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It is a question that is coming up more and more: should I put my money in my 401(k) plan before contributing anything to my IRA? The answer used to be fairly straightforward: always contribute to your 401(k) first, at least up until the point when your company stops matching.

But this idea needs to be revisited. The choices in most 401(k) plans have not kept up with the ever-expanding choices that are available to most people in their IRAs. Many investors are left with only a few choices in their 401(k) plans that have high annual expenses, do not give proper diversification, and give no exposure outside of the U.S. Meanwhile, the universe of low-cost ETFs has allowed investors to diversify into emerging market equities (NYSEARCA:EEM), emerging market fixed-income (NYSEARCA:PCY), precious metals (NYSEARCA:DBP), and even frontier markets (NYSEARCA:FRN). You won’t find these choices in many 401(k) plans.

Making a decision as to which plan your funds should go to can involve some subjective thinking, such as whether or not you have enough diversification and whether or not there are there enough choices in your plan. However, one thing we can quantify is whether or not it’s worth taking money that would normally go to your 401(k) and putting it into an IRA that has lower expense investments instead.

In general I believe that once your company stops matching you 401(k) contributions that your contributions after this should go to an IRA. You will find more choices, better diversification, and lower costs. But what about the portion that your company matches? Is it possible that even these contributions should be going toward lower cost investments in your IRA? Let’s take a look.

I ran a scenario using our publicly available calculator called 401(k) Benefits where I had an investor (let’s call him Jack) who is 40 years old, with $70,000 in income, a current 401(k) balance of $30,000, contributes 5% of his income to his 401(k) plan each year, and plans on retiring at age 65. Every dollar Jack contributes is matched at 50 cents on the dollar by his employer. I also assumed an annual return of 6% per year after any investment expenses and fees. The results are below.

Balance

Today

Balance at

Retirement

Amount Jack

Contributes

Amount

Company

Contributes

Amount

Due to

Investment

Growth

$30,000

$483,017

$131,436

$65,718

$255,863


(Click to enlarge)

Now let’s look at what happens if Jack instead puts all of these contributions into an IRA that has ETFs with lower fees. Let’s assume he will save 1 percentage point per year in fees. However, keep in mind that he will no longer get the company match.

Balance

Today

Balance at

Retirement

Amount Jack

Contributes

Amount

Company

Contributes

Amount

Due to

Investment

Growth

$30,000

$352,864

$131,436

$0

$191,428

It’s perfectly clear that in this example, Jack absolutely should not take the money (that is matched by his company) he contributes to his 401(k) plan and instead put it into his IRA. If he does this then he will end up over $130,000 poorer when he retires. This simply shows the power of company matching. It is sometimes an underrated benefit.

I was curious what the break-even difference in fees would have to be in order for it to make sense for jack to stop contributing to his 401(k) plan altogether. It turns out that the difference in investment fees would have to be 2.4%. If your 401(k) plan has investments that charge this much more than the ones in your IRA, something is very wrong with your company’s plan.

My opinion is this: As long as your company is matching your contributions in your 401(k) plan, you should be putting as much money into it as possible. As soon as they stop matching, it is very likely you can do better in an IRA where you will find lower fees, more choices, and better diversification.

Disclosure: I am long FRN.

Source: Contribute To Your 401(k) Before Your IRA So Long As Your Company Is Matching