Should You Fund Your 401(k) or IRA First?

Most of the time, there’s a clear answer.

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You’ve heard over and over that you need to save more than you think for retirement and you’ve answered that call. You might have even taken your retirement savings one step further and set up a 401(k) and an IRA. If that’s you, congratulations on such a wise decision but how do you decide which gets your money first: your 401(k) or your IRA?

Does Your 401(k) Have an Employee Match?

This is always the first question to ask because you don’t want to turn down free money. Many employers will help you fund your 401(k) by matching your contributions. The more generous companies will match dollar for dollar while others may do 50 cents per each dollar you contribute or some other amount. If your employer is matching your contributions, you should fund your 401(k) before your IRA.

One caveat—most employers also place a cap on the amount they will match. Up to 3% to 6% of your income is common. For example, if you earn $60,000 per year, and your employer matches 100% of income up to 3%, your employer will contribute up to $1,800 assuming you contribute $1,800 as well.

In this scenario, the first $1,800 of your retirement contributions should go to your 401(k), without question.

How Does Your 401(k) Stack Up?

We’re not going to say no to free money but once that perk ends, we need to drill down into the details of your 401(k). Depending on your company, you may have a really good 401(k), or it might be marginal at best. The best way to measure the quality is by looking at the fees

First, look at the menu of offerings you have to choose from. How many options have fees below 1%? Below 0.5% is better but don’t expect all of the offerings to be that low. You should have choices that are well below 1%, however.

Next, look for any other fees you’re paying. These could include plan administration fees, investment fees, and sometimes individual service fees. Total fees are estimated between 2% and 5% of total assets in most studies but your fees might be outside that range.

Compare these fees to what you would pay for your IRA. One of the selling points for your IRA is the number of investment options you have available to you and the wide variance in cost. For example, you could invest in individual stocks that have a one-time transaction fee between $0 and $7. You could purchase shares in a low fee ETF for that same transaction fee plus a small fee built into the fund. Other investments will come with higher fees but with the number of options you have available to you, it’s easy to put together a portfolio that is low in fees.

You will likely need help putting your IRA portfolio together. A fee-only financial advisor should come with at a cost between 1% and 2% of assets or you can use a robo advisor and put together a model portfolio based on your financial makeup for very little cost—often below 0.5% of assets.

Once you have an informed and educated look at the fees with each account, the next round of money will go to the account with the least amount of fees.

Yes, you should consider the performance of your 401(k) versus the past performance of your IRA, but reducing fees is the most consistent way to make money because the fees aren’t based on the performance of the market—something you don’t have control of.

Look Back to the 401(k)

Unfortunately, IRAs have low maximum contribution rates. As of 2019, individuals under 50 can contribute $6,500 and people 50 and over can contribute $7,000, annually. Depending on your income and how far along you are in your career, you might need to contribute more each year. If you max out your IRA, put the remainder in your 401(k) since the maximum contribution is higher (for 2019 that’s $19,000; $25,000 if you’re age 50 or over).

Other Considerations

If investing for retirement were as easy as doing some math, we'd all be retiring comfortably. Here are a couple of complications to think about.

Discipline

If you don’t have the discipline to contribute to your IRA, stick with your 401(k) where contributions are made out of your paycheck. (Although you should be able to set up a deduction to go to your IRA just as easily.)

Taxes

Most 401(k)s are funded before taxes are taken out of your check. You also receive a tax deduction when you contribute to a traditional IRA. With anything dealing with taxes, things are rarely easy and straightforward. Talk to a financial planner or accountant to see how the tax treatment of IRAs and 401(k)s applies to you.