A Down the Trenches Look at Traditional IRA vs 401k

by David Ning · 18 comments

After weeks of waiting and calling everyone to do their part of the process, I finally got my 401k moved over this week. During this time, I realized a few important facts about the 401k offered by my employer.

  1. The employer match will not be fully vested until my 10th year of employment (it starts on my 5th year)
  2. Those high fees in my fund selection really added up over the last few years
  3. Speaking of fund selection, there weren’t much to choose from

When everyone collectively echos the same reasons, even wrong advice can become sage.  This made me wonder: Should I have contributed fully on my 401k or should I have invested in other forms of retirement plans (namely a Traditional IRA)?

Before I explore this further, note that I’m not wondering about this because of the recent market crash.  Whether the market goes up or down is irrelevant because even if I didn’t contribute to a 401k, the funds would be invested in stocks.

401k vs Traditional IRA

So is contributing to a 401k better than a traditional IRA?  Let’s find out as I’m eager to find out as well.

401k’s Case

In order to figure out whether Traditional IRA would be a better option, let’s look at the two main advantages of 401ks: dollars taken out during each paycheck pre-taxed and the company match.

  1. Pre-tax dollars – While a traditional IRA gave you the same pre-tax dollars benefit, you won’t get your money back until at least March or April of next year (when you file your tax return).  This means that for your first contribution of the year, you are giving the tax refund portion a 15 month loan by contributing to a Traditional IRA (and a 3 month loan for the last payment).  Averaging all of this, you are effectively giving out a 9-month loan on the tax portion of all your contributions.  Assuming that you are in the 25% bracket and that you will put these funds in a high yield savings account yielding 2.8%, you are giving up 0.7% of interests by contributing to a traditional IRA.

    Update: Reader Rick gave a creative way to get your money back earlier if you contribute to a Traditional IRA:

    All you have to do is submit a new W-4 form with your employer and claim 1 or 2 more allowances. You can claim 1 allowance for every $3500 you will be contributing in 2009 to the traditional IRA. If you are self employed, subtract your IRA contribution from your estimated income and then figure out your estimated tax to send in.

    Following this advice will means that less taxes are taken out of your paycheck each cycle (or if you are self employed, each estimated tax payment is smaller).

  2. Company Match – As I mentioned earlier, my employer contributed up to 2.5% of my salary.  I took full advantage, but failed to account for the fact that by staying only 5 years, I only got half of that.  Since I contributed 15% of my salary, 1.5% added 10% to my contributions.

Based on these two points, using 401k gave me a 10.7% (rough) advantage per year.

Traditional IRA’s Case

On a numbers perspective, traditional IRA’s only advantage seems to be a possibility of lower fees (due to more choices).

Fees – On my 401k, I have the funds broken down like this:

  • 40% – Blackrock S&P 500 Index Fund
  • 25% – Blackrock Large Cap Growth Fund
  • 10% – Goldman Sachs Midcap Value Fund
  • 25% – Thornburg International Value Fund

Average fees: 1.56% (when taken into fund allocations)

If I invested with a traditional IRA, many low fee funds (or ETFs) would’ve been very similar to the funds I picked. So conservatively speaking, I could save 1% in expense fees.

Another point to note is that while looking at my wife’s 401k fund selections, I noticed that the funds available to her had even higher fees across the board. For her, the advantage of contributing to a traditional IRA would be higher.

Conclusions

As it turns out, investing with my employer’s 401k was the right choice but looking at the details reveals some useful facts.

  1. Employer Match is King – As you can see, the employer match adds a significant advantage to contributing in a 401k.  However, contributing 5% (as opposed to 15%) would have yielded the same match.
  2. Employer Match Limits – If there is no employer match, the math clearly favors a traditional IRA (assuming you can find lower fee options).  Since the employer match is the same whether I contributed 5% or 15%, any contributions over 5% should be made to the traditional IRA instead.
  3. Many traditional IRAs have commission fees whenever you buy and sell securities which will increase the fees.  In order to eliminate that, you can either open a brokerage account with Wells Fargo or Bank of America (assuming you have $25,000 in combined assets with them) or consider options such as Zecco (where trading commissions are $0).
  4. The contribution limits to a IRA is lower than a 401k.  For 2008, the contribution limits for an IRA are $5,000 ($6,000 if you are over 50).  401k limits are at least $10,000 more per year.  Therefore, you should contribute in your 401k up to your employer match, then switch to a traditional IRA.  If you still have money left over at this point, then continue contributing to your 401k.
  5. The limit for IRA works for both traditional IRA or Roth IRA so you essentially need to make a choice.  Is Roth IRA a better option?  That’s a discussion for another time.

So can you find any flaws with my math and is the assessment correct?  If so, why do no one (except Jim Cramer) ever advise people to do this?  What’s wrong?

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{ 18 comments… read them below or add one }

Sam January 26, 2009 at 10:23 am

Wow 10 years vesting, that’s rough. That would make me seriously consider not putting my money in it. If the IRA had higher limits I would just use that. If I saw myself at the company for a long time, I would probably put some in my 401k too.

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Erica Douglass January 26, 2009 at 11:12 am

Hi David,

The IRA/April drawback is also a benefit. I put my IRA money in a high-yield savings account all year and then push it into my IRA account in April. As long as you fund your IRA before April 15, you’re set. So, I haven’t funded my IRA for 2008 yet, but I will in April 09. It’s an interesting benefit.

But overall, the low contribution limits suck. I make too much money to put my money in a Roth…and probably always will, unless they remove the limits entirely.

-Erica

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MoneyNing January 26, 2009 at 12:12 pm

Sam: It’s hard to decide whether you will stay at the company for so long for sure. I didn’t realize it was THAT long, but at least I stayed 5 years and got some of it back. Otherwise, the whole investment would be a complete waste since a traditional IRA would clearly be better.

Erica: If you delay your contribution, you are basically believing that investments will always under perform savings right?

I mean, every year, you are delaying your contribution for one year. If investments performs worst than high yield savings, you are better off. But by delaying this EVERY year, you are assuming that investments will ALWAYS under perform.

Then again, having a few thousand dollars in a high yield savings account for emergencies is always a good idea, so I’m sure the answer to “which method is better” is “depends” :)

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Matt @ StupidCents January 26, 2009 at 1:11 pm

I personally like a Roth IRA [over a traditional IRA and] over a 401k because I like the flexibility of choosing my own funds. In rare instances, some 401k offerings do allow a self-directed option. I, however, do not have that luxury.

After we max out both my wife’s and my rIRA (currently $5,000), we only contribute enough to our 401k to get the full employer match. No reason to throw away free money.

While I’m no investor ‘guru’ I pride myself in at least beating the market. Even though I do my research in choosing the best funds the 401k allows, my returns have always been better in both our rIRA’s.

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Sandy January 26, 2009 at 1:17 pm

I always contribute $415 each month into my IRA account. I keep hearing that most people just put in that $5000 lump sum but I never got why people have that much money.

It works out for me because I keep investing and after a while, I have lots accumulated which makes me happy :)

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Matt @ StupidCents January 26, 2009 at 1:37 pm

@Sandy

I don’t put in $5,000 lump sum, but I will put in large chunks. A couple of reasons…

1) Most funds require a minimum investment, most are $1,000 and some even $4,000+.
2) When I do purchase a fund (or stock), there is a trading fee. I know there are free brokerage firms, but I chose a brokerage that allows me flexibility of choosing a wide variety of funds. So with that in mind, I make larger purchases to absorb the fees.
3) I make more money in my high interest savings account than the money market fund my broker uses.

Along your same lines, I do budget a certain amount to retirement, I just don’t find it necessary to do it in pieces during the year.

Stupidly Yours,

Matt

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Erick December 8, 2012 at 1:35 am

Actually it’s more complicated than fakiag income. First of all, your eBay activities are not considered by IRS as a business, which means those fake $5000 don’t qualify for Roth IRA and you still have to pay capital gain tax unless you can prove it is a business. To prove it is a business, you would have to have cost basis in the stuff that you sold and prove that you have been doing it for profit for at least three out of five years. If you don’t pass the profits test, then you’ll have to prove that you carry on the activity in a businesslike manner. This includes, for example, keeping good books and records, promoting your business and holding down costs where possible. Now let’s pretend you prove it is a business, then you’ll have to pay SE tax of about 15% so $5000 would yield about $750 in SE tax. This also means that you can’t contribute the full $5000 to the Roth IRA because you don’t have $5000 of income after taxes. In other words, you have to fake $6000. Here’s the best part, when the IRS audits your tax return and find out about your fake income (trust me, they will find out if you get audit), you’ll get slap with penalties and additional taxes on your IRA contributions. Your $5000 in the IRA is going to get wiped out after figuring the penalties and taxes. This is not even the worst case. Your actions are considered intentional fraud and IRS will most likely press charges. You are not giving Uncle Sam free money, Uncle Sam has the right to the money. And because the earnings in Roth IRA are tax-free, you are avoiding paying taxes. Dude, you really think you can outsmart the IRS?? Why don’t you just open a regular broker account and pay taxes when you have gains. Seriously, you don’t want to mess with the IRS. It’s going to be a painful experience. If you in fact turn $3000 into $100,000, then you wouldn’t mind paying taxes like everybody else. I don’t mean to be like your parent but I just don’t want you to get in trouble especially with the IRS.

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Rick January 26, 2009 at 2:39 pm

I wouldn’t look at it as an either or solution, because the contribution limits on an IRA are pretty low. I’ve always maxed out a Roth IRA, then contribtued to the 401K to get full match. Finally I adjusted the amount over full match depending on curcumstances.

Fund fees suck but I suspect taxes are an even worse drag… Actually a very useful follow up article would be: At what % fees would it make sense to forgo tax sheltering of a 401K?

You would have to make some assumptions about future tax policies, allot for some lower returns of tax efficient funds and pick some investment lengths like 10,20, 30 years…

-Rick Francis

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Stock Investing Guru January 26, 2009 at 3:09 pm

I think employer match is awesome. Everyone please take advantage if your company does that. It’s FREE money to your retirement.

Also, I would suggest starting an IRA as a side retirement vehicle to your 401k if you are legally allowed to do so. I have not looked into it that much as I am an independent contractor, not employee. You will thank yourself later for creating a second retirement reserve.

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Sandy January 26, 2009 at 4:00 pm

The minimum investment is one reason why I follow the advice here, as well as many others to investing in an index fund instead of those high fee mutual funds.

My investment is down right now but I’m sure it will come back. I just have faith.

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AKP February 25, 2009 at 9:56 am

Hi,

I have a question related to 401k and traditonal IRA.

Can a person contribute the maximum limit (i.e., $4000 for year 2008 to traditional IRA) as well as deduct 401k (say $12000 for year 2008). One person told me that we can’t contribute in both of them for the same year if the salary is around 100K.

Thanks,
AKP

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MoneyNing February 25, 2009 at 10:13 am

AKP: From what I can tell, what you contribute to your 401k is irrelevant for your IRA, which is only based on the salary limit. So yes, you can do both.

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Don February 26, 2009 at 5:42 pm

Help:
I started contributing to the Employee Savings Plan at Work in December, instead of waiting until January, and am facing an extra $1500 tax bill for 2008 as a result. I am looking for a way to reduce that extra tax.

I put $6000 into a 2008 IRA in April 2008, when I was a contract employee and not covered by a Employer’s Savings Plan or Retirement Plan. In late September I gained new employment and became eligible for my new Employer’s savings plan starting in December. So 3% was deducted pre-tax from my December paycheck only and my 2008 W-2 was marked indicating I was in a Savings Plan (401K).

Instead of being able to deduct the $6000 IRA, I am ineligible to claim it because our combined AGI exceeds $105,000 — (using the IRA Deduction Worksheet for line 32 of form 1040). We also started an IRA for my wife at the same time, and since she is not covered by a Savings Plan, we can claim her complete deduction. So I’m facing extra taxes due to contributing to a Savings Plan for only one month in 2008.

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Jim Blankenship, CFP®, EA May 14, 2009 at 7:56 pm

Two additional benefits to having a 401(k) plan:

1) Access to the account without penalty if you separate from service on or after age 55, due to §72(t)(2)(A)(v). This is only allowed in a CODA plan, not in an IRA.
2) A vehicle to receive a rollover of after-tax contributions and growth in an IRA that has both before- and after-tax contributions when attempting to make a tax-free conversion to a Roth IRA, consisting solely of after-tax contributions.

Granted, these two provisions alone would not be good reasons to contribute to a 401(k) over an IRA or Roth IRA – but rather simply good reasons to have an account in your name.

jb

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cashmere May 10, 2010 at 5:47 pm

I read your post on IRA’s I want to ask this with the current economy and the future projections with the baby boomers is it still wise to invest heavily in our market? I as a business owner prefer more control of my cash flow. Do your agree?

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MoneyNing May 10, 2010 at 5:55 pm

Investing is all about long term, but cash flow is all about immediate needs. You should only contribute to retirement accounts to a point that doesn’t affect your cash flow, as it’s the life blood of your investments.

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vwilli August 18, 2010 at 7:17 pm

I invest about 12 percent of my check in my 401k and about 3 percent in a Traditional IRA that give me 15 percent to save and the rest I live off on. Have about 13 years before I recah 59 1/2 years.

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dale January 29, 2014 at 2:49 pm

question; my wife works full time-I am on a disability pension plus social security disability. Can I contribute to roth ira-maybe under non-working spouse? If so,how much?

Reply

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