Thursday, May 19, 2011

401k or IRA: Which Should You Fund First?

One of the questions that many people have as they plan for retirement is whether they should fund a 401k or an IRA first. And, of course, the answer depends on what you are trying to accomplish with your retirement fund.

IRAs and 401ks have some different advantages and disadvantages, and it is up to you to determine what is most likely to be the best course of action for you. As you try to figure out what to do with your retirement money, here are some things to consider:

The Employer Match

Your employer match is one of the most important considerations when deciding which type of account to fund first. If you have a 401k and an IRA, you might want to consider funding the 401k first if there is an employer match. You don?t have to max out the 401k, but you don?t want to leave money on the table, either. If your employer offers a 50% match up to 5% of your income, you can get a pretty good chunk of free money.

If you make $45,000 a year, 5% of your income is $2,250. If you put that $2,250 in, your employer match will be $1,125. That?s not too shabby, considering it?s free money. That boosts your annual contribution up to $3,375.

Once you?ve got your employer match covered, you can decide whether it?s worth it to put unmatched money in your company?s 401k. If your plan has high fees, or if your plan has options you aren?t happy with, you can put the some of the money in an IRA that you create yourself, using low-cost investments that you like. After you max the IRA out, if you have some money left over for retirement investing, you can reconsider whether you want the unmatched funds in your company?s 401k.

Flexibility

Often, you have more flexibility with investment options when you use an IRA. With a 401k, you are limited to what the employer offers, although you can always ask to have certain investments added to the plan. And, because you can open an IRA for a non-working spouse, it?s possible to double what you save as a couple for a year, since you can max out your IRA and your spouse?s IRA. However, even doubling up, you won?t be able to contribute as much to your IRAs as you could to one 401k each year.

You should also consider the flexibility of withdrawal options. With a 401k, you can borrow against your account, but if you don?t repay the loan, things can get really pricey really fast. Additionally, you have to pay tax penalties. With a Roth IRA, you can withdraw your contributions (but not the earnings) when you want. A traditional IRA also has some flexibility when you withdraw for some expenses. The 401k, on the other hand, has an interesting option that allows you to withdraw money if you retire after 55 ? no penalty (but the money is still taxable).

Tax Situation

Naturally, you will need to consider the tax situation. In the past, if you wanted to withdraw money tax free in retirement, you concentrated mostly on the Roth IRA, paying taxes on your income now. However, if your employer offers the relatively new Roth 401k, you may not have to make that choice.

If you would rather have the tax benefits now, in the form of a deduction, you can contribute more to a traditional IRA or a traditional 401k.

Ideally, you would be able to max out a 401k and an IRA in a year. However, most of us won?t be maxing out all of our retirement accounts; we have to choose between them. With a little thought and planning, you can divide up your retirement contributions in the way that will benefit you the most.

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Source: http://www.bargaineering.com/articles/401k-ira-fund.html

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