Recently I wrote about how to simplify your portfolio down to three basic low-cost index funds. I assumed that a couple would have four retirement accounts: two 401(k)s and two IRAs.
Reader Jason asked why we couldn’t simplify this even further:
Why should you have an IRA and a work portfolio? Depending on your match situation should you go all in at the work 401(k) and get the best match?
Jason, you should always contribute enough to your 401(k) to get the maximum employer match. This is the only thing that literally everybody in the personal finance game agrees on. If we ever make contact with intelligent alien life, the first thing financial planners will ask the aliens is whether they’re maximizing their employer match.
But there are still plenty of good reasons to have an IRA in addition to your 401(k) (or 403(b), or 457). I spoke with two certified financial planners, and we came up with five good reasons.
1. Your 401(k) sucks
Too many 401(k)s are stuffed with expensive mutual funds designed to transfer money from your paycheck to a fund manager. Large companies tend to have great 401(k)s. Small companies? “I work with employees of many different types of companies, many of which are small,” says Dave O’Brien, a certified financial planner in Richmond, Virginia. “Your plan is probably expensive as all get-out.”
How can you tell? Each fund in your plan has an expense ratio, expressed as a percentage. If a fund’s expense ratio is 1 percent and you have $1,000 in it, you pay $10 this year in expenses. Over time, this adds up.
Your 401(k) is required to disclose this information, and more than 1 percent in expense ratios is too expensive. Good 401(k)s offer funds that charge less than 0.1%. Also, look for those five-letter mutual fund ticker symbols. “If there’s no ticker symbol, that’s a red flag,” says O’Brien, who also consults with companies designing 401(k)s. Missing tickers often indicates that your 401(k) is run by an insurance company rather than an investment company–and that often indicates high costs.
If your 401(k) stinks, you should still hold your nose, look for the best funds of the sorry bunch, and contribute up to the match. After that, though, put the next $5,000 into your IRA, says O’Brien. “Get the employer match, then put your money elsewhere,” he says. “Go for one of the low cost places—Vanguard, Fidelity.”
2. You can “tax diversify” by having both a 401(k) and a Roth IRA
Gallons of virtual ink have been spilled debating Roth vs. traditional IRA. Here are two typical arguments:
- -You should use a Roth IRA. Taxes are sure to go up and you should pay them now and get it over with.
- -You should use a traditional IRA. Take the tax break now before Congress changes its mind and starts taxing Roth IRAs.
Unfortunately, it’s impossible to know in advance which will be better unless you can foresee your own future and read the mind of Congress, which does not, technically, have a mind. “We don’t really know what is coming down the pike,” says Tim Maurer, a CFP with the Financial Consulate in Baltimore.
If you have a traditional (non-Roth) 401(k), as most people with 401(k)s do, it works like a traditional IRA: you pay no taxes when you put money in, only when you take it out. Combine that 401(k) with a Roth IRA, which works the opposite way, and you have a chocolate and peanut butter scenario: two great tastes, etc. Once you’re retired, you can withdraw the money in whatever way will make the IRS least flush: Roth first, 401(k) first, or some combination.
Furthermore, says Maurer, a Roth offers flexibility that a 401(k) doesn’t, because you can withdraw Roth contributions (but not interest) at any time without penalty. That money can be used for an emergency, college tuition, or a house down payment. He’s not saying you should steal from your retirement to buy these things, obviously. But if you need to take an early withdrawal, having a Roth to take it from is a lot better than being saddled with a 401(k) loan or a 10% penalty and tax bill. “The fact that the Roth exists, and that you can tap it if you absolutely need to, makes it a more attractive option,” says Maurer.
3. Your current 401(k) doesn’t allow incoming rollovers, and you have an old 401(k) (or two, or three) to consolidate
An incoming rollover is when you take money from an old 401(k) and put it into your current 401(k), with no penalty or tax consequences. Only some plans allow incoming rollovers, and it’s usually a bad idea. If you have a lousy, expensive 401(k) like Dave O’Brien warned you about, why would you put more money in there than you have to? This silo is rat-infested? Great, let’s store all our grain there!
But keeping money sitting around in old 401(k)s is also a bad idea, because those plans are probably just as expensive, and it makes it hard to understand your overall portfolio. You can do a direct rollover into an IRA, pay no tax, and have access to low-cost mutual funds at any major fund company.
Occasionally, however, an incoming rollover makes sense. “It’s a good idea if your new employer’s retirement plan offers you broad diversification, total transparency, and low cost,” says O’Brien. The quintessential example? The federal government’s Thrift Savings Plan ( TSP ), the country’s best 401(k), available to federal employees and members of the armed forces. “You can’t get better than TSP,” says O’Brien. And it allows incoming rollovers.
4. You’ve maxed out your 401(k) and still have more money to save
Self-explanatory, right? The maximum 401(k) contribution for a person under 50 is $16,500. For 50 and over, it’s $22,000. If you contribute more than this, you’re the LeBron of savings. You probably also make too much to contribute to a deductible IRA, so look into doing a backdoor Roth.
5. You might learn something
A 401(k) offers a default investment option and advice from the plan administrator. An IRA at a discount fund company offers neither. This is your opportunity to learn a little bit about investing. Curl up with a good book, like Burton Malkiel and Charles Ellis’s Elements of Investing, and 100 pages later, you’ll be pissed off at your overpriced 401(k) and ready to take charge.
I believe in you. So does Tim Maurer. “If we can’t be trusted with our own dollars,” he says, “we’re going to have a retirement without prosperity.”