexibility to make smart tax decisions when you need to take distributions," says Laura Bereiter, a CFP and director of tax and financial planning at White Oaks Wealth in Minneapolis, Minnesota.

The other advantage of that particular setup is the flexibility to access some of the retirement money in your Roth IRA early if you need it, says Vazza. "This can be especially important for someone entrepreneurial who may decide they want those funds to start their own business someday, for example."

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