So far IRAs have held the upper hand in our comparison, but here that begins to change. One major advantage of the 401(k) is that you are generally able to contribute 15% of your pay (up to $16,500 per year in 2009). With special "catch-up" contributions, people age 50 or above can contribute up to $22,000. Compare that with the maximum $5,000 contribution allowed for an IRA, with a $1,000 additional catch-up for those 50 and above in 2009. If you have serious saving to do, 401(k)s offer a clear advantage here.

The trump card of the 401(k) plan is employer matching. Not all employers match contributions, but those that do offer a huge benefit. For example, if your employer matches 25% up to 3% of your compensation, that means that your employer will add $0.25 for every dollar you contribute up to that earnings limit. That means that you are immediately 25% ahead, an advantage that clearly tips the scales heavily in favor of the 401(k). If your employer's 401(k) has any type of matching, you should always try to contribute at least enough to take full advantage of the matching provision. Only after you've reached the matching ceiling should you consider an IRA alternative. Also, make sure you understand any vesting rules that may apply to the matching funds in your 401(k).

Two other advantages of the 401(k) include the ability to borrow against it in most plans, and the favorable creditor protection it provides. While generally it is a bad idea to borrow from your 401(k), and it is not advised except in a true emergency, it is still an advantage as you can access the money without paying penalties. With an IRA, there is no borrowing provision, and early withdrawals are hit with a steep 10% penalty. Also, if truly bad times were to hit, many states allow creditors to take your IRA assets, but not your 401(k) money.

Regarding withdrawals, both are subject to premature distribution penalties of 10% if taken out prior to age 59½. For example, if someone withdraws $20,000 prematurely from their IRA, the tax penalty will be 10%, or $2,000, plus federal and state income taxes. Someone in the 33% federal tax bracket in a state like California may end up paying 45% to 50% of the amount withdrawn for penalties and taxes. However, with a 401(k) plan, there are often hardship provisions such as death, disability, or severe financial hardship, in addition to the loans mentioned above. Check with your plan administrator for the details of your plan. 401(k) plans are often a bit more flexible in this regard. (Roth IRAs are a little more flexible in this regard.)

Summary

When deciding between your 401(k) and an IRA, make sure you have all the facts about both your employer plan and the IRA options available to you. If your plan has a matching provision, you'll almost always want to focus there until you reach the matching limit, regardless of the specific investments offered by the plan. If no matching is offered, or for contributions made beyond the matching limit, look at the specific investments offered within the plan. Do they meet your investment needs, or do you need the flexibility of an IRA? Does your company plan only offer load funds? If so, you will likely want to maximize your IRA options outside the plan to avoid these fees.

This decision is not an "all or nothing" proposition. For many, the best course may be to contribute to your 401(k) up to the matching limit, then fully fund an IRA. If you have the ability to save even more, additional contributions to the 401(k) would be in order. Both are excellent tools to help you reach your retirement goals, and can be used in combination as your financial circumstances change.

© Sound Mind Investing

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