Roth IRA or 401(k): Which Should You Fund First?

Judging from the many responses I received to my column about whether you should invest in the market or pay down your mortgage, a lot of you are strategizing about how best to allocate your financial resources. That's smart. Managing your personal finances is a lot like running a business, and the best businesspeople are those who make the best decisions about how to allocate their capital.

Grappling with whether to invest in the market or pay down your mortgage isn't the only decision you have to make when determining how to allocate your personal financial resources, though--not by a long shot. For instance, you also have to pick and choose among the different investment-account types available to you. Should funding your 401(k) be your top priority, given that your money goes in on a pretax basis? How do Roth or traditional IRAs fit into the picture?

Because each of these decisions carries its own set of considerations, coming up with a one-size-fits-all financial priorities list can be tricky. For starters, we can't all avail ourselves of the same set of options; one person might have a pension plan, while another has a 401(k). Your tax bracket--both now and at the time you expect to retire--is also a big determinant of how you should prioritize the various tax-advantaged investment vehicles: Is it better to pay tax now or later? Your income level could also put certain investment options, such as the Roth IRA or a deductible IRA, off-limits. Liquidity is also important: If you think you might need the money sooner rather than later, you'll need to avoid vehicles that carry penalties for early withdrawal. Finally, if you're investing in an employee retirement plan with a limited menu of choices, you'll also have to weigh how good that lineup is.

Nonetheless, the following framework makes sense for individuals in a broad range of circumstances. Bear in mind that the following sequence will work better for some investors--for instance, those with a limited pool of money to put to work each year--than others. Thus, consider your own circumstances in deciding which sequence is the right one for you.

Pay Off Any Consumer Debt
I know. I know. Paying down your debt isn't an investment option per se. But if you think about it, avoiding high interest-rate payments--which are the unwelcome byproduct of consumer debt--is probably the safest investment of all. After all, you're reducing your costs without taking on additional risk.

I've heard some pundits say that it might be psychologically beneficial for investors to begin investing at the same time they're digging their way out of credit-card debt. While I can appreciate the sentiment, the math argues for paying off the debt before you begin investing. After all, most credit-card debt carries an interest rate in the double digits, while future returns on stocks and bonds aren't likely to be that high. (Of course, you'll also want to make sure that you've obtained the lowest credit-card interest rate you possibly can.) Mortgage debt is in a slightly different category, as your interest is tax-deductible, but credit card debt has no redeeming features whatsoever.

Invest Enough in Your 401(k) to Take Advantage of Your Employer's Matching Contributions
You've no doubt heard this before: If your employer is matching you on any part of your 401(k) contribution, you owe it to yourself to contribute at least enough to receive the full match. For example, if your employer is making a matching contribution of 3% of your salary and you make $50,000 a year, you'll need to contribute at least $1,500 of your own money to your 401(k) to be entitled to your employer’s full matching contribution. Doing otherwise is like leaving free money on the table.

Invest in a Roth IRA
After you've stashed enough in your 401(k) to meet your employer's match, consider investing in a Roth IRA.

Why fund a Roth, to which you contribute after-tax dollars, before maxing out on your 401(k), to which you contribute on a pretax basis? In a word, flexibility. Whereas you must begin taking distributions from your 401(k) at age 70½, there are no such requirements governing Roth IRA withdrawals. You can let the money compound for as long as you like, and you can continue investing at any age. (With most other tax-sheltered vehicles, you can't make contributions once you hit age 70½.) In addition, withdrawals are tax-free, assuming you're age 59½ and you've held the account for at least five years. It's also worth noting that you can put a huge range of investments in a Roth IRA, whereas 401(k) plans typically require that you select funds from a limited menu.

True, in certain situations it might make sense for investors to contribute the maximum to their 401(k) plans and also avail themselves of traditional deductible IRAs (presuming they're eligible) before contributing to a Roth IRA. For example, if you expect to be in a lower tax bracket when you retire than when you were working, that's an argument for funding the 401(k) or deductible IRA before the Roth. That's because you'll pay taxes on your 401(k) and deductible IRA when you withdraw the money, whereas you contribute after-tax dollars to the Roth.

It may also turn out that you're simply not eligible to contribute to a Roth because your earnings are too high. (To assess your eligibility for the various types of IRAs, check out Morningstar's IRA Calculator.) If your income puts a Roth out of reach, move on to the next two suggestions.

Invest to the Max in Your 401(k) or Other Qualified Plan
Once you've met your employer's 401(k) matching contribution and set aside enough money to fully fund your Roth IRA in a given year ($4,000 in 2005; $4,500 for savers over 50 years of age), go back to your 401(k) and max out. Investors can contribute $14,000 to their 401(k)s in 2005; savers over 50 years of age can contribute $18,000 this year. Because you're using pretax dollars, ratcheting up your 401(k) contribution to the limit might not be as painful as you think. If you're wondering how deeply an increased contribution will cut into your take-home pay, ask your company's human resources department to work up an estimate of your net pay assuming various contribution amounts. (For more tips on getting the most out of your 401(k), click here.)

Consider a Traditional Nondeductible IRA (or a Tax-Managed Mutual Fund)
If you earn too much to contribute to a Roth IRA (and therefore a deductible IRA is also out of reach), you might consider investing in a traditional nondeductible IRA. True, you won't be able to deduct your contribution from your taxable income--unlike a deductible IRA--and you'll also have to pay taxes on your account's investment earnings when you withdraw money. But you will enjoy the benefit of tax-deferred compounding.

Bear in mind, however, that a traditional nondeductible IRA carries all of the same restrictions that accompany a deductible IRA--in particular, you must begin taking distributions at age 70½, whether you're ready or not. Thus, I think you could make a good case for buying a tax-managed mutual fund rather than making a nondeductible IRA contribution. After all, tax-managed vehicles also promise tax-deferred compounding but carry no mandatory distributions.

If you do opt for a traditional nondeductible IRA, make sure you take maximum advantage of the fact that you won't have to pay taxes on any income or capital gains from the account as you go along. Thus, this is a good place to stash investments that are particularly tax-inefficient, including high-yield bond, Treasury Inflation-Protected Securities, real estate, and commodity funds.

Save for College
Hold the letters and e-mails: I completely agree that there are few things more important than saving for a child's future. And 529 plans and Coverdell Education Savings Accounts are also attractive from a tax standpoint, in that qualified withdrawals are tax-free. But you'll want to be sure not to short shrift your own retirement savings while you're socking it away for college. Loans and financial aid may be available to your college-bound child if he or she needs them, but retirees whose nest eggs fall short have fewer options available to them. Bear in mind that you can also withdraw money from your own IRA to pay for qualified college expenses if need be.

Fund Your Taxable Accounts/Pay Down Mortgage Debt
Once you've exhausted your key tax-advantaged options, turn your attention to saving money in your taxable accounts. From here on out, you'll want to stay hyperattuned to the tax efficiency of any investments you select. For tips on selecting the best investments for your taxable accounts, click here.

At the same time, consider making bigger payments on your mortgage than your lender requires you to do. If returns on stocks and bonds are lower over the next decade than they have been in the recent past, it could be hard to call any debt "good debt," even if your interest rate is low and you earn a tax deduction on your interest. (For a discussion of the pros and cons of paying off your mortgage versus investing in the market, click here.)