The No-Brainer Retirement Account I’d Choose Way Before a 401(k)

The 401(k) and similar employer-sponsored retirement savings accounts are, by far, the most popular tool that Americans use to save for retirement.

But just because something is popular doesn’t necessarily make it the best choice for you. To be sure, a 401(k) has a lot of benefits: enrollment is simple, the vast majority of employers who offer them also contribute matching funds, and their annual contribution limits are high. But a lot of investors could benefit even more from an account with lower fees and greater flexibility.

That’s why I’d choose an Individual Retirement Account (IRA) over a 401(k) for my retirement savings.

Say no to high fees

While 401(k) plan fees have dropped considerably over the last decade, they can still have a significant negative impact on your retirement portfolio.

401(k) fees include everything from administration and service fees to expense ratios on the limited number of fund options available in any given plan. When you add all those up, the average participant in a large 401(k) plan (one with more than 1,000 participants) paid about 0.85% of their account balances in fees in 2022, according to the most recent edition of the 401k Averages Book. Those in smaller plans paid even higher fees, on average.

While 0.85% might not sound like a lot, fees can have a substantial impact on your final retirement account balance over time. With an IRA, you can avoid fees altogether. You’re free to choose any brokerage provider you like, and most offer free IRAs and a host of low-cost exchange-traded funds (ETFs) and mutual funds.

Choosing an IRA and filling it with a similar set of fund investments to those you could have chosen in your employer’s 401(k), but with a lower fee structure, is likely to boost your annual returns.

The freedom to choose any investment

However, you don’t need to stick to investment choices that parallel the ones your employer’s plan offers. With few exceptions, an IRA typically gives you a much broader array of investment choices than a 401(k) plan. That can be great for saving on fees. For example, you can buy index funds with expense ratios that are well below 0.1%.

You can also invest in individual stocks in an IRA. That could help you produce market-beating returns, especially since asset growth in those accounts is shielded from capital gains taxes.

That said, smart long-term investors don’t use that ability to avoid capital gains taxes as a reason to frequently trade in and out of stocks in an IRA. The best performances come from buy-and-hold investing. Selling should mostly be done to trim position sizes or if your original investment thesis for a company has ceased to apply or been proven incorrect.

When does a 401(k) actually make more sense?

While an IRA is my first choice as a tax-advantaged investment vehicle, personal finance is personal. Everyone’s circumstances are different. And while the above advantages of an IRA outweigh the advantages of a 401(k) for me, that might not be the case for you.

Here are two instances where it makes more sense to choose a 401(k) before you choose an IRA:

1. Your employer offers a matching contribution. If your employer offers a matching contribution in your 401(k), you should contribute at least enough to get the full match. In terms of return on investment, it’s tough to beat the value of an instant extra 50% or 100%, even if it comes with high fees and limited investment choices.
2. You won’t qualify for a tax deduction for IRA contributions, and you want to invest more than the IRA contribution limit. If you participate in an employer-sponsored plan and your income exceeds a certain limit, you won’t qualify for a tax deduction on your IRA contributions. Importantly, you’re only “covered” if you or your employer make a contribution to the plan in a given tax year. So, if you eschew the 401(k) entirely, you may still qualify for a tax deduction.
   
   If you’re covered by an employer-sponsored plan, you may still qualify to contribute to a Roth IRA — or you could perform what’s called a backdoor Roth IRA conversion — but the tax break you’d get from making 401(k) contributions might be worth more to you right now. In that case, it might make sense to use a 401(k).

All things being equal, though, an IRA is a far better account for retirement savings than a 401(k). Each individual will have different circumstances to consider, but the benefits of an IRA over a 401(k) are too big to ignore entirely.