Most Americans generally have two ways to save for retirement, thanks to employer-sponsored 401(k) plans and individual retirement accounts (IRAs). Both have their pros and cons, but depending on your situation, investing in one type of retirement account may be better than another.
Here are three important things to consider when deciding between investments in a 401(k) or IRA in 2018.
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1. Have you maxed out your 401(k) match?
One of the biggest advantages of a 401(k) plan is that many offer employer matches whereby your employer will chip in some cash to match the money you put in your 401(k). A common structure is a percentage match, up to a particular percentage of your salary.
For example, your employer might offer to match 50% of your contributions up to 6% of your salary. Thus, if you contribute 3% of your salary, your employer would kick in another 1.5% of your salary, bringing the total contribution up to 4.5% of your earnings. In this case, it would be smart to increase your contribution to 6% of your salary to get all the benefit of the employer match.
Employer matches are literally free money. If you haven't maxed out the value of your 401(k) match, then contributing more to your 401(k) is a no-brainer in the new year.
2. What kind of choices does your 401(k) offer?
In general, most 401(k) plans only offer a limited selection of investments. Typically, employers will offer fewer than 30 different investment options, which often include target-date mutual funds, index funds, and actively managed mutual funds.
Depending on your plan, you may want to direct your savings to an IRA after you have maxed out your employer match. That's because IRAs offer more freedom than 401(k)s. Through an IRA, you can invest in exactly what you want to invest in, from individual stocks to tens of thousands of mutual funds and ETFs.
People who work for smaller companies typically have worse investment choices in their 401(k) than people who work for larger companies. That's because the cost of maintaining the 401(k) plan is spread out across fewer participants at smaller employers, and thus the plan sponsor makes up for that by offering higher-cost mutual funds.
Take a look at the funds and investment choices you have to choose from in your 401(k). The very best 401(k) plans offer low-cost index funds and institutional share class mutual funds with expense ratios of 0.20% or less.
Of course, expense ratios are relative. The data table shows what investors pay in fees, on average, for each type of investment fund. If your 401(k) plan offers funds with expense ratios that are significantly higher than shown, you may want to prioritize IRA contributions after maxing out the value of your 401(k) match.
What you pay to invest has a very big impact on long-term investment returns. Data from a Morningstar study show that the single greatest predictor of future returns is a fund's expense ratio. The lower the expenses, the higher the returns for the investor, all else equal.
3. Don't forget about cutoff dates
One of the advantages of an IRA is that contributions up to the date taxes are due can count for the prior year's taxes. If you want to make a contribution to an IRA for the 2017 tax year, you have until April 17, 2018, to make the contribution.
In contrast, not all 401(k) plans offer the option to make contributions after the end of the tax year. Furthermore, most 401(k) plans only allow for contributions by a payroll deduction. This means you'll have to push your paychecks into your 401(k) plan because plan sponsors generally don't allow you to simply write a check to contribute more to your plan.
By making a contribution to a traditional IRA up to April 17, 2018, you'll be able to deduct your contribution against your income for taxes in the 2017 tax year. Contributions to a Roth IRA up to April 17, 2018, can be used to make post-tax investments from your income in 2017.
There's a lot to think about here, but the basic guideline is pretty simple. Max out your 401(k) employer match first. After that, it generally comes down to cost vs. convenience. Making additional contributions to a 401(k) is relatively easy, but the convenience may come at the cost of investment selection and higher fund fees.
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