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How to Decide Where to Put Your Investment Dollars

Christine Benz

Christine Benz: Hi, I am Christine Benz for Morningstar.com. Investors often struggle with how to allocate their investment dollars: company retirement plan or IRA; traditional or Roth accounts. Joining me to share some guidance on how to approach that decision is retirement expert, Ed Slott.

Ed, thank you so much for being here.

Ed Slott: Great to be back. Thanks.

Benz: Let's talk about people, at every life stage, they are often multitasking among different accounts and one question that I know I get a lot, I know you get a lot as well is if I can contribute to an IRA or my company retirement plan, how do I make that decision. Let's walk through some of the key variables. You say that one of the biggies is just how much are you positioned to contribute to these accounts?

Slott: That's the first thing. How much can you do? I have people say, how much can I defer from my 401(k), and its around $18,000. Well, I can't do that. That answers part of that question. You have to see how much you have available because you still have to live. You have actually two different decisions to make: do I want an IRA type plan, or stay with my company. And then under each one, do I want the Roth type or the IRA type. In other words, if you choose an IRA, you have IRA or Roth IRA; if you choose 401(k), if your plan offers it, its 401(k) or Roth 401(k).

Now, there are benefits on both sides. If you have more money to contribute, I always say, max out the company plan, because many companies have a match and that match, the company match is free money. You never want to give up free money. The first dollars you have available, you should do--whether you are doing a 401(k) or Roth 401(k)--max out whatever you can afford in the company plan, so you get the match.

Now, there is one little quirk. If you have a Roth 401(k), you can also get the match, but the match doesn't go into the Roth side, the match stays in the 401(k) side.

Benz: It goes into the traditional.

Slott: Well, the traditional 401(k).

Benz: Right. So, match is obviously key. I assume that if I am looking at my 401(k) plan or company retirement plan I also want to take a little bit of a look at the investment options and fees associated with that plan. If it's a high-cost plan, I may be able to do better and get into some cheaper option with an IRA, correct?

Slott: Right, but IRAs are more limited. First of all, the contribution amounts are very much more limited. For an IRA, its $5,500 or $6,500 if you are 50 or over same with the Roth. And there are other restrictions, age and income restrictions; 401(k)s don't have those restrictions. If you have the money to put in, you may do better piling more into the 401(k) at least to get the match, and then if you want to go outside of them because for some of the reasons--the fees or services whatever--if you qualify, put more into a Roth IRA to grow tax free.

Or if you think, I'm in a high bracket, I want to get a bigger deduction, then go with a traditional deductible IRA. but you got to watch it there. If you make too much money and you are in a plan, your traditional IRA contribution can still be made, but it might not be deductible. So that leads to something called the backdoor Roth. It might not be deductible. You could do a traditional nondeductible IRA and convert it to a Roth, which is totally allowable, the new tax law made that clear.

Benz: That's a strategy for people who are shutout of a direct contribution to a Roth IRA?

Slott: Because of income. When I said--it was not in the actual tax law, it was actually in the conference report, the congressional conference report mentioned that strategy four times, said it's totally available.

Benz: Another question that comes up a lot is, creditor protections. Sometimes you hear that the advantage accrues to the company retirement plan, but does it necessarily or does it depend on my state? How do you approach that?

Slott: Well, it depends. Creditor protection is solid in a 401(k) through federal law.

Benz: Right.

Slott: Not so with an IRA. Now that doesn't mean to say your IRAs are not creditor protected, they are just, as you said, subject to you own state's law. So, for example in my state, New York, I know IRAs and Roth IRAs are fully creditor protected, so it's not an issue. You have to know what the state creditor protection status is for your own IRAs and Roth IRAs, because that's your own property. It's not covered by company federal law, it's covered by state law. So, maybe if you are a professional or doctor, somebody worried about claims, you are better off stocking up in a creditor protected account in a 401(k). Or remember people can have insurance for these things too.

Benz: Let's discuss my age and also my proximity to withdrawals, how that should affect my calculus when approaching the company retirement plan versus the IRA?

Slott: Well there is different age parameters when you are taking the money out. Now let say, you hear a lot about people catching up. They couldn't make the big contributions because they were raisings kids, putting them through college, and all of that, and now they are aged 50 or something and they really have the money to put the pedal to the metal. That's where those higher contribution limits might help them in the 401(k) or the Roth 401(k), because now they can put more in there as opposed to their own IRA, or maybe they can do both. But again, if you are trying to catch up like that, make sure always max out the 401(k) if there is matching. You never want to walk away from free money. And then maybe the IRA or the Roth IRA.

Benz: As you mentioned that there are different rules about withdrawals and required withdrawals. If I have a Roth IRA, I'm home free in terms of mandatory withdrawals in that I won't have to take money out on a preset schedule. Let's talk about the other accounts and the rules that govern them from the standpoint of when you can actually get at the money and then when you absolutely have to begin taking the money out.

Slott: Right. Well, at 70 1/2 you have to start taking the money out, but if you're still working in a company plan it might pay to leave the money in the 401(k) or Roth 401(k) because there's something known as a "still working exception." If you don't own more than 5% of your company--which most people don't unless you're self-employed--you can delay required minimum distributions (if your plan allows that provision; they don't have to) until you retire. That can put off RMDs until you retire. It might pay to keep some there. With the IRAs, there is no such rule. The money has to come out. Also with the Roth 401(k) you should know they are subject to RMDs. People get confused because Roth IRAs are not subject to lifetime RMDs, but Roth 401(k)s because they are part of a plan.

Benz: So that's when the money has to start coming out. How about when I can actually access the money, it seems like if I want a little more flexibility maybe the advantage accrues to the company retirement plan, where you get in at age 55 under some circumstances.

Slott: If you want the most the flexibility--and it depends on your reason--you're better off with an IRA, because with an IRA you can take the money out at any time for any reason. Now there might be a penalty, but you always have access. With a 401(k) there may be rules or restrictions where you may not have access. But on the other hand as you said, there's an age 55 rule if you separate from service at age 55 or older and need the money before age 59 1/2 say at age 58, you can get it out without a 10% penalty. In that case if you had rolled it to an IRA and taken it from the IRA at 58 you would have a 10% penalty. You have to know which exceptions apply to you. The IRA is actually more flexible because you can always get to your own money. It doesn't mean there won't be a penalty, but you can always get to your money.

Benz: Actually Roth IRA contributions are the best from that standpoint, right? You can withdraw that money at any time.

Slott: Roth IRAs are fantastic. Your Roth contributions can be withdrawn at any time, for any reason, tax- and penalty-free. That's why everybody who can should at least contribute to a Roth, it's always accessible at any age.

Benz: Any other tips that you would offer for people attempting to navigate this? 

Slott: The big tip we said upfront: Know how much you're budgeting to put into a retirement plan. Again get that company match and see what the company offers and your own situation, like we talked about at the end. If you think you may have to withdraw early, it might pay to leave it in the plan and see if you qualify under those exceptions to the 10% penalty. But there are different exceptions to an IRA, for example, let's say you need the money for educational expenses, you have a child in school and you're a 55 years old. That exception does not apply to money from a 401(k), only to an IRA. in that case you'd better off rolling to the IRA, taking the money from there, still subject to tax. But if you use it for the education exception there is no penalty. That exception does not apply to plans. If you need money early you really have to know which exceptions to the 10% early withdrawal penalty apply to plans, apply to IRAs, and there are exceptions that apply to both.

Benz: Maybe a good spot to get some financial guidance, I think.

Slott: Oh, yes, definitely.

Benz: Ed, thank you so much for being here to address this topic.

Slott: Thanks Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.