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Author: Mark0Young Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 25310  
Subject: Re: confusion with 401(k) and RothIRA - please h Date: 1/15/2005 1:21 PM
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so i did it 'almost' all wrong?

Generally, participating in a "tax favored" program where one gets the tax advantage at one end (Roth IRA) or the other end (pre-tax contributions to a 401(k)) is better than a taxable account for investing for retirement.

There are several reasons why the Roth IRA is often recommended:

1. You can open a Roth IRA at almost any financial institution so you can pick investments that meet some criteria, such as low expenses (e.g., individual stocks at a discount broker, or Vanguard funds), diversification to fill in a hole in the 401(k) offerings (e.g., many lack small caps, or REITS, or something with a value slant).

2. You have the flexibility of withdrawing regular contributions at any time, for any purpose, without tax or penalty. (The investment itself may impose surrender charges or short-term holding charges, but there is no federal penalty.) While I don't recommend using a retirement account as an emergency fund, it is nice to have options when one's back is against the wall.

3. The tax treatment of the Roth IRA, at least under current tax laws, allows one to withdraw the earnings tax free in retirement (specifically, if one has had a Roth IRA for at least 5 years and one is at least 59.5 years old). So if one wants to withdraw a sizable sum for a major purchase in retirement, this won't affect your taxes. Contrast that to a withdraw from a 401(k) where a sizable withdrawal can potentially end up pushing one into a higher marginal tax rate.

4. The 401(k) (and a Traditional IRA, including a "rollover IRA") has Minimum Required Distributions when one turns 70.5, so one would be forced to start taking money out and paying taxes on the withdrawal, whether or not one needs that money. A Roth IRA has no MRD, so one who lives to a ripe old age could keep the money invested longer.

5. An inherited Roth has better tax treatments than an inherited 401(k), which might or might not be a consideration.

So, for the above reasons, the suggested investing for retirement priorities are:

1. Contribute pre-tax to the 401(k) or 403(b) or similar plan up to the employer match, if any. If no match, go to #2.

2. If one qualifies to do so, contribute to a Roth IRA up to one's legal limit. This also includes a "spousal Roth IRA" if one has a non-working spouse.

3. If one still has money to invest for retirement and the expenses aren't too high (one message I saw said over 1.5% annual expenses is too high), contribute pre-tax to the 401(k), 403(b), or 457 up to one's legal limit.

4. If one still has money to invest for retirement, consider whether to make taxable investments (preferably in something reasonably tax efficient) or to pay down one's mortgage.

Now there are exceptions to the above:

- If one expects the retirement marginal tax rate to be lower than one's current wage earning marginal tax rate, reverse 2 and 3 above if the 401(k) or 403(b) expenses aren't too high: it is better to pay taxes when one's marginal tax rate is the lowest.

- If one has an occupation that tends to attract lawsuits, likewise reverse 2 and 3 above so one has ERISA protection from creditors.

- If one has lots of money in the 401(k) or 403(b), let's say 5 million dollars or more, it may be better to not contribute to the 401(k) or 403(b) beyond the employer match and, after contributing to the employer match and Roth IRA (if one is qualified), make taxable investments. It is better to pay long-term capital gains rates on taxable investments when sold to meet cash needs than to have MRDs push one into the highest marginal tax rates. Fortunately (?) most of us aren't in that situation.

- If one has sufficient assets in the 401(k) or 403(b) and Roth IRA for 59.5 years old and later (hint: it is recommended that one has 25 times the annual withdrawal rate in one's nest egg for retirement) and one is planning on early retirement, if one doesn't want to make use of SEPP (Substantially Equal Periodic Payments clause of 72T to have penalty-free withdrawals from retirement accounts before one is 59.5, or before one is 55 for withdrawing from the most recent employer's plan one had retired from after one has turned 55 or older), adding to taxable investments may make sense so one can start living off of taxable investments before one turns 59.5 without the trouble of setting up a SEPP. (SEPP must last at least 5 years or until one is 59.5 years old, whichever is longer.)

Did you do wrong by contributing as much to the 401(k) instead of funding the Roth IRA? If expenses are reasonably low, doing the "wrong thing" is minuscule compared to not doing anything--and I know many people who aren't even contributing to a 401(k) or 403(b) or Roth or even a taxable account and they are doing themselves a far, far greater disservice than you could possibly do by investing in a different "tax favored" account than our cookie-cutter advice.
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