Another great email from a reader. This one has to do with the common investor’s dilemma: IRA vs. 401k.
“Thank you for this great ebook! I have been looking for something like this. Very generous of you to make something like this in the first place and make it available to all.
I am new to the world of investing and I wanted to run an idea past you. I assume you are extremely busy, but you don’t have to respond if you don’t have the time.
I read a book called “The White Coat Investor” which really launched my interest in investing. From there I really started considering investing in the “Savings” concept of putting aside a set amount of my paycheck for something like a traditional IRA, 401k or Roth IRA.
I watched a video from Robert Kiyosaki online (I had read his book awhile ago), and in his video he had kinda poked at this idea of “savings” and implied it was a poor man’s way of thinking. It kinda resonated with me.
I just graduated from dental school with a massive debt of 450k and I’m applying for residency, which would if I were to get in would take 6 years to complete. Now while the specialty I am considering is an extremely high paying profession, Robert Kiyosaki’s idea really penetrated with me: regular people work for money, but rich people have money work for them.
It made me realize that it didn’t matter to me what my income would or would not eventually be, but the fact that for the rest of my life I would have to actively work for an income bothers me, not because of the work itself, but because, God forbid, if something were to happen to my health or another hindering obstacle were to come in the way, then what?
More importantly, financial literacy is not taught in medical or dental school and I think it is a shame for someone not to know much about it.
With that said, I’m not interested in a financial adviser either. I want to learn. I want to become an investor. A white coat investor. So as you can tell, your ebook was an amazing find for me. I heard about you through the Money Tree Podcast interview. I’m glad I stumbled upon it.
Now to my question. I want to be an Intelligent Investor (I’ve ordered that book too from amazon, it’s on its way.) I know I have an amazing amount to learn, but I have an idea I wanted to run past you.
For the next whatever number of years I need to plan my budget to not only include my living expenses, but repaying my student loans as well. With that said I wanted to do the following:
Take 10% of every paycheck and use it for investments (to practice the dollar cost averaging idea and build my portfolio.) 5% I wanted to put into an IRA of some type or perhaps my work’s 401k. And another 5% into savings for heck of just plain practicing the habit of conserving (while it might not ultimately serve me well as investing might.)
The question is, do you think I should invest in an IRA like a 401k? I’ve been doing some research and some critics are calling it a horrible idea pointing out to the many who lost their retirement savings because of the market crash and also because of the mediocre investing options these plans supposedly offer.
Are these critics right or is it the fault of the investor for not diversifying their assets and knowing how to work the market?”
Ah, the classic IRA vs. 401k dilemma. There’s a couple of things to consider.
But first, understand that I am not a financial planner. I’m just a regular guy who happens to have a little more experience with investing than you do, the average beginner.
Secondly, everyone’s situation is different, and so everyone’s personal answer is going to be different. Pretty much every single company’s 401k plan is unique and different than most every other company, so make sure you are diligent and research the differences.
Now that we put that out of the way, here’s what you need to know about the IRA vs. 401k. With the IRA, you have complete control of your investments. You can buy any stock, bond, or even a piece of real estate with your IRA.
The 401k is not as flexible. With most company provided 401k plans out there, you have a limited choice of funds to choose from. Obviously this is detrimental and unappealing, especially to the do-it-yourself investor.
This one difference is a big one. What if you are a decent stock picker, and could’ve easily outperformed the subpar mutual funds a 401k would offer? Or what if you are a prudent investor in low-cost index funds, but only high fee loaded funds are available to choose from?
Those limitations of the 401k can make a big difference in your returns, and this is why the IRA is almost always preferred. HOWEVER, there’s an important caveat to this.
What the 401k can offer people that an IRA can’t is a company match. The company match is essentially free money. What the company usually does is “match” the amount of money you contribute to your 401k (up to a certain percentage), and the money (after vesting) will be added to your 401k balance to then grow some more. You can think of a 401k company match as giving you a 100% return on your money, so it’s definitely worth doing.
Now we see why people get confused on the IRA vs. 401k. Sure, flexibility of the IRA is nice, but the difference in returns that you can get from outperformance will probably only be a couple of percentage points. Compare that to a company match 401k where you are getting a 100% gain on a full match.
How do you pick?
The financial guru Dave Ramsey, who I really respect and am inspired by, suggests doing the following when it comes to the IRA vs. 401k discussion:
1. Contribute up to the maximum percentage of company match for the 401k
2. Fully fund a Roth IRA ($5,500 yearly limit)
3. Use the rest of your money to go into your 401k
I agree with this logic. You really should fully take advantage of the company match, and so that’s first priority.
Next you’ll want to fully fund a Roth IRA. The downside to the IRA is that the government has put a limit on how much you can contribute to it each year. The limits change as often as tax laws do (yearly), so be sure to run a quick check on Google to see what it is. As I am writing this in 2014, the limit is $5,500 for singles and $11,000 for married ($5.5k each).
Also, you can’t qualify for an IRA if you make over a certain amount each year. In 2014, this amount is $181,000 for filing married. Sorry big income earners, the government doesn’t like you.
Finally, use the rest of your investing allocation into the 401k for its tax sheltered advantages. Dave recommends 15% of your income towards retirement if you are debt-free, and I’ve often encouraged at least 10%. So just use the priority above and you’ll maximize your dollars.
It doesn’t end there. Once you’ve decided what to do IRA and what to do 401k, you’ll need to decide whether to go Traditional IRA or Roth IRA. I’ve covered that too.
Oh, and as for the critics, they are just noise.
**IRA vs. 401k Solution**
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