Among the many decisions we all must make about retirement, one of the most perplexing relates to the types of retirement account options. For many of us, there are a lot of choices including a 401k, Roth 401k, Deductible IRA, Roth IRA, and a Non-deductible IRA. And that’s not even counting 403b accounts, SEP IRAs, Self-Directed IRAs, and of course taxable accounts.
And if that weren’t enough, for many of us the best options are a combination of 401k, IRA, and taxable accounts.
Recently I came across a post on the Bogleheads forum (an excellent investing forum) that addressed this question. According to the good folks at Bogleheads (named after the founder of Vanguard, Jack Bogle), retirement investing should be placed in the following types of accounts in the order listed:
1. 401k/403b up to the company match
2. Max out Roth IRA
3. Max out 401k/403b
4. Taxable Investing
While your situation may be unique, I think the above priority ranking is, as a general rule, quite sound. Here’s the rational behind this list.
401k/403b up to company match
When your employer matches some of your contribution, it’s critical to take full advantage of the match. Otherwise, you’re just turning away free money. The value of the match makes this the first place to stash your retirement savings.
Roth IRA
Once you’re saving enough in a 401k to get the company match, additional retirement savings should go to a Roth IRA, according to the Bogleheads. While I think arguments to the contrary could be made here, I like this approach for two reasons.
First, most generally assume that taxes will go up in the future. So unless you are in the top brackets today (2011 tax brackets; 2012 tax brackets), many recommend paying the taxes on the income now, and enjoying tax free growth and retirement distributions later with a Roth IRA. And with retirement savings in both a 401k and Roth IRA, you have some investments that are tax deferred and some that grow tax free, which is a nice way to hedge your bets when it comes to future taxes.
Second, with any IRA, you can choose where to open the account. Many 401k plans charge extremely high fees and have limited investment options. For those who like to keep investing simple, Betterment is an excellent option for an IRA (read my review here). If you like to trade, I think Scottrade is a great choice because of low fees and physical branches just about everywhere, but there are many brokers that offer IRA accounts.
Keep in mind that your income may disqualify you form opening a Roth IRA. You can check out the 2012 Roth IRA limits here.
Max out 401k/403b
Once you’ve maxed out your Roth IRA, then top off your 401k. Keep in mind the limits on contributions, which can change from year to year. For 2012, the contribution limit has been increased from $16,500 to $17,000. The catch-up contribution limit for those aged 50 and over remains unchanged at $5,500.
Taxable Accounts
Unless you qualify for a SEP IRA, the next and last stop is a taxable account. Here you can open an account with a mutual fund family like Vanguard or Fidelity, open a brokerage account, or use a service like Betterment.
As I mentioned above, every situation is different. The above priority list may not be ideal for everybody. But I think it’s a sound way to approach retirement investing.
Good overall idea, however, I would recommend going to a brokerage account before topping off your 401k. There are things in life (wedding, new house, etc) that your investment account can pay for that your 401k cannot. Just my two cents.
I agree to a point. I’d grab the match first no matter what. Then I’d move to an external IRA.
The question of when to Roth is another story. Te Boglehead order ignores one’s current bracket. In a forthcoming article (as in “I have it in my head, but need to write”) I’ll discuss the approach of “Living in the 15% bracket.” New working folk in the 15% bracket should go Roth all the way, Roth 401(k) if available and Roth IRA, and pretax accounts as their earnings increase. I’d say this approach will apply to a great number of people (a plurality, if not majority) and tax optimize their income.
There are worse things than to have tax free money, but the too-much-Roth crowd risks saving in the 25% bracket and withdrawing what could be taxed at 15%. The choice is not so simple. Which is why 150 of us can write on this and offer 151 different opinions.
I take issue with the statement that most people assume taxes will go up in the future. While I agree that the government will need to raise more revenue in the future I can think of a few scenarios in which that occurs, but the Roth is still at a disadvantage to the traditional IRA:
1) Revenues are increased by closing loopholes (i.e. eliminating mortgage interest deduction for large mortgages) and tax rates are actually lowered. In my opinion this is a highly likely scenario due to its political appeal. Politicians would love to claim they lowered taxes and eliminated loopholes. In that scenario you would have prepaid your taxes at a higher rate.
2) A national sales tax or VAT is introduced to increase revenue, while tax rates are lowered. In that case not only did you prepay the tax at a higher rate, but you then get taxed again by the sales tax when you spend the Roth money during retirement.
3) Tax rates go up for awhile but are reduced again before you retire. Let’s say the politicians actually do raise tax rates, but by the time you retire, they lower them again. If you have 20-30 years before retirement this is certainly plausible.
I’m not saying you should not contribute to a Roth but I think it’s definitely worth considering these scenarios before blithely assuming tax rates must be higher in retirement and therefore Roth should be the default choice after getting the 401k match.
My company is “enhancing the employer match frequency from quarterly to per pay” (which is every two weeks…anybody seen any studies that calculate how much a benefit that is?