Choosing the right vehicle for your retirement savings is essential to maximizing their growth. Many people have the opportunity to contribute to a 401(k) through their employer. Those who don't have this option can open an IRA on their own. But what do you do if you have both types of account? Is it smarter to contribute more to one than to the other?
Yes, but the right retirement account will depend on several factors. Here's a brief overview of IRAs and 401(k)s and how to determine where your retirement savings should go first.
When to contribute to your 401(k) first
If your employer matches your 401(k) contributions, your money should go here first regardless of any other considerations. Why? Because a matching contribution is essentially an instant return of 50% to 100% on your investment, and you won't find that anywhere else.
A common employer match is $0.50 for every dollar you contribute up to 6% of your salary. In this case, if you contribute $5,000 this year and your annual salary is $50,000, you'll receive a 50% match on the first 6% of your salary, or $3,000, which amounts to an extra $1,500 from your employer.
That said, some employers will match your contributions dollar for dollar, and their match may be limited to a smaller or greater percentage of your salary.
Take advantage of this free money if it's available to you, but note that you may not get to keep all of that money if you plan to leave your employer after a short time. 401(k)s usually have a vesting schedule that determines when employer-matched funds become yours. Some companies require you to work for the company for a certain number of years before you become fully vested. Others employ a percentage-based system in which, for example, 25% of employer-matched funds are yours after a year, 50% after two years, and so on. Make sure you know your company's vesting schedule before you begin making contributions, especially if you don't plan to work there long.
Another advantage of 401(k)s is that contributions can be automated. A fixed amount will automatically be deducted from your paycheck each pay period, so you won't have to think about it. If you feel you would struggle to save for retirement on your own, a 401(k) might be a better option for you than setting aside money for an IRA.
If you're aged 55 or older and you plan to leave your job soon, a 401(k) is also the way to go. You're typically not allowed to withdraw funds from your 401(k) or IRA if you're under age 59 1/2. Doing so will cost you a 10% early-withdrawal penalty on top of income tax. But according to the IRS Rule of 55, if you're laid off, get fired, or quit your job at or after age 55, you can withdraw money from your current 401(k) without penalty. However, you will still pay a penalty if you withdraw money from other 401(k)s or IRAs.
When to contribute to your IRA first
IRA contribution limits are lower than 401(k) limits -- $5,500 (or $6,500 for those aged 50 and older) compared to $18,500 (or $24,500 for the 50-plus crowd) in 2018. However, if your employer doesn't offer a 401(k), you should definitely open an IRA rather than stashing that money in a savings account. Even if your employer does offer a 401(k), there might be times when you'd rather contribute to an IRA instead.
Retirement accounts come in two types: traditional and Roth. Contributions to traditional accounts don't count toward your taxable income this year, but you will be taxed when you withdraw the money. Contributions to Roth accounts are taxed in the current year, but not when you take the money out. While Roth 401(k)s do exist, they're not as common as traditional 401(k)s. If you're in a lower tax bracket now than you'll be in as a retiree, it makes sense to contribute to a Roth account so you hang on to more of your money. If your employer only offers a traditional 401(k) account and doesn't match contributions, a Roth IRA may be a better fit for you.
If you don't plan on exceeding the $5,500 IRA contribution limit, you may be better off putting your money in an IRA as well, assuming you don't get a 401(k) match. This is because 401(k)s often charge higher fees and offer fewer investment choices than IRAs, and this can eat into your profits.
You can contribute to both
There is no one-size-fits-all approach. You might want to contribute enough to your 401(k) to get your employer match and then put any extra savings in a Roth IRA account. Or you can contribute an equal percentage to both.
Think about what stage you're at in life and which type of account best matches up with your goals. Any retirement savings account is better than none at all, but by taking the time to consider your options, you can give yourself the best chance at building a comfortable nest egg.