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

Money magazine published a list of 25 Rules to Grow Rich By. 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.**

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

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  1. Harry Sit says

    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.

  2. goldi says

    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.

  3. sewall says

    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.

  4. Andy says

    I have a question related to Roth IRA, though not directly related to this particular topic. I have been contributing to my wife’s and my own Roth accounts (my wife doesn’t work), around $400/month for each account throughout this year. An unexpected income (a one-time cash dividend from the startup company I’m working for) pushed my income over the income limit. What should I do in this case? Do I just withdraw the money I’ve put into the account that’s designated for 2010 (just principle or gain too)? Will there be any penalty? Any special process I need to go through?

  5. Harry Sit says

    Andy – When you are married filing jointly, the eligibility to contribute to a Roth IRA is calculated against the combined adjusted gross income between the two of you. If your combined AGI exceeds the limit, neither of you can contribute to a Roth IRA.

    You can “recharacterize” the contributions as Traditional IRA contributions. Your IRA custodian have forms for doing so. They will open a traditional IRA for each of you and put the contributions plus a little bit of earnings into the traditional IRAs.

    The resulting traditional IRA contributions may or may not be deductible. It depends on whether you are covered by a retirement plan (such as a 401k) at work. If you are covered by a retirement plan at work, you can’t take a deduction because the income limit for taking a deduction is lower than the income limit for contributing to a Roth. If you not covered by a retirement plan at work, the contributions are deductible.

    If you are able to deduct the contributions, you can just leave the money in the Traditional IRA. If you can’t take a deduction, *and if you don’t have other traditional, SEP, or SIMPLE IRAs*, you can convert the Traditional IRAs to Roth. You will pay a little bit of tax on the earnings, but not much.

    If you are in this situation, in a round-about way through recharacterizing and converting, you are back to Roth IRAs. This is called a “backdoor Roth.” The key is not having other traditional (including rollover from previous 401k type plans), SEP, or SIMPLE IRAs.

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