If your 401(k) doesn't match contributions, should you max out your IRA contributions before contributing to it?

Question

I've seen described three main advantages of 401(k)'s over IRAs:

1. Employers often match 401(k) contributions.
2. If your employer offers a 401(k), then the deductability of contributions to a traditional IRA is limited above certain income levels (in 2008, $73k for single or $121k if married filing jointly). Similarly, contributions to a Roth IRA are limited above $120k or $189k if married filing jointly.
3. 401(k)'s have much higher contribution limits.

There are also a few more obscure advantages (I saw some subtle point about lawsuit liability somewhere), but I think those are the main ones. Of course, there are disadvantages as well, such as less investment flexibility and sometimes higher fees.

I understand the first two points, but I don't really understand the third one. Suppose your employer doesn't match contributions and you make less than $73k (or the equivalent income limits mentioned above), which makes the first two points irrelevant. Then can't you just first max out your contributions to an IRA and then make any further investments in your 401(k), thereby getting the best of both worlds? It seems that the only disadvantage here is the slight inconvenience of having to manage two retirement accounts.

(Of course, some people don't feel personally comfortable managing their own investments in an IRA, even if only in index funds, but I'm putting that issue aside.)

Answer 1

The old advice to decide where to put money:

• first pull enough from each paycheck and deposit in the 401(k) to maximize the match
• second set aside each month enough to fill the IRA
• then if you have more to save then go back to the 401(k) to use the rest of the contribution limit.

Adding the Roth IRA and Roth 401(k) to the mix made the decisions a Little more complex.

In your situation putting 0% into the 401(k) in step one meets the rule because there is no match to maximize.

One thing to consider about the IRA is the feature that you can wait until April to decide how much to put into the IRA and what type of account. If you will be near one of those limits that will determine if the IRA is deductible or if you are eligible then waiting until after January 1st but before April 15th will allow you to determine which account type you should be depositing the money. You can set aside each month enough, then wait until the new year to make the deposit.

Answer 2

The situation is income and 401(k) plan dependent and will require you to do some analysis and future planning. For income, do you antticipate your income being greater than the Roth IRA threshold? For 2018 that AGI is 120K if single, 189K if married. Those limits increase most years, so if your household is likely to be a larger earner in the future, it would lean you toward contributing to 401(k)s. More on this later.

The 401(k) Plan

Some 401(k) plans have fees with poor investment choices. In that case it is almost always better to invest on your own outside of the 401(k) with your first investment dollars. Some plans are so poor, that one is better off doing strait taxable investments after they max out their IRA(s). This is a determination that you will have to make with a bit of research.

Others are very attractive. No fees, great fund choices and a Roth option. This allows a person to contribute 18.5K into a Roth if they so desire. If you were doing this on your own, then the max would be 5.5K. In this later case, invest in your 401(k) with impunity.

Income Considerations

If you come to the point where you (and potentially your spouse) are able to max your 401(k) contributions and still have more left over to invest, then you might want to do a Roth outside of employer sponsored plans. One vehicle for this is a back door Roth for those with high incomes (who are the ones typically able to max out employer sponsored plans and have money left over). One hindrance to a back door Roth is having a large amount of money in IRAs. So if you anticipate being in this situation in the future it is almost always better to have money in a employer sponsored plan.

One particular couple, that I know of, is in this situation. The husband has a large rollover IRA and it precludes him from doing a back door Roth without paying a lot of taxes. The wife, however, has all her retirement money in a 401(k), so she can do the backdoor Roth without any tax consequences.

A lot to think about for sure!

Keep in mind, however, that most 401(k) plans allow you to roll money into the plan. So if you do find yourself in this situation, and start a new job, you can roll your money into the employer sponsored plan and be able to do a backdoor Roth.