Advice needed on where to effectively place cash

[Hubbard521]

I’m looking for some advice from you wise Mustachians on how to most effectively place my cash stash.  I’ve been sitting on some cash for a while -- unsure of how to properly invest it and debating using it as a down payment on a condo.  Here’s my breakdown:

Cash   55k (8k for emergencies; 47k waiting to be placed)
Roth   11k
401K   6k

Other pertinent information:

I’m 25 years old and have minimal student loans (which I’ll probably take care of first).  My salary is 67k.  Please note, I don’t currently have an employer match on my 401K.  In terms of lifestyle, I grew up in a family with very poor financial stability, so I’m naturally very frugal, don’t have a TV, ride a bike, etc.

At this point, I’m unsure of whether I should be stuffing money into my 401k even though I have no employer match, placing money into non-IRA index funds, or investing in real estate. 

As  far as real estate is concerned, I live in Chicago and am currently renting.  I should mention that I’ve only recently begun looking at real estate and reading into forums such as biggerpockets.  In other words, I’m a complete tyro.  I’ve looked at a few two bedrooms with the assumption that I could rent one out and the knowledge that I might be re-locating within a year and would then have to rent out the entire property.  Conversely, I could buy a rundown 2-flat, rehab it, and then rent it out using a management agency when I’m presumably out of town a year later.

I’d greatly appreciate any feedback.  Thanks!

[JohnGalt]

I personally would still max out my 401k for the tax deferral even without an employer match - I plan on being in a much lower tax bracket when I withdraw that money.  It could turn out to be up to a 25% immediate gain on that money - depending on how taxes look in retirement.  That's not even counting not paying taxes on any trades I make before withdrawing. 

As far as what to invest in... That's going to be a very personal decision, you'll need to decide what you're interested in and comfortable with.  I don't know anything about the real estate market in Chicago - but if it's favorable to owners and you're interested in it, I do think the current interest rates make leveraged investing in real estate a play worth checking out. 

[tannybrown]

The rub is that the thing you want to use the cash for will determine where you should put it.

For example, if you want to use it as a downpayment in the next 3-6 months, I'd just keep it in a cash account.

If you want to use it as a downpayment in the next 3-6 years, spreading it around with an asset allocation including some mutual funds and bonds might be a better idea.

As for the 401k, I believe it's too late to put that $47k in the 401k per se, but you could effectively max your 401k to get to the $17k annual match, and then use the $47k to supplement the remaining paycheck income and essentially "live" off that cash...over a period of years, it would get that cash in the 401k.

[Hubbard521]

Thank you both for your responses.

I have to again stress that I'm incredibly new to all of this and only have the slightest stubble, as it were.  So you're saying I'd be better off putting money into my 401K, despite the fact that I have no employer match, rather than separate, non-retirement index funds?  I'm only 25 and would like to hit FI well before I could touch that money.

I realize the dilema, Tannybrown.  I'm currently debating buying a condo (that would in turn become a rental property within a year) or just investing in other areas.  The buyer's market in Chicago is good at the moment, but not stellar.

[tannybrown]

There are ways to access funds in a 401k prior to retirement.  The one floated around here is the "5 year pipeline" in which you:
1) quit your job (no income, yeah!)
2) pull one year of expenses out of a 401k
3) convert it to your Roth (paying minimal taxes on that small amount)
4) let it sit in a Roth for 5 years
5) pulling out that money and paying no tax

The plan above allows you to essentially avoid paying much tax at all, because your funds needed to live in retirement are going to be in a very low effective tax bracket.  The rub is finding a way to live during that 5 years, without earning a ton of income that pushes you to higher brackets.  One way is to live off the funds you've contributed to the Roth and/or brokerage accounts.

Re: what to do with the funds, the more important thing is to figure out what you want to do, than figuring out the best way to do it, IMO, if that makes sense.

[Hubbard521]

Thanks again, Tannybrown.  I've seen that early access method on here before while perusing the forum.  What's still unclear to me is whether or not it's still advantageous to go through that whole process rather than simply putting the money into a general Vanguard index fund.  If I had employer match it'd be a no-brainer for me, but I don't.  Pardon my ignorance but let me see if I have this right.  Because I'm in the 25% tax bracket now and would presumably be in the 10% or 15% tax brackets upon early retirement I'd be able to save 10% or so by putting the money into a 401k rather than straight into an external index fund?

[tannybrown]

Right.  The investment mix/asset allocation you put the funds in is kind of moot: I assume you could have the same mix within your 401k (or something close) or in a taxable brokerage account.   The question is what kind of tax sheltered account (if any) you should have your money sit in for all those years between now and early retirement.  (Note, I don't know what kind of investment options you have in your 401k, and what the fees are.  Those should come into account.  That said, the tax advantages typically outweigh the limited options and higher fees in a 401k.)

Here's another way of looking at it.  You are going to pay taxes on your income: it's just a matter of when.  You can pay taxes on that income now (when your taxable income is something like $57k after standard deduction/exemption) or you can pay taxes later (when your taxable income could be something like $10k after the standard deduction/exemption).  The unknown is what tax rate someone with a taxable income of $10k will be in 20 years, whether the standard deduction exemption are still around, etc.

[grantmeaname]

It's important to point out that you're comparing your marginal (highest) tax rate now to your effective (total) tax rate in retirement, so you'll likely save a good deal more than 10% in your example, and you'll still come out ahead as long as tax rates increase moderately.