401k vs IRA
By Harper Willis
When you transfer funds from an old employer’s 401(k) plan, you can roll the funds into a new employer’s 401(k) plan, or into an IRA. Here we’ll outline the pros and cons of each method.
Rolling over into a 401(k) plan
Pros
No investment minimums: There is generally no investment minimum required to start a 401(k) plan, as there is with most mutual funds and other types of investments, so you can roll even a very small sum into one. By contrast, the investments you choose for an IRA might have substantial minimums.
Matching contributions: Many employers will match a percentage of every contribution you make to their 401(k) plan. If you invest $5,000 a year in an IRA with a 7% return for 40 years, you’ll wind up with $1.1 million. If you make the same investment in a 401(k) and your employer kicks in a 50% matching contribution, you’ll wind up with $1.65 million (assuming the same return).
Cons
Less Investment Flexibility: Some 401(k) plans offer a very limited range of investment choices. Others may offer you a strong selection of mutual funds and similar vehicles. But no 401(k) can offer you the range of investment options available through an IRA.
Potential Fees: A few 401(k) plans may limit you to investment options that carry relatively high fees. More typically, the plans offer investments with average or even below-average fees. But if you’re the type of investor who likes to shop for low-fee funds (which makes a lot of sense, by the way), then an IRA provides more opportunity to do that.
Rolling over into an IRA
Pros
More investment options: If you open an IRA account with a brokerage firm, you can invest your money however you like, with one or two minor exceptions (gold bullion, for example).
It’s better for your heirs: The designated beneficiaries of an IRA can take small, taxable distributions stretched out over their expected lifetimes, leaving more time for tax-favored growth than if they had to cash it out all at once. While 401(k) plans are allowed to offer this option, most don’t.
Cons
You Can’t Borrow from Your IRA: In a pinch, you can borrow money from your own 401(k) plan penalty free as long as you pay it back within 5 years. IRAs don’t have that option.
Lower contribution limits: As of 2011 the annual contribution limit for an IRA is $5,000 with a $1,000 annual catch-up contribution allowed after age 50. That compares to a maximum of $16,50 for a 401(k), with a $5,500 catch-up contribution (some employers impose lower limits—but those limits are typically higher than the IRA limits).
The bottom line? Most folks will want to go with the 401(k), since it allows higher annual contributions—and may provide matching contributions to boot. However, some older investors who switch jobs or retire may want to consider the IRA for its significant estate planning advantages.