Author Topic: Reader Case Study – Confused about Investment Order considering Early Retirement  (Read 639 times)

Amari

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Hello there-- first-time poster, but I’ve been lurking quietly on the forum for about a week now, and reading MMM obsessively for the past month. I am a recent college graduate, BSBA May 2016, and started my full-time job in October 2016. I was very amused and inspired to find the Mustachian/FIRE community; I did not know this lifestyle existed but I definitely had a little bit of this mentality in me all along, just now I am a full on, committed, convert.

Based on some rough calculations from MMM resources, I believe I can reach FI within 11 years. I was hoping to get some additional advice and guidance on things I can do better with regards to spending and investing.

Life Situation: Single, 22, 0 dependents, live and work in Northern NJ/Greater NYC HCOL area

Gross Salary/Wages: Pre-tax annual 57,000

(The following is based on a bi-weekly payroll statement from 3/3)
Current Pre-tax deductions: 18 (health, dental, vision insurance)
Taxable Earnings: 2,178
Tax Deductions: 531 (Federal and state)
Other Deductions: 193 (Roth 401k + Loan Advance 0% Interest)
Net take-home: 1,454

Current Expenses:*
Rent – 800
Utilities/Internet – 75
Fuel – 100
Groceries – 125
Tithe – 200
Miscellaneous – 100

Monthly budget total – 1,400

Assets:*
Betterment Roth IRA – 18,100 (Allocation 90% stocks/10% bonds)
Vanguard Roth 401k – 1,100 (Targeted 20XX Retirement Index)
Savings/Checking – 2,500

Car* – KBB of 2,500 (fully paid)

Liabilities:*
Student Loans – 0
Credit Cards – Paid full every month

Summary:*
Current net worth: 20,300
Additional Savings/Investments FY 2017: 17,000 (Estimated for remainder of year)
Estimated net worth FY 2017: 37,300
Savings rate: 60%

Additional Comments:
(I ramble in this whole section, please feel free to skip to questions)

* Current expenses – My company reimburses me for gas, about 80-130 per month. Cellphone is paid for by my company. I can save on groceries/meals because dinner is normally paid for when we work late (which is often) and I will always have leftovers to bring home. No gym—I have a yoga mat and exercise at home. I did not specifically budget for discretionary expenses since I over-budgeted for most of the categories (such as utilities, only 55 last month), and since I can go weeks or even months without spending on unnecessary things/trips. Also took off about 2,400 from additional savings in summary just in case.

* Assets – IRA: Not very happy with myself about this; when researching Traditional vs. Roth 3 years ago (I’ve maxed out on three 5,500 contributions 2015-17), general idea was if you plan on earning more in the future, pick Roth. I was not in the early retirement mentality back then and deeply regret it. Now that my income will likely be lower once I reach FI, I wish I had taken advantage of the tax deductions.

401k: Same rationale when I started my Roth 401k; however I will stop contributing to that starting this next payroll deposit, and the rest of the year it will go into a regular 401k. My company contributes 25% up to 6%, which is also my current contribution.

HSA: Recently enrolled in this last week after reading Mad Fientist’s blogpost; maxing out at 3,400 a year so my bi-weekly take home should reduce by 162 for the remainder of the year.

Car: I drive around a second hand, fully paid-off, 2004 Honda Civic that I got for my 17th birthday (thanks, Dad!). He currently pays the insurance and it’s still under his name. He did not mind helping because he knew I was trying to pay off some debt, but in the next month or 2 I intend to take over the insurance. Should be about 100/mo. Also a side note, pretty recently (as in a little over a month ago pre-MMM blog obsession) I was very tempted to finance or… get ready… even lease, a cool new SUV like what all the other yuppies at work drive. Don’t worry, at this point I am 95% convinced I don’t need a new car. But unlike a true mustachian, I really must keep one around because my job in client services means I could have assignments up to 50 miles away, but at least I do get reimbursements for gas.

* Liabilities – Student Loans: Aggressively paid off all 12k within 7 months of graduation, 5 of those months were very minimal income only from nannying/server gigs. Looking back, they were low interest (3.2-4%) so a part of me regrets putting all my extra cash towards that instead of just setting up a payment plan and investing the rest. But I suppose I can sympathize with JL Collins’ preference for simplicity, and also might have been worth getting rid of my irrational mental anxiety of being in debt.

Credit Cards: Another story I’m not proud of, I accumulated about 6k in credit card debt from the time I graduated and moved out in May, to when my FT job started in October, due to rent/furniture/groceries/shopping/going out. I was young, naïve, and had major FOMO. They were on 0% APR (for first 12-21 months) so I never owed interest on them. I aggressively paid this 6k off too, as soon as I finished with my loans. As of the beginning of this month, I no longer have any debt (though my cash balance is rather low). Obviously, I intend to pay off my credit cards in full from now on, which should be very easy since I am fully debt free.

* Summary – I was very conservative in this section; I didn’t factor in the expected additional income from bonuses/promotion/raise which will happen in the fall. Within my field and role, it is very common that the pay increases are normally 5-8% a year and if I maintain spending at this level, I can probably reach FI earlier than the 11 years estimated.


Specific Questions:

I read MDM’s post in Investment Order, and I have a few questions about some of the suggestions.

0. Establish an emergency fund to your satisfaction – Done? ^Q1           
1. Contribute to your 401k up to any company match – Done.           
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield. – N/A           
3. Max HSA – Done.             
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level – ^Q2           
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for an IRA, swap #4 and #5) – ^Q3           
6. Fund mega backdoor Roth if applicable – N/A, I think?           
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield. – Done (too soon, probably).         
8. Invest in a taxable account with any extra. – ^Q4

^Q1 – I don’t know why, but I’m oddly comfortable keeping only about 1-2k in my savings for “emergencies.” I figure I have over 21k in available credit from my credit cards, and there’s always the investment accounts to tap into for real emergencies. (I technically lived on credit last year for 5 months before I started my job.) Is there any danger in this thinking?

^Q2 – A few sub-questions on this: A] Should I contribute to a Traditional IRA for 2018 and onward? B] Can I, or should I, move my 2017 contribution from the Roth to a Traditional within this year/asap? C] If so, are their taxes/penalties associated with doing that? D] Same for 2016? I think I read somewhere you can contribute up until the April 15 file deadline of the following year (so in a month) if I choose to move it.

^Q3 – Maxing on the 401k intimidates me because it’s around 18,000 that will go into a retirement account that I am not supposed to touch until 59. That seems problematic if I want to reach FI by 33. I saw Mad Fientist’s post on how to utilize retirement money before that age, read it a few times but it still doesn’t make sense to me. A] Would anyone be able to please explain it to me in more detail—possibly in a scenario that fits my case/plans? Especially about the Roth ladder, 72t, etc. Also confused since I started out with a Roth IRA account. B] What happens, or what should I do, with the current 1,100 in the Roth 401k that I foolishly contributed to before considering ER?

^Q4 – (A little related to Q3) If it were up to me, I am very inclined to put the remainder of my savings into a taxable investment account (probably VTSAX). A] Why shouldn’t someone aspiring for FIRE prioritize a taxable account? B] How do you, logistically, live off of your nest egg once your targeted balance is reached? Considering you have multiple investment accounts, IRA, 401k, HSA, Taxable, etc.

Yikes--did not mean to create this monster of a post. If you made it this far, I would sincerely appreciate your candid thoughts/advice/feedback. I’m young, new to this, and still learning so I would love to learn and absorb as much as I can from the experts. Thank you very much in advance.

RidetheRain

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Hi! Welcome! It's always nice to see other young people around here and you are in a great position which is always nice. Way to find MMM at the right time in your life.

Q1. This is really dependent on you. What if you lose your job? What if you break your arm? What if your best friend loses his job and you want to let him crash on your couch? What if a family emergency pulls you away from work? I'm not a fan of living on credit cards because of the interest rates and stocks can always go down. I keep my EF 1/3 in stocks, 2/3 in cash for safety. I would make sure you have at least rent and emergency travel costs because that's what can't wait the few days for a stock sale. Do what makes you feel confident for all the crazy things that can happen in your life. Some people don't keep any emergency money at all and just absorb into lines of credit (better interest rates than cards)

Q2. It's not bad to have different types of retirement accounts. Really, it's a game of what is my current tax rate and what is my future tax rate. I'm a hedger and contribute to both, personally. I would poke around the investment section of the forum on this one. People can have varying opinions on this one.

Q3. Ok, this is confusing so I'll give you the cliff's notes version.
1. Absolutely contribute to tax sheltered accounts!
2. Rollover your 401k to and IRA (if you have bad 401k options at your employer then do it sooner rather than later)
3. Wait 5 years.
4. Withdraw a set amount each year.
You need to have something to cover that 5 years and you do pay taxes in there so make sure you time if properly.

Q4A. You don't use taxable because of tax. Retirement accounts are tax-sheltered. Some contributions are tax deductible, some accounts you are only taxed on the earnings, some you're only taxed on contributions. Taxable everything is taxed. Always. If you contribute $1000 then you are taxed on that income, taxed on the earnings, and aren't rewarded (deductions) for saving.

Q4B. You will live off the accounts in three ways:
1. Dividends. This is easy because it's just un-invested money hanging out in your account. When you have a lot of money invested these can get big.
2. Rebalancing money. When you rebalance your investment you will have to sell stock that you have too much of and instead of re-investing then you should withdraw what you need. The rest can go to rebalancing.
3. Selling stock.
As for all the different accounts. My advice is to keep it simple. Fewer accounts are easier to manage and often you will get better rates based on balance.

extremedefense

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Following because your situation is very similar to mine. 22M graduating May 2017, working FT making 61k.

MDM

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+1 to RidetheRain's answers.

If you are going to be FI in ~11 years, then "as much into traditional accounts as early as possible" is probably correct for you.  That's because you'll have neither pension nor SS at that point, so your marginal tax rate on withdrawals from the traditional account is likely to be lower than your marginal saving rate is now.

If possible (although not required), you do want enough in taxable accounts to cover the five years needed to fill the Roth pipeline.  See How to withdraw funds from your IRA and 401k without penalty before age 59.5.

If you have other questions, or the ones you had weren't answered fully for you, just (re)ask!

Vapour

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First off, congrats on doing such a good job financially at the start of your career!  I noticed you mentioned a few times in your post that you really regret things like contributing to a Roth instead of Traditional or paying off your student loans.  While these may not have been completely optimal choices, they were still really good ones, so don't beat yourself up about it.  Think about how great it was that you paid off your loans and started invested instead of spending that money.  Also, I think Roth IRAs can make sense when you're starting out, since they can act as an emergency fund (you can withdraw your contributions penalty and tax free) so that was actually a pretty good choice in my opinion.  Going forward, I'd definitely recommend going with the Traditional Pre-Tax accounts for both 401k and IRA.  It's up to you whether it's worth your time to try and re-characterize your Roth IRA contributions to a Traditional IRA for 2016 and 2017.  I don't know what the process is like, so I can't help you there.  If you want to do 2016, you'd need to do that immediately to get it done before you file your 2016 taxes.

It sounds like you're driving a lot for work.  While I don't think you need to go out and finance or lease a new car, I do think you should consider having a car replacement and/or maintenance fund of some sort.  With a lot of miles being driven and an older car, it's just more likely that something major will come up. Just something to keep in mind.

Q3. Ok, this is confusing so I'll give you the cliff's notes version.
1. Absolutely contribute to tax sheltered accounts!
2. Rollover your 401k to and IRA (if you have bad 401k options at your employer then do it sooner rather than later)
3. Wait 5 years.
4. Withdraw a set amount each year.
You need to have something to cover that 5 years and you do pay taxes in there so make sure you time if properly.

I think this is missing a step or is unclear between steps 2-3.  If you rollover your entire Traditional 401k to a Traditional IRA, that is a non-taxable event.  What you'd then do is convert an amount equal to your annual living expenses from your Traditional IRA to a Roth IRA and repeat every year.  You need to wait 5 years before you can then take this converted money out of the Roth IRA penalty and tax free (taxes paid at the time of conversion).  So for the first 5 years, you would need to withdraw from somewhere else to avoid the penalty, like a taxable account or your previous Roth contributions.  I believe you could also do a direct rollover/conversion from your Traditional 401k to Roth IRA each year in the amount equal to your annual expenses, if you want to keep the money in your 401k instead.  Just don't convert the entire 401k to a Roth IRA at once as you'd have a huge tax bill and the goal is to reduce taxes!

MommyCake

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I don't have anything to add to what was already said, but wanted to say hello since you're also from north jersey!  I don't think there's many of us.