One of my buddies at the gym recently asked me what’s the best way to start saving for retirement. He asked whether he should open an IRA or a 401(k). Let’s discuss the options.
In This Post
Option 1: Invest in your 401(k)
A 401(k) is a workplace retirement account that allows workers to contribute to a retirement account directly from their paycheck on a pre-income tax basis, meaning that your taxable income is reduced now, but you’ll pay income taxes on the money when you withdraw it in retirement.
For example, if you’re in the 25% tax bracket, when you contribute $1,000 to a 401(k), your taxable income is reduced by $1,000, which will save you $250 in taxes. This results in a net reduction in your paycheck of $750.
This is the reason I favor contributing on a pre-tax basis… you can get more money working for you today, while putting the taxes off to the future. The assumption being that you’ll be in a lower tax bracket in retirement because your income will be lower and/or you’ll have multiple types of assets that will allow you to structure your income to reduce your tax burden.
Another variation is the Roth 401(k) that was created a few years ago, which acts in the same manner as a Roth IRA — the money is contributed on an after-tax basis, but all withdrawals in retirement are income tax free.
The major benefits of the 401(k) are:
- the investments are automatic because they are taken directly out of your paycheck
- your employer may offer a matching contribution (generally 50% of what you contribute up to 6% — you contribute 6% of your salary, they contribute 3%, for a total of 9%)
- the investment options are generally lower cost versions of funds than you could buy directly from the provider
Option 2: Open an IRA
The Traditional IRA acts in the same way as a 401(k) when it comes to taxes. The amount you contribute reduces your taxable income, resulting in a lower tax bill. The example above is exactly the same for the 401(k) and the Traditional IRA.
When you open an IRA, you maintain control of the money, which many people like. However, that control also results in responsibility… you have to choose the company, set up the contributions (payroll deductions, monthly deductions to your bank account, or write a check), and potentially pay more in fees than you would in a 401(k).
On the plus side, you have an almost infinite number of choices… many, many investment companies to choose from and you have access to all of their mutual funds. In the 401(k), you only have access to the funds your employer has selected (usually around 6-10 funds) unless they offer a self-directed option.
With the 401(k), you can contribute up to $17,500 per year (+$5,500 if you’re over 50 years old), while the IRA maximum contribution is $5,500 (+$1,000 if you’re over 50 years old). The IRA maximum contribution can be affected based upon your income, your age, and whether you’re eligible to contribute to your employer’s retirement plan.
Here’s a maximum IRA contribution calculator from Schwab which will show you the maximum amounts you can contribute to a Traditional IRA or a Roth IRA based upon your income, whether you have a retirement plan at work, and your age.
What would I recommend?
I would recommend contributing to your 401(k) because it requires less effort on your part and there is the potential for the employer match (which boosts your balances!) either now or in the future. However, this option is only open to you if your employer offers a 401(k) [or similar plans like the 457 or 403(b)].
Many small businesses don’t offer a 401(k) due to the paperwork required, the thought that employees wouldn’t contribute, or many other reasons.
Since my friend’s employer doesn’t offer a 401(k), his best option is to open a Traditional IRA. If he does so now (or before April 15th), he can still contribute for last year and reduce last year’s income taxes!!!
Many would argue that a Roth IRA is the better option since they believe that taxes will rise over the next 30-40 years. But, I’m a fan of “a bird in hand is better than 2 in the bush.” I’d rather take the tax deduction now so the net impact to my cash is less.
Where to open an IRA?
This depends on how much you can open the account with. Due to the costs of servicing accounts and mailing/emailing statements, some companies will not do business with you unless you have a minimum amount to invest. Others are more friendly to the “little guy” who is just starting out and will open an account with a small initial investment and a promise to contribute a minimum amount every month.
Vanguard Investments
Their minimum is $1,000 for an IRA, with the $20 annual account service fee waived when you sign up for online access and e-statements.
T Rowe Price
Their minimum is also $1,000 for an IRA, with the $20 annual account service fee waived when you sign up for online access and e-statements.
Capital One ShareBuilder (formerly ING Direct)
There is no minimum to open an account and offer both FDIC insured products (savings accounts and CDs) and investment products (ETFs, Mutual Funds, and Stocks).
Others
There are so many others to choose from. You just need to find the company that suits you best and you feel most comfortable with. Some people like working with an advisor, who can counsel them, while others prefer to do their investing themselves with very little assistance.
What to invest in?
The 401(k) and IRA are tax codes. They aren’t investments. They are types of accounts that can hold investments such as Money Market accounts, CDs, Stocks, Bonds, ETFs, Mutual Funds, and many other types of assets.
I can’t give you a specific answer since I don’t know your risk tolerance and timeframe until you retire, or what other types of savings and investments you have.
However, many people start off with a Balanced Fund (mixture of stocks and bonds), an S&P 500 index fund (invests in the largest US companies), or a Target Date Fund (a pre-determined mix of investments designed to reduce risk as it approaches your retirement age).
Conclusion
We have many options how to save for the future. The 401(k) and IRA are just two of them… but they are the most popular accounts that the “average” person contributes to.
Whichever avenue you pursue, remember this… the two best times to invest are ten years ago (meaning we all wish we started a long time ago) and right now!
Don’t over-analyze all of the options… start now.
You can always move your account to another company, or you can always choose another investment option from the company you’re investing with.
If you have any questions, please leave a comment. Thanks! Happy investing!!!
