Suze Orman Money Matters

A few weeks ago, I heard a financial adviser on TV say that one of the biggest mistakes you can make is suspending your 401(k) contributions after you qualify for the company match.

I think that's really bad advice, and I want to make sure you understand why.

Max Out, and Then What?

In 2007, you can invest up to $15,500 in a 401(k) plan; if you're 50 or older, the max is $20,500. In addition to your contributions, most plans also offer an employer matching contribution tied to your salary. One typical formula is for an employer to match 50 percent of your contributions up to a max of 6 percent of your salary.

It's an absolute no-brainer that everyone should contribute enough to their 401(k) to get the maximum employer match. But then a question arises: Does it make sense to keep contributing to the 401(k) after you've maxed out on your employer's contribution?

My answer depends on your personal financial situation. Here's my strategy.

Making More Out of Less

If your FICO credit score is below 620, your priority after getting the full company 401(k) match is to pay down your debt so you can boost your credit score. That low score costs you way too much in higher interest rates on credit cards and car and home loans, as well as on your car insurance premium. A low score could also mean that a landlord won't rent to you, and can even keep you from landing a job you want.

If you limit your 401(k) contributions to just enough to get the maximum company match, you'll have more money in your paycheck even after taxes. You can use that to increase your credit card payments.

But if you have a strong FICO score, aren't paying high interest on any credit card debt, and already have an emergency cash fund in place, your next step after getting the maximum company match on your 401(k) should be to fund a Roth IRA.

Why a Roth?

This year, individuals with modified adjusted gross incomes below $99,000, and married couples filing a joint return with income below $156,000, can invest the full $4,000 in a Roth. Contributions are reduced for individuals with incomes between $99,000 and $114,000, as well as married couples with incomes between $156,000 and $166,000. (You can contribute $5,000 if you're at least 50 years old.)

You want to switch over and fully fund a Roth after achieving your employer match on a 401(k) because of your future tax bill. If you follow the standard rules, withdrawals from your Roth will be 100 percent tax free in retirement. Withdrawals from your 401(k) will be taxed at your ordinary income tax rate. Currently, that can be as high as 35 percent, not including state tax.

Unless you're currently in a very high tax bracket and are sure you'll be in a very low one in retirement, odds are that you'll do better with the Roth because of the tax treatment.

Stashing Away for Your Mortgage

I could make your eyeballs spin with the math involved, but I'll provide a scenario I think many of you can relate to instead.

The primary reason you save for retirement, obviously, is so you can cover your living costs when you're no longer working. One of the biggest retirement expenses is a mortgage, and with so many people trading up or refinancing later in life, it's going to be increasingly common for retirees to still be paying off a house into their 70s and beyond.

For example, let's say at age 50 you bought or refinanced a home with a $300,000, 30-year fixed rate mortgage at 6.5 percent. That works out to monthly payments of $1,896, or $22,752 a year. At age 65 you decide -- or are forced -- to retire, so there's no more income. You want to stay in the house you love, but are worried about the 15 years of payments left on the mortgage.

By my calculations, you would need a 401(k) stash in the vicinity of $500,000 to be able to cover the house payments without eating into your principal. I'm assuming that this $500,000 earns a conservative 5 percent a year, which comes to $25,000 a year. That $25,000 will be enough to cover the mortgage assuming your income tax rate in retirement is just 15 percent; if you're in the 25 percent bracket, you'll be a little bit short after netting out the tax owed on your withdrawals.

If you anticipate that your tax rate will be higher than 25 percent, you would obviously need to save more to cover your mortgage once you retire. For example, if you expect to be in the current top income tax bracket of 35 percent, you'd need about $700,000 in your 401(k) to generate enough income to cover your mortgage.

Who Needs a Tax Break?

I have a better idea. After 15 years, your mortgage balance will be about $217,000. To pay it off in full you would need a 401(k) balance of about $335,000 to net the $217,000 after taxes. (Withdraw $335,000 in one year and chances are you'll be stuck in the 35 percent tax bracket.)

If you had at least $217,000 in a Roth IRA instead, you would be in great shape, because that $217,000 could be withdrawn tax-free. If you ask me, saving $217,000 is a lot easier than saving $500,000, or even $335,000.

Sure, people will argue that if you opt for a Roth rather than max out on your 401(k), you lose out on the fact that 401(k) contributions reduce your taxable income and Roth contributions come out of after-tax income (i.e., they provide no tax break). But this presumes that you'll diligently invest the extra tax savings from a 401(k). If you're that disciplined then you deserve the retirement-savings prize, but my experience is that most people end up spending their tax savings rather than investing them.

A Retirement Funding Knockout

I even advise those of you who have the option of participating in a Roth 401(k) at work to invest to the point of a company match first, then concentrate on funding a Roth IRA. Even though the Roth 401(k) is a great choice -- and more and more employers will be offering it in the coming years -- I still like the Roth IRA because of the extra flexibility it gives you.

With a Roth IRA, you can always withdraw your contributions at any time without any taxes or penalties; that's not the case with your 401(k). I'm not suggesting you ever raid your retirement savings, but it's an extra security blanket to know that your Roth IRA contributions can double as an emergency cash fund.

A Roth is a better estate planning tool, too. The IRS requires that everyone begin taking required minimum distributions from their 401(k) accounts (as well as traditional IRAs) no later than the year you turn 70-1/2. Even if you don't need the income, the IRS does -- the purpose of this rule is to make sure the government finally gets to collect some income tax from your account. But there's no required withdrawal with a Roth IRA: You can leave 100 percent of it invested to pass along to your beneficiaries.