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Last week’s column talked about some of the “everyman” tax shelters available these days — including 401(k) plans and IRAs. Today I want to talk about how those two different accounts relate to each other.
Let’s start with a simple question …
Which Is Better — A 401(k) Plan or an Individual Retirement Account?
We’ll assume that your employer offers a 401(k) plan and that you also meet the income requirements to fund either a Roth IRA or a regular IRA.
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| It’s worth taking the time to figure out what retirement accounts work best for you. |
My next question is going to be whether your employer also offers some sort of a contribution match.
If the answer is “yes,” and it probably is, then I’m almost always going to suggest going with the 401(k) plan first.
After all, your employer’s match is essentially free money, and an immediate return on the money you personally investment. Under this scenario, even putting your own contributions into cash equivalents is earning you something with rock-solid safety.
Sure, there could be some sort of vesting schedule that requires you to stay on as an employee before all the match is permanently yours, but it’s still a worthwhile opportunity. And please note that your own contributions are always yours to keep no matter what.
In addition, your 401(k) contributions will reduce your immediate tax burden. With tax day less than a week behind us, I’m sure that’s something you can appreciate!
Now, how much should you contribute to a 401(k) plan? If possible, at least enough to get the maximum match.
Beyond that, and assuming you have more money you can contribute to a retirement plan, I would then take a closer look at your other options.
Contributing the remainder to your 401(k) plan will continue to help you reduce your immediate liability to Uncle Sam. In 2010, the regular contribution limit is $16,500 with another $5,500 catch-up contribution limit for anyone 50 or older.
Of course, the exact benefits of putting more money into a 401(k) greatly depend on your bigger financial picture …
For example, will it help you avoid a higher tax bracket? Will it lower your modified adjustable income to the point of allowing you to take additional tax deductions or credits? Do you also live in a state and/or city with a high tax rate (and that allows you to deduct retirement contributions)?
As you can see, there’s a lot to think about. But it is worth spending a couple minutes to figure out.
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| With a few simple steps, your 401(k) can easily roll over to an IRA. |
By the way, you should also consider your age. Why? Because the farther away from retirement you are, the more attractive the Roth IRA might be.
After all, it trades immediate tax relief for long-term tax-FREE growth in your portfolio. Obviously, the more time your portfolio has to grow, the more powerful that advantage becomes. And the farther out your time horizon is, the more likely it is that you’ll want to hedge against future tax hikes.
In such scenarios, you could simply opt to fund your 401(k) plan for the match and then contribute the rest of your funds to a Roth IRA every year. That’s a really nice balanced approach, in my opinion.
Okay, But What Should You Do If You Leave Your Job …
Or If You Have an Existing 401(k) Plan with a Previous Employer?
Obviously, if you’re at least age 59½ and you plan on retiring, you can withdraw the entire amount and start enjoying it penalty free. Note that your employer will withhold 20 percent for taxes.
However, if you’re not yet retirement age and you’re planning on getting another job, you have four choices …
Choice #1. Cash out your plan. This is the absolute worst move, in my opinion. Sure, you’ll get some money right away. But you’ll also be responsible for taxes and most likely a 10 percent penalty to boot.
Choice #2. Leave the money right where it is. Most employers (or their plan administrators) allow this, though many impose a certain minimum account balance, such as $5,000. This is a fine choice if you really like the options available through your old employer’s plan. However, from an administrative standpoint, it’s a pain because it will be one more account to keep track of.
Choice #3. Roll the money over to your new employer’s plan. If you’re going to participate in your new employer’s plan (and I hope you will!), then it’s likely that you’ll be able to bring your old 401(k)’s assets into the fold. That will allow you to keep all your retirement assets in one place. Plus, it will be much easier to see how your overall portfolio is allocated.
Choice #4. Roll the money into an Individual Retirement Account. Yes, you would still have one more account to keep track of. But you also have:
- Unlimited investment options. You are no longer at the mercy of your company’s plan. In an IRA, you can buy stocks, bonds, mutual funds, ETFs, etc.
- Low trading costs. Some employer pension plans charge exorbitant fees for managing your money, and often these costs are hidden. In contrast, there are plenty of no-fee IRAs available from deep-discount brokerage houses.
Again, only you can decide which option would work best for your particular situation. But in my opinion, the rollover IRA option is going to be best for most people and circumstances.
The bottom line is that both 401(k) plans and the various flavors of IRAs offer you unique opportunities, especially when it comes to controlling your tax situation. So I encourage you to learn all you can and use them to best advantage.
Best wishes,