The 401(k)’s high contribution limits, employer match, and automatic paycheck withdrawals make it a popular choice for retirement savings. But it can also have drawbacks that make it a poor first choice for some people.
If any of the following scenarios apply to you, consider placing your money in an IRA first and returning to your 401(k) later, should you max out your IRA.
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1. Your company doesn’t offer a 401(k) match and charges high fees
A 401(k) typically charges higher fees than an IRA, but it’s easy to overlook this if your company also matches some of your contributions. These extra contributions can potentially be worth thousands of dollars, depending on your salary, your personal 401(k) contributions, and how the company’s matching system works. That’s probably a lot more than you’re losing in fees annually.
Not all companies match employee 401(k) contributions, though. An IRA might be a better fit if yours doesn’t because it could save you money on fees compared to sticking with your 401(k). You can put your retirement savings here first, and if you reach the $6,000 annual contribution limit for 2021 ($7,000 for those 50 or older), then you can switch back to your 401(k).
It doesn’t hurt to talk to your employer about adding some low-cost investment options, like index funds, if it doesn’t offer any right now. This could make your 401(k) a more-appealing place for your savings, even if it doesn’t come with a match.
2. You want more freedom to choose your investments
A 401(k) usually limits you to a few investment options your employer selects, but these aren’t always a great fit for your long-term goals. You can ask your employer to add some other investment options if you’re not happy with the existing choices, but it doesn’t have to comply. If the company refuses, you might prefer to save in an IRA instead.
IRAs offer a greater variety of investment choices, and you’re in complete control, so you can decide what you want to invest in and change that up as often as you see fit. But you also have to weigh your comfort level with managing your own investments. Those with little experience investing may prefer to stick to what their employer offers in their 401(k) instead.
3. You want a Roth account but your company only offers a traditional 401(k)
Traditional, tax-deferred 401(k)s are the most common, though Roth 401(k)s are rising in popularity. Traditional 401(k) contributions reduce your income for the year, but you must pay taxes on your distributions. Roth 401(k) contributions don’t affect your taxable income this year, but then you get tax-free withdrawals in retirement. Some companies offer both types, so you can choose the one that will benefit you the most, but others may only offer a traditional 401(k).
If you’d like to contribute to a Roth account and your company doesn’t offer one, a Roth IRA might be a better place for you to put your retirement savings first. Paying taxes now is often a smarter financial move for those who think they’re in the same or a lower tax bracket now than they’ll be in once they retire. Then, if you max that out and you’d like to save more, you can switch back to your 401(k).
IRAs and 401(k)s both have their pros and cons. Rather than just contributing to your 401(k) because it’s there, you should weigh its costs, matching system, and investment options to decide if it’s the best place for your savings right now. If it’s not a great fit, start with your IRA first.