401K vs. IRA

Matt asked me recently which was better, a 401K or an IRA.

I wanted to answer it here in case future readers wanted to know...

It's a good question but in some ways it's like asking whether a pickup truck is better than a sedan. The answer is: it depends.

In a nutshell: 401k's are usually associated with your employer. The account is YOURS and the assets are yours, but the plan itself is usually (and by usually I mean I can't think of one that is not) attached to work. Moreover, since each company's plan can have many different features, you may have trouble getting to your money in case of emergency. Some plans allow loans, some don't. On the other hand, some employers "match" a portion of your contribution as a way to 1) help you retire and 2) incentivize you to participate and 3) allow them to admit high-dollar earners into the plan without it getting too top heavy. This is important to Wades because during this generation, the Wade Family is literally shifting into the "high earner" category of any organization we are associated with.

IRA's on the other hand, are your Individual account. You can consider it a savings account with perks. You can open one virtually anywhere, including a bank or a credit union or a mutual fund company or a brokerage. The IRA holds liquid assets such as cash, money market funds, certain bonds, stocks, etc. Fancy IRA services can even hold the deeds to real estate and other real properties. As this is YOUR account that you set up independent of your employer, you can do anything you want with it. There are restrictions, of course, but getting money out is up to you (and the penalties and the taxes, but NOT a company telling you what you can and can't do.)

Other significant differences:
ASSETS: Ira's are VERY flexible. 401k's are usually pretty limited to a dozen or even fewer investments, and they are almost always mutual funds.
My single most critically important piece of advice for investing in a 401K - make damn sure the funds they are selling you are exchange traded or NASDAQ funds. Do not ever ever ever buy a fund that you can't track in the newspaper or online at www.bigcharts.com

OWNERSHIP: An IRA is yours yours yours. A 401K is yours but in the caring hands of your employer until you quit. It is rare, but there have been cases of employers neglecting to actually send in the checks to fund the 401k. Sadly, this usually happens with crappy companies and so when you lose your job is when you find out that the CFO absconded with the cash. And, they might have even put you in fake funds (see above). Again, this is very very rare.

CONTRIBUTIONS: IRA's can be pretty limited as to how much you can put in them, like a few thousand bucks a year. This is to keep Ross Perot from eliminating that last few percent of income taxes that he hasn't been able to get rid of. 401ks, on the other hand, are designed for active income earners (workers) and therefore allow you to shield a lot more from taxes (like $15 or $16 thousand a year). And, the contribution you make from your paycheck is pre-tax dollars which reduces your drag through the year.

MATCHING: 401ks have it all over IRA's here. When your employer matches a percentage of your contribution, it is literally FREE MONEY. My employer matches 4%, which isn't bad. Some employers are even more generous. This match might have a vesting schedule, but still... free money is nice.

In general, I've always felt that if you are offered a 401k, go with that first unless it is absolutely draconian with its rules and sketchy. And you can ask me about that.

There's a lot more to think about, like when is an IRA contribution tax deductible and what about when it is time to retire, but we can cover that another time.