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Which is better: An IRA or 401(k)?
Working Americans eyeing retirement typically look to their company’s 401(k) plan as the best place to nurture a nest egg. These plans contained about $3.5 trillion in assets in 2012, up from $1.6 trillion in 2002, according to the Investment Company Institute.
For many people, a 401(k) plan is the best choice, especially if their employer matches employee contributions up to a given percentage of their pay. A 401(k) also is easy to set up and use, with contributions flowing directly from your paycheck. Many companies automatically enroll their employees, so workers don’t have to do a thing.
However, another popular retirement vehicle — the individual retirement account, or IRA — offers some key advantages over a 401(k).
Following are five ways in which investing in an IRA may trump using a 401(k) plan.
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Bigger and better selection of mutual funds
Most company 401(k) plans offer a limited number of investment choices. The average 401(k) plan offers participants a selection of just 19 funds, according to a recent study by the Plan Sponsor Council of America.
Those constraints disappear when you open an IRA with one of the nation’s leading mutual fund companies. For example, T. Rowe Price sells more than 100 of its own mutual funds, Vanguard offers more than 150 and Fidelity has nearly 200.
In addition, these custodians allow you to purchase mutual funds from other companies. Fidelity says its customers can select from an array of more than 10,000 funds from hundreds of firms.
Having a wide variety of investment options can protect you from the mistake of putting too much of your nest egg into a single mutual fund, says Nathan Kubik, a Certified Investment Management Analyst at Carnick & Kubik, which has offices in Denver and Colorado Springs, Colo.
“There is no way to guarantee a (single) fund will perform well,” he says.
Investing with a firm that offers a greater selection of funds allows an investor to build a diversified portfolio that matches his or her level of risk tolerance, Kubik says.
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Lower expense ratios and other costs
A 401(k) plan is a great place to build your nest egg, but the price of admission can be high.
The average 401(k) investor paid 0.63 percent in expense ratios in 2012, according to a study by the Investment Company Institute. That represents a fee of $6.30 for every $1,000 invested.
While that might not be so bad, 401(k) investors often are subject to a host of other fees that can further eat into returns.
By contrast, IRA investors can eliminate many such charges simply by purchasing no-load mutual funds from companies that hold the line on costs.
“Fees are one of the few things that investors can control,” says Joshua Itzoe, partner and managing director of the institutional client group at Greenspring, a wealth management firm based in Towson, Md. “The lowest-cost way to invest is through index funds or ETFs.”
For example, someone who holds the investor class shares of Fidelity’s Spartan Total Market Index Fund pays an annual expense ratio of just 0.1 percent — or $1 in costs for every $1,000 invested.
If you have at least $10,000 to invest in the Fidelity fund, your expenses drop to 70 cents per $1,000 invested.
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Option to invest in ETFs and individual stocks
In most 401(k) plans, you are limited to the mutual fund choices offered by your company. However, open an IRA and you have access to the world of exchange-traded funds, or ETFs, and stocks.
“Investing in ETFs or individual securities through an IRA can have many benefits,” Kubik says.
For example, ETFs typically charge lower expense ratios than mutual funds. Also, if you are someone who trades frequently, an IRA’s tax-deferred status can help keep your costs down, Kubik says.
“It is easier to have a very tactical portfolio,” he says. “An investor can buy and sell securities without the concern of tax consequences.”
Derek Tharp, a wealth manager with Mote Wealth Management in Cedar Rapids, Iowa, says that ETFs can be a wise choice in an IRA. However, he believes that portfolios of stocks are difficult to manage and are unlikely to provide enough diversification to protect investors over the long haul.
“The average investor should stay away from individual stocks,” he says.
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Easier access to Roth advantages
Investing in a 401(k) plan allows you to delay paying taxes to Uncle Sam for decades while your money grows.
But that big plus also comes with a drawback. Until you finally pay the tax, “the government still owns a portion of the investment,” Tharp says.
Putting the money into a traditional IRA creates a similar dilemma. But choosing a Roth IRA allows you to pay the tax up front and then enjoy tax-free growth now and untaxed withdrawals later.
“Tax deferral is a nice benefit, but it is nowhere near the benefit of tax-free growth,” Tharp says.
Some employers now offer a Roth 401(k) plan that mimics the benefits of a Roth IRA. However, such plans have not been universally adopted. For example, a Vanguard study found the Roth option was offered by 49 percent of the 401(k) plans for which it serves as the custodian.
Itzoe says a Roth makes the most sense for investors who expect their tax rate to be higher in retirement. However, it is hard to forecast that in advance.
“I wish I had a crystal ball and could tell you what tax rates will be in the future,” he says.
Because of this uncertainty, he recommends splitting funds between tax-deferred and Roth accounts.
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More options for withdrawing money penalty-free
In most cases, if you are younger than 59 1/2 years old and make a withdrawal from a retirement account — either an IRA or a 401(k) — you generally will have to pay taxes on the money, plus a 10 percent penalty.
But there are exceptions to the penalty rule, and some of them apply only to IRAs and not to 401(k) plans.
For example, first-time homeowners may tap their IRA for up to $10,000 to be applied toward a down payment for a house without paying a penalty.
You also can withdraw IRA cash penalty-free to fund higher education costs for yourself or immediate family members.
Try those maneuvers in a 401(k) and you will pay a 10 percent penalty.
Finally, if you open a Roth IRA, there are even fewer limitations to early withdrawals.
“You can always withdraw your contributions tax- and penalty-free,” Itzoe says.
In addition, you can spend the money however you like. Keep in mind that this rule only applies to your contribution, and that any early withdrawal of investment earnings is subject to a 10 percent penalty.
So, which is better: an IRA or 401(k)? Both have much to recommend themselves, but some might argue that IRAs have several distinct advantages.