Author Topic: Should I be maxing out my 401(k) or saving for down payment on a house?  (Read 4218 times)

Perspicacity

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Hey there - I recently stumbled across Mr. Money Mustache  and the more I read the more I find myself getting sucked into the world of financial independence. I'm fortunate enough to be in a pretty good starting place, but this blog has prompted a few questions. Most importantly, should I be maxing out my 401(k) right off the bat, or does it make sense for me to continue saving cash for a down payment for a house?

For some background: I am currently 23 and graduated about a year ago with no debt of any kind. I started a new job in January and my base salary is $60,000, though 28% is deducted every month for federal, state, social security and medicare taxes. Currently, I have 6% of my paycheck (or $3,600 annually) going into my 401(k) with a 6% employer match. Another 10% (the maximum amount) goes into my company's stock purchase program, which allows me to purchase shares at a 15% discount. After all these deductions (and healthcare), I am left with $2,734 each month. Of this money, $900 goes to rent and $400 covers all other expenses (I don't own a car and my company pays for a monthly public transportation pass). This means that I'm saving roughly $1,400/month in cash. At this point I already have ~$30,000 in cash with another ~$7,500 in stock in a standard brokerage account. Based on my calculations, within a year I should have $60,000+ in cash, which I hope will be sufficient for a down payment (reaching this number does require selling my stock bought through the company's purchase plan, which I am free to do at any point). I keep an extra $2,000 as a safety net and am also eligible for a decent yearly bonus from my company. I keep these excluded from my calculations so I'll have some money to fall back on if necessary. I also expect I'll receive a decent tax refund based on TurboTax's calculator.

Cost of living: In my city, housing costs are unfortunately high. The $900 I am paying for rent is definitely on the low end. I have already compromised by living in a not-so-great part of town and having multiple roommates, but am unwilling to go lower by sharing my individual room. As you can imagine, homes sell for high prices in the city too. From some preliminary research, it seems possible to land SOMETHING for around $300,000, though it would likely be a crappy condo. My only real requirements would be that it has access to public transportation and that it has 2 (or ideally 3) bedrooms.

My rationale: Looking at my total expenses, rent makes up nearly 70 percent. Since cutting spending is so fundamentally critical to preparing for early retirement, housing costs seem like the logical area for me to attack. With a multi-bedroom home, the goal is to have either one or two roommates who would pay me rent. Based on some preliminary calculations, mortgage + HOA fee for condo + insurance would probably run me somewhere around $2,000/month. If I had two roommates each paying $900 or $1,000, then boom! My housing costs are covered and I'm actually building equity instead of just throwing my money at a landlord.

My dilemma: Is this a feasible goal, and does my math check out? I know I haven't shown all my calculations though I think I've included enough info to explain how I reached my conclusions. Alternately, would I be better off to simply continue renting for a while, enabling me to max out my 401(k) and contribute to an IRA? As I keep reading up, I'm learning to appreciate the power of tax-advantaged accounts. My current thought is that it's worth postponing my investment 'stash for a year in order to significantly reduce housing costs and to start building equity. The potential savings increase seems like it would be huge. In a year, I will only be 24, so time will still be on my side. However, I understand that the earlier I can get my investments working for me, the better. I'd love to hear your thoughts - am I on the right track? Do you see any significant errors in my math or thought process? Are there ways that I could further streamline my strategies? Let me know if there's any other info I can provide to clarify my situation.

ShoulderThingThatGoesUp

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Houses are always more expensive than you think. At your marginal tax rate it's hard to beat maxing a 401k and tIRA.

Jack

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Houses are always more expensive than you think. At your marginal tax rate it's hard to beat maxing a 401k and tIRA.

+1

Without bothering to actually do the 1040 math, at $60K filing single I'm guessing that maxing your 401k and tIRA would save you several thousand bucks a year in taxes alone.

I suggest considering your employee stock purchase plan + anything above and beyond maxing your 401k and tIRA as your down payment fund. (You are getting rid of the company stock ASAP in favor of something diversified like VTI, right?) Your house-hacking plan is fundamentally a good one, as long as you get on Bigger Pockets and learn how to evaluate and buy the property as an investment first rather than an emotional decision about your personal residence. (In other words, you want it to be sufficiently-profitable -- not just break-even! -- if you rented it out entirely and didn't live there yourself.) However, IMO it should be the second priority after your retirement accounts.

Jack

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I don't see a Roth IRA mentioned

That's because $60K income filing single is way into the "traditional is better than Roth" side of the spectrum.

Perspicacity

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Thanks for the input! It's definitely helpful to hear others' perspectives on my path forward. The more I read, the more maxing retirement accounts out is sounding like the way to go. Why would you recommend a traditional IRA over Roth? Is the tax advantage from traditional just that much better?

As a side note, if I were to switch to 401(k)/IRA maxing, what should I do with my cash reserves on hand? I'm somewhat hesitant to throw it into the market in the event that I do need that liquidity in the near/mid-term future.

boarder42

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keep what youre comfortable keeping on hand so you dont lose any sleep.  for everyone this is different.  my E fund is basically just a credit card and i have a month to figure out where to get the money if something were to happen... this can come from various sources like dropping my 401k cont. to the employer match, or not funding my taxable account.  or finally pulling money from my taxable account if needed.  every one is different on how they handle Efunds based on their risk profile and their support network.

seattlecyclone

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I don't see a Roth IRA mentioned, and I would definitely do this before and instead of the employee stock purchase program.

Disagree. Assuming you can (and do) sell the stock as soon as you get it, this program is essentially free money from your employer at no risk. Once you have gone through the first round of stock purchases, further participation in the program doesn't even need to constrain your other financial goals (such as saving in an IRA). Instead you can take the proceeds from your first stock sale and put it right in your IRA, use it for living expenses, or whatever.

As to traditional vs. Roth, the main thing in this consideration is whether you expect your tax bracket to be higher or lower in retirement than it is now. If higher, Roth generally makes sense. If lower, traditional generally makes sense. For those of us who have high savings rates, it's reasonable to expect a much lower income in retirement since our pre-retirement income is much higher than our spending, while our retirement income will generally be less than or equal to our spending.

I do think saving for a house makes sense with any money you have left over after maxing out your retirement accounts. If you expect this to happen within a couple of years I think you're wise not to risk it in the market. Instead use a bond fund or a savings account or a CD ladder or similar.

Jack

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As a side note, if I were to switch to 401(k)/IRA maxing, what should I do with my cash reserves on hand? I'm somewhat hesitant to throw it into the market in the event that I do need that liquidity in the near/mid-term future.

We're about halfway through the year and you're currently contributing $3600 annually, so you should have about $18000 - ($3600 / 2) = $16200 left to contribute, or $1246 per pay period (assuming you get paid every two weeks and my wild guess that there are 13 periods left this year is correct). So set your contribution level to that. Then start contributing $211.53 per week to your tIRA, or just lump-sum the $5500 today if you want. Since your cash flow for the rest of the year will be negative, spend down some of your reserves on living expenses. (If my math is correct, you'll still have about $17k of your current $30K left at the end of the year.)

On January 1, you would want to reset your 401k contribution to $692.31 per pay period and your tIRA contribution to $105.77 per week.

I'd go ahead and keep the house down payment fund in the market. If it's down, just wait -- nobody's going to force you to buy a house during a stock market crash, after all! (Besides, if it's a 2009-like scenario where the real estate market has crashed even harder, your losses incurred by selling low are offset by your gains from buying low and there's no problem anyway.)

Choices

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I don't see a Roth IRA mentioned

That's because $60K income filing single is way into the "traditional is better than Roth" side of the spectrum.
I think this is up for debate, but an IRA of some sort should be included.

Choices

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As a side note, if I were to switch to 401(k)/IRA maxing, what should I do with my cash reserves on hand? I'm somewhat hesitant to throw it into the market in the event that I do need that liquidity in the near/mid-term future.

We're about halfway through the year and you're currently contributing $3600 annually, so you should have about $18000 - ($3600 / 2) = $16200 left to contribute, or $1246 per pay period (assuming you get paid every two weeks and my wild guess that there are 13 periods left this year is correct). So set your contribution level to that. Then start contributing $211.53 per week to your tIRA, or just lump-sum the $5500 today if you want. Since your cash flow for the rest of the year will be negative, spend down some of your reserves on living expenses. (If my math is correct, you'll still have about $17k of your current $30K left at the end of the year.)

On January 1, you would want to reset your 401k contribution to $692.31 per pay period and your tIRA contribution to $105.77 per week.

I'd go ahead and keep the house down payment fund in the market. If it's down, just wait -- nobody's going to force you to buy a house during a stock market crash, after all! (Besides, if it's a 2009-like scenario where the real estate market has crashed even harder, your losses incurred by selling low are offset by your gains from buying low and there's no problem anyway.)

Contributing 18K to the 401K lowers the AGI and makes the Roth IRA look even more attractive.

Jack

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Contributing 18K to the 401K lowers the AGI and makes the Roth IRA look even more attractive.

Here are estimated tax brackets for 2016.

The OP's gross income is $60,000 per year, which puts him solidly in the 25% bracket. If he contributed fully to his 401k his AGI would be $42,000 per year, which is still $4500 above the start of the 25% bracket. Whether he maxed his 401k or not, the vast majority of a Roth IRA contribution would still get taxed at the same 25% marginal rate.

If you go by the "rule of thumb" about trying to guess whether your tax bracket in retirement will be higher, then the 15% bracket is where that guess becomes difficult to get right (and the most likely outcome is that tax rates would be equal in retirement). In other words, at 15% the Roth vs. traditional choice is a toss-up; Roth doesn't become strictly better until you're all the way down in the 10% bracket.

But that rule of thumb doesn't matter. What matters is that the Mad Fientist has proven that for Mustachians, traditional is better pretty much all the time as long as your tax liability is greater than $0. Even his example calculation is almost identical to the OP's situation ($60K income/$18k spending in the example vs. $60K income/$15.6K spending for the OP)!

Choices

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Contributing 18K to the 401K lowers the AGI and makes the Roth IRA look even more attractive.

Here are estimated tax brackets for 2016.

The OP's gross income is $60,000 per year, which puts him solidly in the 25% bracket. If he contributed fully to his 401k his AGI would be $42,000 per year, which is still $4500 above the start of the 25% bracket. Whether he maxed his 401k or not, the vast majority of a Roth IRA contribution would still get taxed at the same 25% marginal rate.

If you go by the "rule of thumb" about trying to guess whether your tax bracket in retirement will be higher, then the 15% bracket is where that guess becomes difficult to get right (and the most likely outcome is that tax rates would be equal in retirement). In other words, at 15% the Roth vs. traditional choice is a toss-up; Roth doesn't become strictly better until you're all the way down in the 10% bracket.

But that rule of thumb doesn't matter. What matters is that the Mad Fientist has proven that for Mustachians, traditional is better pretty much all the time as long as your tax liability is greater than $0. Even his example calculation is almost identical to the OP's situation ($60K income/$18k spending in the example vs. $60K income/$15.6K spending for the OP)!

Do you know if this table includes the standard deduction of $6300? If not, I think there's still a good argument for Roth, and some feel that at such a young age Roth is good even at $60K (see above).

I don't want to get into a big debate about traditional vs Roth here, as it's been covered extensively elsewhere and there are definitely pros and cons to both. My main point was that an IRA is another savings option that hadn't yet been discussed. Hopefully we can agree on that.

Perspicacity

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Wow, that Mad Fientist example fits me almost perfectly! After seeing the tax math supporting a 401(k), I can't really think of any justifiable reason to not be maxing that out. IRA is slightly more complicated, but contributing to either traditional or roth seems miles better than neither.

As much as I would like to have down payment money immediately, it feels ridiculous to pay >$5,000 more in taxes this year while trying to "save" for a house instead of maxing my 401(k).

To address some earlier points about my company's stock purchase program, I definitely plan to continue contributing the max amount. I forgot to mention that on top of being 15% discounted, the purchase price is the lower of two: the price at the beginning of the quarter, or the price at the end of the quarter. Given that, I think I'd be passing up significant free money by not participating.

It sounds like handling my current cash may be the most complicated thing to juggle at the moment. Even with high rent I'll still be living on just over 25% of my total base salary, so I guess I can't complain too much about my current situation. If my timeline for home ownership is extending, I suppose I shouldn't be too scared of investing my current savings in the market.

I'll definitely work to keep ironing out my plans - thanks so much for all the advice. While a lot of the math ends up being pretty simple, I'm continually surprised by how much nuanced information it takes to adequately prepare for retirement. (Sorry for what turned into such a long post. I find that forcing myself to articulate my thought process is the best way to clarify things for myself.)

boarder42

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you're pretty young your income will likely grow fast the next few years. so you will easily be able to save for a house and max all tax advantaged accounts with your raises.

SoccerLounge

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Disagree. Assuming you can (and do) sell the stock as soon as you get it, this program is essentially free money from your employer at no risk.
This is why I started using stock purchase programs. Not for the long-term value, but as a sort of benefits equivalent of card churning.

Jack

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Do you know if this table includes the standard deduction of $6300? If not, I think there's still a good argument for Roth, and some feel that at such a young age Roth is good even at $60K (see above).

Good point. I also forgot about exemptions (likely $4000 for the OP). That still doesn't get the AGI down to the 10% bracket, though.

Also, if by "some" you mean you, then could you explain why the taxpayer being of a young age makes Roth better than traditional? I don't see how it's relevant.

My main point was that an IRA is another savings option that hadn't yet been discussed. Hopefully we can agree on that.

No, we can't agree on that. Everyone in the thread before you posted did discuss IRAs -- traditional IRAs, that is. Not all IRAs are Roth, but you seem to be using the terms "IRA" and "Roth IRA" interchangeably.

See:

Houses are always more expensive than you think. At your marginal tax rate it's hard to beat maxing a 401k and tIRA.

Without bothering to actually do the 1040 math, at $60K filing single I'm guessing that maxing your 401k and tIRA would save you several thousand bucks a year in taxes alone.



Wow, that Mad Fientist example fits me almost perfectly! After seeing the tax math supporting a 401(k), I can't really think of any justifiable reason to not be maxing that out. IRA is slightly more complicated, but contributing to either traditional or roth seems miles better than neither.

On the contrary: IRAs are exactly equally complicated as 401Ks, which is why ShoulderThingThatGoesUp and I mentioned them in the same breath instead of "discussing" IRAs separately to Julie's satisfaction. IRAs come in traditional and Roth varieties, but so do 401ks (if your employer has decided to offer the Roth 401k option, which not all do).

The main difference is that a 401k is handled through your employer, while an IRA is an account you open and contribute to directly. (There are a few other differences related to rollovers and strategies for higher income levels, but they aren't particularly relevant here.)

To address some earlier points about my company's stock purchase program, I definitely plan to continue contributing the max amount. I forgot to mention that on top of being 15% discounted, the purchase price is the lower of two: the price at the beginning of the quarter, or the price at the end of the quarter. Given that, I think I'd be passing up significant free money by not participating.

Absolutely. Just remember that you can then withdraw it again later, after it's finished vesting or whatever. You can set up a "pipeline" whereby you'll have the same amounts being contributed and withdrawn in each period such that the net effect on your budget is zero. I'm not saying you should do that -- if you can afford to let that taxable investment account accumulate (after selling the company stock to buy a diversified ETF) then go for it! It's just that the money isn't inaccessible in the same way as a retirement account.

Choices

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Perspicacity, here's a great post on employer stock. How long do you have to hold before you can sell?
http://www.apathyends.com/company-stock-must-own-hard-pass/

Choices

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My main point was that an IRA is another savings option that hadn't yet been discussed. Hopefully we can agree on that.

No, we can't agree on that. Everyone in the thread before you posted did discuss IRAs -- traditional IRAs, that is. Not all IRAs are Roth, but you seem to be using the terms "IRA" and "Roth IRA" interchangeably.


You were right that IRAs had already been mentioned. My bad.

Perspicacity

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Perspicacity, here's a great post on employer stock. How long do you have to hold before you can sell?
http://www.apathyends.com/company-stock-must-own-hard-pass/

Thanks for the article! There is no required holding period with my plan; the purchases occur quarterly and I'm free to sell as soon as I own the stock. I plan to evaluate on a case-by-case basis as I receive the shares whether to hold or sell immediately for a 15% profit.


On the contrary: IRAs are exactly equally complicated as 401Ks, which is why ShoulderThingThatGoesUp and I mentioned them in the same breath instead of "discussing" IRAs separately to Julie's satisfaction. IRAs come in traditional and Roth varieties, but so do 401ks (if your employer has decided to offer the Roth 401k option, which not all do).

The main difference is that a 401k is handled through your employer, while an IRA is an account you open and contribute to directly. (There are a few other differences related to rollovers and strategies for higher income levels, but they aren't particularly relevant here.)

My employer actually does offer a Roth 401(k), though I haven't addressed it much since the traditional 401(k) seems to have such powerful tax consequences. Overall Roth vs Traditional IRA sounds like it may be approaching the "tossup" range since, with deductions, I would be in the 15% bracket.

COlady

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I don't see a Roth IRA mentioned, and I would definitely do this before and instead of the employee stock purchase program.

As for buying a house in a high COL area, use one of the rent vs buy calculators to see if it makes sense, and check out these other tips to see if you'd be a good owner/landlord.
http://www.choosebetterlife.com/5-financial-myths-busted/

Where else can you get a pretty much guaranteed 15% return on your money besides an ESPP (assuming there's no holding period).