Jill has a dilemma. Because of the economy, her employer is no
longer making contributions to her 401(k). Friends have told her
she would be better off putting that money in an Individual
Retirement Account (IRA). She came to me and asked me for my
This is a very common question. The answer to what to do with
your retirement funds depends on the answer to three questions:
- Are you eligible for a 401(k), 403(b), SIMPLE or SEP?
- Does your employer match any portion of the
- What is your household modified adjusted gross income (HH
MAGI) for the year?
Once you know the answer to these questions, you can determine
where to put your retirement plan contributions by using this
flow-chart. Let's use Jill as an example.
(click to enlarge)
Jill works for an architect. She is able to save $5500 per year
for retirement. She is eligible for a 401(k) plan at work but there
is no longer a company match. Her HH MAGI for this year will be
By applying these numbers to the flowchart, we can see Jill's
best bet is to put that $5,500 in a Roth IRA rather than her
employer's 401(k). The important caveat though is that it has to
make it into the Roth. The nice thing about 401(k)'s is that the
deductions are automatic.
Now, let's imagine, as the economy improves, Jill's employer
re-instates a dollar-for-dollar match up to 3% of pay. What changes
should she make?
In that scenario, the flow-chart tells her to first contribute
to her employer plan up to the match, then to a Roth IRA (because
she is under the Roth income limit), and finally the remainder to
her employer plan up to its limits.
For the sake of illustration, let's assume Jill can save a bit
more. We will make her 56 years old, single, no kids, no debts and
a very moderate lifestyle. Now she can save 20% of her pay or
$13,200 per year.
The first step would be to calculate how much she needs to put
in her 401(k) to get the company match. The formula is percentage
of pay they limit the match to, called the match level divided by
the match rate.
For example, to get the full match from an employer who matches
50 cents on the dollar up to 6 percent of pay, you would divide .06
by .5. This tells you to contribute 12 percent of pay to get the
full company match. In Jill's case, she needs to contribute 3% of
pay, or $1,980 to get the entire employer match.
The next step is to determine how much she can contribute to her
Roth. The contribution limit to an IRA, either Roth or Traditional,
for 2010, is $5000. But because Jill is over 50, she can also make
an additional $1000 per year catch-up contribution. So she can put
$6,000 in her Roth.
The remainder, which is $13,200 minus $1,980 minus $6000, goes
into the 401(k). So that is an additional $5,220 going to her
So now Jill knows how to set up her contributions. She takes the
$7200 she plans to put in the 401(k) and divides it by the number
of pay periods. Assuming 24 pay periods, for example, she would put
$300 per paycheck into her 401(k). She would also contribute $250
per pay period to her Roth.
I mentioned earlier that a key consideration that doesn't appear
on the flow-chart is whether the money will actually make it into
the Roth or whether it is more likely to get spent since it isn't
an automatic payroll deduction.
Ideally, you want to set up your IRAs at a brokerage firm that
accepts direct deposit. Vanguard and Fidelity both offer this
service. Others do as well. Vanguard allows you to allocate each
deposit among various funds just like your 401(k).
If your employer doesn't offer direct deposit, make sure you set
it up on your end. One way to do this would be to deposit the money
in your savings account and then use automatic bill pay to transfer
it to your IRA immediately following each pay period.
The point is, you want to set it and forget it. If there is any
chance that, by being responsible for the transfer yourself, you
will spend this money rather than deposit it, you would be better
off putting it in your 401(k).
What about putting the money earmarked for an IRA in as one big
lump sum at the end of the year? If your disposable income is high
enough that this isn't an issue for you, or you are a diligent
saver, no problem. The one downside is that you will be losing the
opportunity cost of earnings on your investments during the time it
sits in your savings accounts.
The bottom line is your retirement money needs to work as hard
as possible to give you the best shot at the retirement lifestyle
you have planned for. Different account types have different pros
and cons. A logical system for determining where to put your
retirement plan contributions will help.
No statement in this article should be construed as a
recommendation to buy or sell a security or to provide investment
advice unless specifically stated as such. All investments involve
risk including possible loss of principal.