IRA? 401(k)? Can I do both?


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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 advice.

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 contributions?
  • 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 approximately $66,000.

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 401(k).

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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Personal Finance , Retirement

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