There are two approaches to this question – the mathematical answer, and the behavioral answer. If there are no matching funds for the 401(k), depending on the investment options available in your company plan, you may be able to get lower fees within an IRA. The reality of the situation, however, is that it is far easier to set an automatic deduction into your 401(k) as forced savings than it is to remember to put away the money voluntarily either over the course of the year, or right before you file your taxes.
If your employer does not offer a match, we would recommend the following contribution order:
- Contribute up to the IRA contribution limit ($5,500 in 2014) to take advantage of the wider investment options (generally lower fees) available to IRAs.
- Contribute up to your 401(k) contribution limit (you still get the pre-tax deduction, but are forced to deal with a shorter list of investment options). Make sure you keep an eye on the fees charged for the investments in your company’s plan. We generally recommend looking for index funds1 with low fees2.
1Empirical evidence is very strong that “active” funds (where managers pick stocks) do not outperform passive funds (where the fund invests in a market index) after expenses so we do not believe it’s worth paying for active management. Sure, a great investor like Warren Buffet does occasionally beat the odds, but are you able to spot a Warren Buffet ahead of time? We know we’re not. So choose a fund with the word “index” in the name.
2Mutual funds take a percentage of the money you invest to run the mutual fund. This percentage is called the “expense ratio” and it’s in the description of your fund. Check the expense ratios of your mutual fund options and go for the lower ones. Anything above 0.50% is too expensive, in our opinion.