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.
- The employer match will not be fully vested until my 10th year of employment (it starts on my 5th year)
- Those high fees in my fund selection really added up over the last few years
- 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.
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.
- 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).
- 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.
As it turns out, investing with my employer’s 401k was the right choice but looking at the details reveals some useful facts.
- 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.
- 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.
- 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).
- 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.
- 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?
Editor's Note: I've begun tracking my assets through Personal Capital. I'm only using the free service so far and I no longer have to log into all the different accounts just to pull the numbers. And with a single screen showing all my assets, it's much easier to figure out when I need to rebalance or where I stand on the path to financial independence.
They developed this pretty nifty 401K Fee Analyzer that will show you whether you are paying too much in fees, as well as an Investment Checkup tool to help determine whether your asset allocation fits your risk profile. The platform literally takes a few minutes to sign up and it's free to use by following this link here. For those trying to build wealth, Personal Capital is worth a look.