Dear Dr. Don,
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I am 52 years old and have $155,000 in my 401(k) and another $25,000 in a Roth individual retirement account. I am four years away from paying off my house. And in three months, I will have paid off two consumer loans. That means I'll have an extra $1,000 every month to invest. Do you think it would be better to put the bulk of that each month into my Roth IRA or my 401(k)? Or possibly, I could split the money between the two accounts. I've basically paid off all the interest in my house. I am not sure it would be wise to put any of the extra money in house payments. What do you think?
-- Michael Muster
If your employer offers matching contributions to your 401(k) plan and you're not contributing all the way up to the limit of the match, then that's the first choice for the best home for this money.
Beyond that, I would lean toward recommending you contribute more to your Roth IRA for two reasons. It would give you some tax diversification in your retirement savings, and a Roth IRA doesn't have the minimum distribution requirements during the lifetime of the original account owner.
One caveat to my recommendation is that, in general, Roth IRAs make the most sense when you expect to be in a higher tax rate in retirement than the marginal income tax bracket faced when you made the contribution to the account. That's because qualified distributions out of a Roth IRA are tax-free. If you're in a high marginal federal income tax bracket now and don't expect to be in retirement, then the investment in the Roth IRA is just protecting you against the risk that the federal government might raise tax rates in the future. That's the "tax diversification" argument.
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I don't completely agree with your suggestion that there's no reason to make additional principal payments on the house. Yes, interest expense is a decreasing component in your monthly mortgage payment. If you are just four years away from the house being paid off as you say, however, the mortgage interest expense deduction may not be doing all that much for you. That increases the effective after-tax rate on your mortgage. For you to be better off investing in your retirement accounts versus prepaying your mortgage, you have to expect to earn more on your investments on an after-tax basis than you pay after-tax on your mortgage.
What does all of that mean? Investing in certificates of deposit in your retirement accounts instead of making additional principal payments isn't going to make sense if the effective rate on your mortgage is 4%, and CDs are yielding less than 2%.