401(k), Roth IRA, then Back at 401(k)

October 22, 2006 by TFB

Money magazine published a list of 25 Rules to Grow Rich By. Blogger Blueprint for Financial Prosperity also picked it up and put the full list on one page. A few rules are a little silly, for example, Rule #22:

Resist the urge to buy the latest computer or other gadget as soon as it comes out. Wait three months and the price will be lower.

Three months! Gosh, stop buying those crap altogether! That's why most people can't contribute the maximum amount to their 401(k) and Roth IRA. I guess if Money said wait three years it would cause an outcry and slow down the economy by 1 percentage point, so it settled with waiting three months.

What I really want to comment on is Rule #6:

All else being equal, the best place to invest is a 401(k). Once you’ve earned the full company match, max out a Roth IRA. Still have money to invest? Put more in your 401(k) or a traditional IRA.

Except for the last part "or a traditional IRA" (I'll get into that later), this is the sequence I recommend as well. If your employer offers a company match, that's practically a part of your compensation package, you should contribute enough to earn the full match, no matter what. Otherwise it's like you are not claiming a part of your salary. Match formula vary by employer. Most typical I've seen is 50% match up to 6% of your salary. So if you contribute 6%, the employer matches 3%. In that case, you should contribute at least 6%. Enough said.

Rule #12 also says

If you’re not saving 10% of your salary, you aren’t saving enough.

I'd make it 15%. After you earned the full match in your 401k, if you qualify*, you should open a Roth IRA at Vanguard and contribute $4,000 to it. Why not just use the 401(k)? Because you typically get a better deal in a Roth IRA at Vanguard than what you can get in your 401(k), unless you work for a very large company and they have knowledgeable people in charge of your 401(k). Put it into the Vanguard LifeStrategy Moderate Growth Fund, the TFB Award winner for the Best Mutual Fund for Investing More Than $3,000, and you are done.

If you are trying to save 15% of your salary, full match in your 401(k) plus $4,000 probably won't make it. Now put the rest into your 401(k). Forget about the "or a traditional IRA" part in Rule #6. That's not possible. Traditional IRA and Roth IRA share the same annual limit. If you contributed the maximum $4,000 to your Roth IRA, you can't put anything into a traditional IRA.

I will make a calculator for this strategy if I can't find one on the Internet.**

* See this post about Roth eligibility limits by JLP at AllFinancialMatters.

** UPDATE: I couldn't find one so I created a calculator for this myself.

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Comments

4 Comments on 401(k), Roth IRA, then Back at 401(k)

  1. Dogberry on October 31, 2006 | permalink
    2.  

    I could not figure out what they meant by putting more in a traditional IRA either.

    A question that I am considering. If you don't have access to a 401k then what should you do after you have maxed out the 4k of a Roth IRA?

    Dogberry
    Money & Investing Dogberry Patch

  2. TFB on October 31, 2006 | permalink
    3.  

    If you don't have access to a 401k/403b type plan, then you have to invest in a regular mutual fund account, after you maxed out the 4k for IRA, either Traditional or Roth depending on your tax bracket — high tax bracket traditional, low tax bracket Roth.

  3. goldi on December 31, 2007 | permalink
    4.  

    There is a great book dedicated to this topic called "It's Your IRA". It is an excellent resource for those wanting to learn more about investing in Roth and Traditional IRAs. It is available through Amazon or you can go to ItsYourIRA.com for more details. It is definitely worth a look.

  4. sewall on March 12, 2009 | permalink
    5.  

    The IRA contribution limits rise over time. As of 2009 they're $5k per individual per year.

    There are other reasons not mentioned above to stuff as much in one's Roth as one can (after getting the company 401(k) match): (1) it is reasonable to expect all our tax rates to go up (US is taking on tremendous debt), thus, in general one should pay taxes now and not in retirement (the ordering of individual tax rates may, of course, be reversed); (2) There are no RMDs for Roths. You won't be forced to start taking your money out when you reach 70.5. You can leave it there until you need it; (3) You can withdrawal your contributions anytime without penalty. It isn't a great idea to go raiding your Roth. But, if you need to, you can do so without a penalty. This latter point makes it hard to justify not maxing out one's Roth. It takes special and generally rare circumstances for which it is not a good idea.

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