optimized living

When I first had access to a 401k with matching, I spent a lot of time trying to figure out what order I should be contributing cash to my retirement vehicles. Many people will immediately tell you that you should be maxing out your 401k each year. I disagree. The order that I’ve come up with is this:

• 401k up to your employer matching limit
• Roth IRA
• 401k up to maximum

The first one is obvious, if your employer is willing to give you free money, then take all that you can get. You can look at this as an immediate boost to your return on investment. Putting the Roth IRA before the remaining 401k contributions is where I get a lot of disagreement. Here is why I think it makes sense:

• Hedge your tax risk. By having both a pre-tax and after-tax account you are
  giving yourself two choices with different tax consequences when you withdraw money at retirement. Depending on the tax rates at the time and other factors, withdrawing from one account may be more beneficial. Plus, my guess is that future tax rates will be higher, making the Roth IRA a good choice.
• Roth IRA’s phase out as income rises. As your income rises the ability to
  contribute to a Roth IRA is reduced. The phase-out occurs as your modified adjusted gross income is between $95,000 and $110,000 (between $150,000 and $160,000 if you are married and file a joint return). Whether these phase-out figures will change over time I’m not sure, but at some point we may cross these boundaries. Contributing to a Roth IRA early is critical then since later we may not have the choice.
• Investment choices. The IRA lets you pick exactly what you want to invest in.
  You’re not locked to a predefined set of choices like a 401k.

Obviously if you are contributing to your 401k up to the employee match, and then your Roth IRA you’re doing a pretty good job saving for retirement. If you have extra money to put to retirement, and I would highly encourage it, you can keep contributing to your 401k.

So this order is what I’ve come up with as optimal. Ultimately you are not really comparing between only investment accounts. You could put extra money on your mortgage instead so that by retirement you own your house free and clear. Trying to decide if that makes more sense is a question for another day.