25 Rules to Grow Rich By #6: Long-Term Investments

The Simple Dollar is running a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.

Rule #6: All else being equal, the best place to invest is a 401(k). Once you’ve earned the full company match, max out a Roth IRA. Still have money to invest? Put more in your 401(k) or a traditional IRA.

First of all, many places of employment don’t offer 401(k) plans. I have never worked in an environment that has offered a 401(k) plan. So, upon first reading, I would be led to believe that I should be maxing out a Roth IRA every year.

The actual truth of the matter is that you should simply look for an individual retirement plan at work of any kind that provides company matching. For me, this has varied among 403(b)s, government-run individual retirement plans, and other situations. The key here is company matching; it’s essentially an enlargement of your salary that they give you for behaving responsibly. By not doing this, you’re turning down an immediate 50% to 100% return on your investment.

A Roth IRA is another good place to sock away some extra money because of the tax shielding. Even if you don’t earn as much through the IRA as you do elsewhere, you never have to pay taxes on a dime of it provided you wait until retirement to withdraw from it. If you do this early in life, you’re going to earn a lot of money that you never have to pay a dime of taxes on, which is a big leg up over other investments. This part of the rule makes a good deal of sense.

Where I begin to disagree is with dumping more money into individual retirement plans once you’ve maxed out your matched retirement plan and your Roth IRA. If you are doing both the full matched retirement plan and the full Roth IRA and you’re starting young with it, you’re going to have retirement in the bag.

Instead, you should use remaining investment money to look at a slightly less long term future. Wouldn’t you like to buy that dream home when you’re 45 or 50 and you can still enjoy it for thirty or forty years? To avoid penalties for withdrawal, you need to put it in a high-earning place that you can access in ten or fifteen years, even if you have to pay taxes on the earnings. This way, you enable the possibility of buying some great things for your family when you reach the forties and your children are starting to grow up.

Of course, if you’re already approaching retirement age, put it in the tax-sheltered options, but if you’re young, this often is not the best option. Let’s rewrite that rule:

Rewritten Rule #6: All else being equal, the best place to invest is in an investment plan through your work benefits up to the full company match. After this, invest in a Roth IRA. Still have money to invest? Put it in a place that you can easily access in ten or fifteen years, like an index fund.

You can jump ahead to rule #7 or jump back to rule #5.

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  1. Jim Lippard says:

    One suggested modification: If you currently have too much annual income to contribute to a Roth IRA, you should max out a nondeductible IRA in order to take advantage of the new rule that permits a nondeductible IRA to be converted to a Roth IRA in 2010 (even if your income is too high to contribute to a Roth IRA). This requires paying taxes on the gains you’ve seen in the nondeductible IRA up to the point of conversion, but you can pay those taxes over 2011-12.

  2. Jonathan says:

    This is tricky, as some companies only match up to as little as 0.5%-1% of pay. 1% of pay + $4,000 in a Roth won’t cut it for many people, so I would still consider putting more money in a 401k or similar tax-sheltered options before resorting to taxable accounts.

    Remember, if you end up needing money earlier than 59.5, there are ways to to get that money out without penalty. In addition, you can withdraw your Roth IRA contributions at any time without penalty.

  3. Jim Lippard says:

    Jonathan: To account for that, I’d put the priorities as:

    1. Get the company match on the 401K.
    2. Max out a Roth IRA, if eligible.
    3. Max out the 401K.
    4. Max out a traditional IRA (even if it’s completely nondeductible, to take advantage of the 2010 Roth conversion option).
    5. Put money in other investments.

  4. Brian (WA) says:

    The only problem with a 401K and an IRA is that you are deferring taxes now but you will have to pay them later. Why would you want to pay higher taxes later than you would now? I would suggest investing in non qualified plans rather than qualified plans. That way you can keep all of the money you make. I would rather make 8%, and net 8% keeping all of it during the distribution and transfer years rather than make 8%, pay taxes and wind up with a 5-6% net during the distribution years and pay even more during transfer.

  5. steve says:

    It seems like this was your turn to oversimplify. Wether the particular person is saving enough with 6% + $4000 depends, among other things, on what percent of their income $4000. Also I have the opposite opinion from you on starting young – when you’re old enough to have income but young enough to have no kids and some time before you retire, it’s the *perfect* time to sock away as much as you can. It’s only going to get harder to find money once you have some rugrats, but if you saved prodigously while you were young, you might be ok even if you save a lot less while the kids are in the house. And the earlier you invest, the longer it has to grow.

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