Your employer's 401(k) plan is an easy way to build a nice retirement nest egg, but it does have some drawbacks. For instance, you are usually restricted to a small group of investment funds as opposed to being able to invest your money in any stock, fund, or bond you want to, as you can do with an IRA.
However, there are plenty of good reasons to invest in a 401(k), including the "free money" benefit that is the employer match. But how much of your paycheck should you set aside in your company's 401(k) plan?
Perks of a 401(k)
Many employers match a certain amount of your 401(k) contributions, essentially giving you free money toward your retirement. In addition, there are a few things you can do with a 401(k) that you can't do with a traditional IRA.
For example, you might be able to borrow money from your 401(k) to buy a house or to pay for your child's education. You'll generally be required to pay yourself back with interest (which you get to keep) over a period of up to five years.
Also, with a traditional IRA, you are required to begin taking distributions once you reach 70 ½ years of age, no matter what. With a 401(k), as long as you're still working you can allow your money to continue to grow on a tax-deferred basis until you need it.
And for many investors, one of the biggest reasons to invest in a 401(k) is convenience. Having money deducted directly from your paycheck can make saving easy, especially for people who have trouble saving money on their own.
The employer match should be a minimum
In a nutshell; at the very least you should contribute as much money as your employer is willing to match.
Let's say your employer offers to match 50% of your contributions of up to 6% of your salary. Well, if you make $50,000 per year, this amounts to you setting aside $3,000 per year on a tax-deferred basis. And, your employer kicks in an additional $1,500 that you wouldn't be entitled to otherwise.
Many employers have even better matching programs, such as dollar-for-dollar matching of a certain percentage. Not taking advantage is like accepting a pay cut. This is money you are entitled to as a benefit of your employment, so use it.
So, should you contribute even more to your 401(k)? It depends...
But what should you do if you max out your employer match and still want to save a little more? You have two basic options. You could choose to contribute more to the 401(k) plan, all the way up to the annual limit. As of the 2014 tax year, the "elective deferral" limit set by the IRS is $17,500 per person, and those 50 or older can contribute an additional $5,500.
Or, you could put your extra money in an IRA, which gives you more control over your investments. For example, in an IRA you can invest in whatever stock, bond, or fund you choose. However, the annual contribution limit for an IRA is lower, at just $5,500 per person ($6,500 if over 50).
Basically, if you prefer to invest passively by letting your plan's fund managers handle your investments (and there's nothing wrong with that), your 401(k) can be your only investment vehicle. In other words, if your employer is willing to match your contributions up to 6% of your salary, but you can afford to save 10%, go ahead and throw all in the plan if you prefer not to worry about it.
However, if you want some independence in your investing, an IRA is the better choice for your extra investment dollars – after your employer's match is maxed out. It all depends what kind of investor you are and how much control you want over your own portfolio.