Is a 401(k) better than an IRA?

To me, it seems an odd question -- they're two tools for the same job, best used together -- but it's a question that comes up fairly often. Usually, it's part of a larger discussion -- as someone said to me recently, "I don't like the investment options in my 401(k) plan. I feel like I should just do an IRA instead, but isn't a 401(k) better?"

The answer, of course, is "yes and no." 401(k)s and other workplace savings plans usually have a lot of built-in advantages, though the devil is in the details -- and the details depend on decisions made by your employer.

But no matter the details, most plans have these things going for them:

  • They get you saving. The big obstacle to retirement savings success for many people is getting started in the first place. Many employers now automatically enroll new hires in their 401(k) plans -- you take the job, you're in the plan -- and some even automatically start deductions.
  • The saving is painless. Once you're enrolled in the plan and your investment elections are made, the investments just happen. You don't have to remember to do it, you don't have a chance to procrastinate, and since the money comes out of your paycheck before taxes, you might not even feel the hit. Before you know it, you're saving several thousand dollars a year for retirement, no willpower necessary.
  • Your employer helps out. Most plans match your contributions up to some level -- 50% of your contributions up to 6% of your salary is a common structure, though plans vary widely. That's free money, money that your co-workers who aren't in the 401(k) aren't getting.

But what if there's nothing good in there?
Of course, all of that is much less exciting if the options in your plan stink. For some, that's where an IRA comes in. An IRA -- whether traditional or Roth or rollover -- with a discount broker offers you the opportunity to invest in nearly anything, especially stocks, in a tax-advantaged (and cost-effective) way.

As we all know, the best stocks will greatly outpace nearly any mutual fund. Want to load up on small-cap CAPS favorites like paper-recycling expert Kadant (NYSE:KAI) or Massachusetts auto-insurance star Safety Insurance (NASDAQ:SAFT)? Or maybe you'd like to add less-exciting (but maybe not less profitable) dividend-paying perennials like Rust-Oleum maker RPM International (NYSE:RPM) and Southern Company (NYSE:SO), a very well-run regional electric utility, to your retirement investment mix.

When your 401(k) choices are limited, it's tempting to skip the plan entirely and just go with the IRA. "Limited" doesn't necessarily mean a short list of options, either. For instance, some plans really push lifecycle funds, which have advantages for some but are often frustrating for more knowledgeable investors.

I've also seen 401(k) plans that had four or five equity funds -- but they were all from the same fund family and shared several top holdings, usually S&P 500 heavyweights like ExxonMobil (NYSE:XOM), General Electric (NYSE:GE), and Johnson & Johnson (NYSE:JNJ). In terms of performance, those funds were quite similar.

Even if you have diverse choices, if they're lousy performers, or the fees are really high, or both, you may feel you can do better elsewhere.

But I think you can't. It's hard to match the match.

You really want to give up that match?
Almost every 401(k) plan has something worthwhile in it. Sure, it may not be the low-fee five-star fund of your dreams, but is there something there you can live with, especially when the match is factored in? If your employer is offering a 50% match, that's a 50% return on your investment -- before you even invest!

Unless you are really confident in your stock-picking skills (and you can back up that confidence), it's hard to walk away from the match. Of course, that doesn't mean you have to max out your 401(k), especially if the match is only on the first 5% or 6% of your salary.

So here's what to do:

  • Find something in your plan that fits into your asset allocation plan
  • Invest enough to collect the full amount of the match
  • Use IRA investments to fill out the rest of your portfolio

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