IRA or 401(k) — Which Should Have Priority?

"If I can afford to contribute to either an IRA or a 401(k) but not both, which should I choose?" The question is a common one, and the answer depends on your situation. Both types of accounts provide tax-deferred growth, and IRAs have the same tax deductibility as 401(k)s (I'm referring here to the "non-Roth" variety of IRAs and 401(k)s.)

Still, there are differences between IRAs and 401(k) that should be considered in determining which option makes the most sense in your particular situation. Let's take a look at these differences.

• Control. With an IRA, you're in control. You control which financial institution holds your IRA and, if you want to, you can choose to move your IRA to another company. With a 401(k), these decisions are at the sole discretion of your employer. So on this point, the advantage goes to the IRA.

• Investment options. IRAs aren't investment specific. In other words, many different types of investments are allowed within an IRA, ranging from CDs to precious metals. Your investment choices usually depend on the financial institution you choose to place your IRA with. For example, if you open your IRA with a bank or savings institution, you'll likely end up in a savings account or CD. These are typical bank products, and will return specified interest rate (usually ranging from about 1% to 5% per year), depending on economic conditions.

If you open your IRA with an insurance company, you may end up in a fixed or variable annuity. These are the products that insurance companies manufacture. A fixed annuity is low risk and a typical return might be 4%-6%, depending on market conditions. Variable annuities have sub-accounts which are managed like mutual funds; however, due to the higher fees, the net returns to investors are not quite as good.

For most people, opening an IRA with a bank or insurance company probably isn't the best option.

If your IRA is with an investment company, such as Fidelity or Vanguard, your investments likely will be in mutual funds, giving you access to potentially higher returns. While the stock market generally averages about a 10%-12% return, performance can vary widely (as we’ve seen over the past couple of years).

Most 401(k) plans also are invested in mutual funds, too, but there is a clear advantage to IRAs. The reason is that many 401(k) plans offer only a handful of mutual funds from which the employee can choose — sometimes as few as 6-10 options. With an IRA, on the other hand, your mutual-fund options are virtually unlimited depending on which provider you use. This makes an IRA clearly more flexible than a 401(k).

• Rules of the game. The rules for participation, contributions, and withdrawals are what truly distinguish an IRA from a 401(k). (Much has been written about the strengths and weaknesses of the two main types of IRAs — "traditional" and "Roth" — so we won't focus on that here. Just realize that your 401(k) vs. IRA comparison can change dramatically depending on which type of IRA you choose.)

If your employer offers a 401(k) plan, you can participate provided you meet the eligibility requirements of the plan. These requirements usually include age, length of service, and number of hours worked, to name a few. Contact your plan administrator for details regarding your specific plan.

Thus far, IRAs have held the upper hand in our comparison, but here that begins to change. One major advantage of the 401(k) is that you're able to save a greater amount of your pay (up to $16,500 per year in 2011) than you can to an IRA. With special "catch-up" contributions, people age 50 or above can contribute up to $22,000. Compare that to the maximum $5,000 contribution allowed for an IRA, with a $1,000 additional catch-up for those 50 and above in 2011. If you have serious saving to do, 401(k)s offer a clear advantage here.

The trump card of the 401(k) plan is employer matching. Not all employers match contributions, but those that do offer a huge benefit. For example, suppose your employer matches 25% of what you put in up to a limit equal to 3% of your compensation. That means for every dollar you put in, your employer will add $0.25 up to that earnings limit. That means that you are immediately 25% ahead, an advantage that clearly tips the scales heavily in favor of the 401(k). If your 401(k) has any type of employer matching, you should always try to contribute at least enough to take full advantage of the matching provision. Only after you've reached the matching ceiling should you consider an IRA alternative. (Also, make sure you understand any vesting rules that may apply to the matching funds in your 401(k).)

Two other advantages of the 401(k) include the ability to borrow from your account (in most plans), and the favorable creditor protection 401(k)s provide. Generally speaking, it's not a good idea to borrow from your 401(k), but if you had a true-emergency situation, it's nice to know that you can access the money without paying penalties. With an IRA, there is no borrowing provision, and early withdrawals are hit with a steep 10% penalty. Also, if truly bad times were to hit, many states allow creditors to seize your IRA assets, but not your 401(k) money.

Regarding withdrawals, both IRAs and 401(k)s are subject to premature distribution penalties of 10% if money is taken out prior to age 59½. For example, if someone withdraws $20,000 prematurely from an IRA, the penalty will be a tax bill of 10% (i.e., $2,000) plus all regular federal and state income taxes that would be paid on $20,000 in income. Someone in the 33% federal tax bracket in a state such as California may end up paying as much as 45% to 50% of the amount withdrawn in penalties and taxes!

Fortunately, many 401(k) plans have "hardship" provisions — related to events such as death, disability, or severe financial hardship — that may ease the tax burden for early withdrawals. Check with your plan administrator for the details of your plan.

SUMMARY

When deciding between your 401(k) and an IRA, make sure you have all the facts about both your employer plan and the IRA options available to you. If your plan has a matching provision, you'll almost always want to focus your retirement investing there until you reach the matching limit, regardless of the specific investments offered by the plan.

If no matching is offered, or if you want to make contributions beyond the matching limit, look at the specific investments offered within the 401(k) plan. Do they meet your investment needs, or do you need the flexibility of an IRA? Does your company plan only offer load funds? If so, you will likely want to maximize your IRA options outside the plan to avoid these fees. (You may want to look into a Roth IRA, especially if you have many years before retirement. A Roth offers no tax deduction on the front end, but withdrawals in retirement will be tax free.)

This decision between a 401(k) and an IRA is not an "all or nothing" proposition. For many, the best course may be to contribute to your 401(k) up to the matching limit, then fully fund an IRA. If you have the ability to save even more, additional contributions to the 401(k) would be in order. Both IRAs and 401(k)s are excellent tools to help you reach your retirement goals, and can be used in combination as your financial circumstances change.

Learn more about Christian investing and finances at the Sound Mind Investing website.