Considering that you can buy 200 different types of toothpaste and watch 150 cable channels, your life is probably complicated enough. Do you really need an IRA and a 401(k)? The truth is, you very well may, because two types of retirement savings can be better than one.
401(k) features
An IRA offers tax breaks and investment flexibility, and it can sometimes even double as an emergency fund. With all these perks, why bother with a 401(k)? Because retirement can be expensive. While an IRA makes a great savings vehicle, it has a limitation -- a contribution limitation.
Let's say Ira B. Broke opens an IRA and contributes the maximum allowed beginning next year -- $5,000 -- every year for 25 years. He earns the market's historical 10% rate of return and retires with more than $600,000 to spend on golf and hair plugs.
Sounds like a lot, right? Maybe not, if you follow the advice of the gurus at the Rule Your Retirement newsletter. If you don't want to outlast your money, they suggest withdrawing a conservative 4% each year. That means Ira must limit his travel and cosmetic procedures to $24,000 annually. That may be plenty, but if Ira has a higher standard of living in mind, even $1 million may not be enough.
Add a 401(k) to your savings plan, and you can pretty much erase any worries that contribution limits will pinch your retirement lifestyle. Using a 401(k), you can save as much as $15,500 this year and next. And don't forget that your employer might be giving you free money.
IRA advantages
Why would anyone bother with an IRA, if a 401(k) lets you save so much more? Because an IRA can be more flexible than a yogi in a bound reverse twist.
Your 401(k) can hold a lot of money, but your choices of investments will be limited. If you're lucky, you have some excellent low-cost mutual funds from which to pick. IRAs, on the other hand, offer the opportunity to invest in anything you want. That means you can use your IRA to make up for any shortcomings in your 401(k), which may have a good U.S. stock index fund but lack options for diversifying your investments.
Missing some flair in your 401(k)? Your IRA can pick up the slack. Here are some examples: If your plan doesn't offer a good option for investing internationally, you can use your IRA to invest in an ETF like iShares MSCI-EAFE Index (NYSE:EFA). Closer to home, if you're interested in promising small companies like ValueClick (NASDAQ:VCLK), Diebold (NYSE:DBD), and National CineMedia (NASDAQ:NCMI), you can get them all with shares of the Fidelity Small Cap Independence (FDSCX) fund.
Here's an extra perk. If you open a Roth IRA, you can even hedge your bets against contributing too much for retirement. That account lets you take back any contributions tax-free, as long as you leave the earnings alone.
Best of both
Want to have your cake and eat it, too? You can do just that by splitting your retirement savings between an IRA and a 401(k). There's no rule that says you must max out one account before you start on the other.
If your employer offers a matching incentive for retirement savings, start there. Save enough in your 401(k) to sop up every penny of free money. Once you've done that, and you want to save even more, start filling up an IRA. You'll have the best of both worlds.
Keep reading to learn:
- everything you ever wanted to know about Roth IRAs and more;
- how to maximize your 401(k) in 60 seconds or less; and
- why you should prepare for a gruesome retirement.
