For years I have been debating where to put a modest monthly allocation available for retirement planning once I have hit my company's match in my 401(k). For many of us, the answer to allocation prioritization between 401(k)'s, IRA's, and Taxable accounts is initially fairly simple. First and foremost, make sure you take advantage of your company's match, if they offer one, in your 401(NYSE:K). That's free money. Take it!
Then comes the hard part. What do you do with what you have left, if you have anything left?
- Do you finish out your 401(K) to the limit that you have available ($17,000 per year in 2012, unless you're over 50 where it increases to $22,500)
- Do you put that money into a Roth IRA (maximum contribution of $5,000 a year, unless you're over 50 where it increases to $6,000)
- Do you invest that money in Dividend Reinvestment Programs (DRIPs), which are taxable accounts?
- Do you consider yourself invested, and put that money toward a vacation or home addition?
The answer to this question depends on your income, what you're investing in through your Roth and taxable accounts, your willingness to be in charge of your own investment choices, and your preference of investing in your future versus yourself or your home.
As your personal financial situation changes the answers to these questions may also change.
Let's assume that someone has an additional $5,000 a year to invest after they met their company's matching contribution. For those on Seeking Alpha, the chances are that you will not be passive in the management of that money. There is also a good chance that you will want to put it into a money making investment. Therefore, leaving it in your 401(K) is probably not ideal. Choosing to put this money in your 401(K) is best for those who would rather let someone else manage their money in one of their company chosen retirement funds. Putting money into a vacation, although fun, would probably not be your choice if you are saving for retirement either.
For those who want to manage their own investments, the next best option is to invest the money in your Roth IRA, if you qualify. The reason for this is that any capital gains made within the Roth will be tax free if taken out after retirement. Another advantage of the Roth is that any contributions made can be withdrawn tax free. Therefore, if you suffer from a crisis which depletes your emergency fund and still requires you to pull cash out of your investments, you can do so up to your contribution in the Roth without tax consequences.
Within your Roth you can buy anything you can buy in your taxable account, so why pay taxes on the same stuff?
Qualification for the Roth is the key criteria here. If you are single then you have to make under $125,000 a year, with a phrase out beginning at $110,000. For those Married and filing jointly that figure rises to $183,000 or less with a phase out beginning at 173,000.
Now we face the question of DRIPs. Unlike the Roth, there is usually a fee associated with taking money out of a DRIP. Also, since it is a taxable account, anything you take out will be taxed, no matter when you remove the money (before or after retirement). So, why is this even a debate? One reason, if you have already set up the drip and you do automatic investing every month as well as automatic dividend reinvestment, then you're building a dividend machine without expending a lot of effort.
You can build such a machine in your Roth as well, but each time you want to purchase you will have to decide what is worth buying. In the DRIP, that decision is made for you. Therefore, the argument comes down to ease with the DRIP vs. tax advantages and potential for emergency withdrawal with the Roth.
Since this is a Seeking Alpha crowd, ease of investment is probably not a higher priority than tax advantage and choice of new investment, so Roth probably wins with most folks who qualify for the Roth.
For the person making more than qualifies them for a Roth, the best answer is a taxable account. May I recommend DRIPs.