In a previous blog post, Is a 401k the Best Place to Save for Retirement, I showed that contributing to a 401k is far superior to a Taxable Account even if a person is in a very high tax bracket. But today, I want to compare the 401k vs IRA. If you only have so much money to invest each year, which of these accounts should get your attention (and your dollars)?
Since there are essentially two types of personal IRAs, I’ll compare the 401k to both the Traditional IRA and the Roth IRA.
401k vs TRADITIONAL IRA
First, it’s important to note that a Traditional 401k (I’ll cover the Roth 401k a different day) and a Traditional IRA are treated exactly the same way from a tax perspective. You contribute to both with pre-tax dollars (meaning you get a tax deduction today for every dollar you contribute) and both are fully taxable when money is withdrawn.
Let’s go over some of the differences between the 401k vs IRA.
401k’s often times provide you with free money in the form of an employer match. Thus, if you make a contribution, the employer will match that contribution up to some limit. In some cases, you receive free money from the employer even if you don’t make a contribution.
IRAs on the other hand do not provide you with a company match. It is solely funded with your own contributions.
With a 401k, you are limited to the investment choices that the 401k company provides. In my experience, the choices are usually very poor, expensive, and often times there aren’t many options to choose from. And don’t think that large employers have an advantage, because they don’t. I’ve seen some of the largest companies have only a handful of investment choices.
With IRAs you can virtually choose from any investment in the world. This, in my opinion, allows you to properly diversify your investment portfolio and possibly reduce the risk you take. In addition, IRAs allow you to choose investments that many 401k plans generally don’t have. A good example of this is that most 401k plans have International “Large” Company Stock Funds but almost never have International “Small” Company Stock Funds. This is ashamed because the latter has historically outperformed the former by almost 5% per year.
That is a tremendous difference to your bottom line!
Congress currently (2021) allows you to contribute up to $19,500 per year to your 401k ($26,000 if you are age 50 or older). This is far superior to the $6,000 ($7,000 if 50 or older) limit imposed on IRAs.
401k vs ROTH IRA
There are not really any similarities between the Traditional 401k and Roth IRA.
There are; however, several differences. All of the differences that apply to the 401k vs IRA above also apply to the 401k vs Roth IRA. However, there is one additional difference that applies here.
Contributions to a 401k, as mentioned above, are made with pre-tax dollars while withdrawals are fully taxable. The Roth IRA is the exact opposite. Contributions to it are made with after-tax dollars while withdrawals are tax-free.
Now even though this is a major difference, your investment portfolio will grow to the exact same amount if you are in the same tax bracket today as in the future. So, if your tax bracket remains constant throughout your lifetime, then there is no tax difference between a 401k vs Roth IRA. This brings me to my next point.
3 BUCKET STRATEGY
It’s easy to know your current tax bracket, but we have no idea what your tax bracket will be in the future. It’s primarily because of this reason that we routinely recommend the following for clients:
First, contribute to your 401k up to the amount necessary to get the full company match. If no company match then first maximize a Roth IRA.
Second, contribute the max to your Roth IRA if eligible. Once you reach a certain income, you are no longer eligible ($140,000 for singles and $208,000 for married couples).
Third, begin investing back into your 401k up to the max.
Fourth, begin investing in a Taxable Account.
If you can do all four items, then you will essentially have a 3 Bucket Diversification Strategy in place. Your portfolio will consist of pre-tax money, tax-free money, and taxable money.
This ultimately gives you options (i.e. flexibility) as to which account to withdraw from in the future. If your tax bracket is extremely high in the future, then you can forego withdrawing from your 401k / Traditional IRA and instead withdraw from your Roth IRA or Taxable Account. Imagine if tax brackets were at the 50% level in the future and you withdrew $100,000. Would you really want to withdraw that money from your 401k / IRA and pay $50,000 to Uncle Sam? I think not!
If tax brackets are really low in the future, then that would likely be an ideal time to withdraw from your pre-tax buckets. That would allow you to pay very little in taxes while allowing your tax-free and taxable accounts to continue growing which may come in handy down the road if tax brackets rise.
When it comes to comparing the 401k vs IRA (Traditional and Roth), they all have their advantages. Your first priority should definitely be to contribute toward the 401k to get the company match. Beyond that it’s usually wise to maximize contributions into a Roth IRA so that you have more control over your investment selection than that provided by a 401k. And once you’ve done that, the 401k is usually the next place you should invest because its tax-deferred nature can oftentimes make up for a lack of investment quality or selection.
Although, as I’ve said in the past, “don’t let the tax tail wag the investment dog”. In other words, tax deferral and tax savings shouldn’t be your primary focus when investing; quality investments should be. There have been some limited situations where the tax deferral of a 401k was not worth it because the investment options were pretty terrible and/or really expensive. And in those situations, we’ve steered clients away from their 401k.
What is your strategy for investing? Please share any thoughts or comments below.
Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™