Financial Tips: When should a person use an Individual Retirement Account rather than a 401(k) plan? When should a person leaving an employer convert her 401(k) plan into an IRA?
Most financial advisors believe that workers saving for retirement should invest in a 401(k). rather than an IRA. Many government rules favor 401(k) contributions over iRA contributions. First, employee contribution limits for 401(k) plans are around 3 times higher than limits for IRAs. Second employees are allowed to make additional contributions to 401(k) plans but are not allowed to make similar contributions to IRAs. Third, many employers routinely match employee contributions. Fourth, the IRS imposes limits on deductibility of some iRAs but not the deductibility of 401(k) plans. Fifth, the IRS restricts Roth IRA contributions for higher income households but does not restrict contributions to Roth 401(k) plans.
IRS rules allow 401(k) plans to automatically enroll workers who do not opt out. However, there are situations where people are better off investing in an IRA separate from their employer than in the firm 401(k) plan.
The main factor favoring IRAs over 401(k) plans is the higher administrative costs of 401(k) plans. Fees on 401(k) plans are applied to the entire 401(k) balance and are often between 1 percent or 2 percent per year. These fees can substantially erode a workers 401(k) balance over the course of the workers lifetime.
High 401(k) fees are more prevalent at small firms than large firms. People working at a firm offering a plan charging high 401k) fees and offering little or no employer contributions need to look at other investment options than their 401(k) plan. High 401(k) fees can substantially erode retirement savings. These fees can largely be avoided by using an IRA rather than a 401(k) plan to save for retirement.
I constructed a spreadsheet to estimate the impact of high 401(k) fees at retirement savings. The assumptions in a baseline analysis involved a person with a starting salary of $50,000 who works for 35 years and realizes wage growth of 2% per year over her entire career. This person contributes 10 percent of her salary to a 401(k) plan and earns an annual return of 7%.
When fees are 2 percent of the end-of-year 401(k) balance the total fees over the entire 35-year career are slightly more than $153 k compared to an ending balance of slightly less than $600 k.
By contrast, when 401(k) fees are 0.5 % (a reasonable fee structure that exists at many firms) total fees over the 30-year career are around $48 k and the ending balance is around $830 k.
Note the difference between ending balances of the two scenarios is much larger than the difference in fees because additional 401(k) income from the lower fee compounds at the average rate of 7 percent per year.
One possible strategy for a worker at a firm that match some employee 401(k) contributions is to make a small contribution to the 401(k) to take advantage of the employer match and then invest additional funds in an IRA. This strategy may or may not be feasible depending on IRS rules governing IRA contributions, deductibility of IRA contributions, and the individual’s household Adjusted Gross Income.
The 401(k) fees are applied to all assets in the 401(k) plan. In the current low interest rate environment, the expected return on government bonds adjusted for 401(k) fees is negative. In this circumstance, it may make sense to place more 401(k) funds in equity and accumulate debt investments outside of a 401(k) account where they are not subject to 401(k) fees. One alternative, which many people overlook, is direct investment in Treasury bonds and bill at Treasury Direct.
Firms like Fidelity, Schwab, and Vanguard aggressively ask people who leave their employer to convert their 401(k) plan to an IRA. This is the rare case where aggressive solicitation from financial firms is actually sound advice. Fees on well-designed IRAs are often near 0.2%. The decision to maintain funds in a dormant high-fee 401(k) plan could lead to a substantial loss in retirement savings.
One of the key selling points of conventional 401(k) plans is the ability of these plans to reduce current year tax obligations. By contrast, Roth 401(k) plans and Roth IRAs do not reduce current year tax obligation but do reduce taxes in retirement. A person with low current year tax obligations and the ability to reduce taxes through other means such as contributing to health savings account may choose to reduce or eliminate contributions to a conventional 401(k) plan. This person might instead invest through a Roth 401(k) plan if available at her firm or through a Roth IRA. The lack of a Roth 401(k) option may lead some investors who are concerned about tax obligation in retirement to consider a Roth IRA over a conventional 401(k) plan.
The issue of deciding between a 401(k) plan and an IRA is related to several other issues including – the choice between debt reduction and mortgage savings, the choice between investing in a health savings account or a retirement account, and the choice between a conventional and Roth IRA. Other financial tips on these related issues will follow shortly.