Case Study - 2 pensions, debt-free in July, what next?

[notactiveanymore]

Husband and I will be debt free at the end of July. We will have paid off 55,421 in 6.8% student loans in 21 months. During the time we've been paying off debt (also how long we've been married) we have only been contributing the required amounts to retirement. We are now trying to figure out how we want to do retirement funding and how we want to balance that with other savings (emergency fund, downpayment fund, and saving for a new [used] car for husband)

Life Situation:
Him - 28, works for the state
Me - 26, work for a commission of local governments

IRS filing status: MJ-1, also I am in a SS exempt position

No dependents, planning on starting a family in the next couple years. We'll both continue working full-time and expect childcare expenses to be around $900/month for an infant when that time comes.

Gross Salary/Wages: $80,500 joint

Pre-tax deductions:
Husband contributes 4% (his salary is 37,000) required to the state defined contribution plan
Health insurance is covered 100% for both of us through my employer
Currently not contributing anything else

Take-Home pay:
$66,748 - I get paid biweekly, so most months our takehome is $5324 with two extra checks of $1430 yearly.

Current expenses:
$534      Giving
$100      Car Savings
$2700    Debt (ish, usually more, sometimes just under depending on gifts required mostly)
$690      Rent (cable & internet included)
$120      Utilities
$121      Cell Phones
$16        Life Insurance
$129      Car Insurance
$37        Gym Sinking Fund
$170      Fuel
$340      Groceries
$120      Blow Money
$78        Entertainment
$33        Personal Care
$20        Gifts
$15        MISC

We rent, but we'd like to start saving for a down payment after we've got an emergency fund saved up. We'd be looking at a purchase price around $190k with plans to try and move summer 2018.

Assets:
My Car (2010 Hyundai Elantra) - $7000
His Car (2000 Chevy Malibu) - $1000
New Car Savings: $1700
Other Savings: $2000
Husband's retirement: ~$1600
My 401(a): $960
My 457: $1010

Liabilities:
Student Loans, originally $55,421 at 6.8%, monthly payment on standard repayment around $600, but we're several years ahead on payments.
Current balance is $7680 and we'll have it paid off in July. Description

RETIREMENT CONSIDERATIONS

Me:

• 3 years in to a 5 years vest with local government pension. Very stable pension and if I change jobs I'd stay in local govt.
• Final 36 month Average Salary  X years of service X .02 = monthly benefit
• 100% employer funded, 5 year vest, no COLA
• Normal retirement eligible at 67 or rule of 80.

Him:

• 2 years in to 10 year vest with the state government pension. Stable pension and he plans to stay with the State
• We live 30 miles from state capitol, so there are tons of job change options.
• Final Ave Pay X years of service X .017 = monthly benefit
• Required 4% employee contribution, 10 year vest, benefit includes COLA
• Normal retirement eligible at 67 or at least 55 and rule of 90
• If he leaves before vesting, he can roll his contributions into something, but of course doesn't get any growth

Retirement Account Options:
Through employers, either of us could contribute to our 457s
We don't have a Roth set up, but that seems to be our only other option


Specific Question(s):
Once we're debt free, we want to start really hitting retirement. I'm still in Dave Ramsey mode from all the debt-payoff, and his retirement advice is to contribute up to company match in 401k then fund Roths and if you're not yet to 15% retirement savings rate then you go back to 401k's.

With our pension situation and lack of 401k match, where should we focus our retirement savings? We don't plan on retiring super early, I've thought late 50s for me. But we'd like to be FI way sooner.

We will be also saving our efund (10k), new-used car fund (6k) and downpayment (30-40k), but until we have kids, we should have about 35k after-tax for our various savings goals and retirement.

[MDM]

Specific Question(s):
Once we're debt free, we want to start really hitting retirement. I'm still in Dave Ramsey mode from all the debt-payoff, and his retirement advice is to contribute up to company match in 401k then fund Roths and if you're not yet to 15% retirement savings rate then you go back to 401k's.

With our pension situation and lack of 401k match, where should we focus our retirement savings? We don't plan on retiring super early, I've thought late 50s for me. But we'd like to be FI way sooner.

The down side to making the wrong choice is worse if you pick Roth.  In other words, if you use traditional but you end up doing so well that you pay a higher tax rate in retirement, that's not so bad.  But if you choose Roth and things don't go so well, the IRS won't give your taxes back.

Thus until you are, for all practical purposes, certain that your retirement marginal rate will reach your current rate, traditional seems best.

[ender]

The down side to making the wrong choice is worse if you pick Roth.  In other words, if you use traditional but you end up doing so well that you pay a higher tax rate in retirement, that's not so bad.  But if you choose Roth and things don't go so well, the IRS won't give your taxes back.

Thus until you are, for all practical purposes, certain that your retirement marginal rate will reach your current rate, traditional seems best.

This is exactly how I think about it.

If traditional ends up being worse for me, it means we've "won."

Also depending on what you do as a family when you have kids and how many you might have, you may end up with some years of a lot lower taxes where Roth is actually "free" for you. If your marginal tax rate is 0% because of kids and other deductions... perfect! Particularly if you can save some in pretax accounts to reduce your actual taxable income. Each kid is about $6-8k more worth of non-taxable federal income. So a few kids and a decent contribution to a pretax 457 might end up with no actual income taxes and so a Roth IRA makes perfect sense.

[notactiveanymore]

Thanks!

It's always hard to throw off the Dave Ramsey fog and start questioning things a bit more. The wrong-choice scenario makes a lot of sense, I just wasn't sure if we should diversify a bit with Roths since we will (probably/hopefully) have the taxable pension income. But I love the idea of putting some in Roths when our tax liability is the lowest. If everything goes as currently planned, we'll probably buy a house and have a baby in the same year, so that seems like a good one to target!

I'm trying to find the answer to one more thing. I read this while doing some traditional IRA:

If you’re married filing jointly and both you and your spouse participate in an employer-sponsored retirement plan, the maximum tax deductible contribution phases out once your income exceeds $96,000 and you become ineligible for a tax deduction when your income reaches $116,000.

So we're still 16,000 away from the income limit here, but I'm on a pretty good track at work and my husband has a lot more income potential which he should be able to capitalize on soon with the State. So does participating in 457s count as participating in an employer-sponsored retirement plan? Or does being in a defined benefit or defined contribution plan count?

It seems like we could do a combination right now of 457 to reduce our taxed income and then IRA as a tax deduction. But in another 3-4 years, we will have a good shot of being over 96k.

[SmallTownDA]

457 contributions count as employer sponsored retirement plans and reduce your income for purposes of qualifying for the traditional IRA deduction. Once you've paid off your debt (really impressive by the way), you should have enough left over to max out both of your 457's. The 457's are really great if you are planning to retire early because there's no early withdraw penalty. I would check out your fund selections. I have a full set of Vanguard funds in mine, so it's just as good as an IRA would be. If you have no good low-fee index funds available, prioritize the IRA's and then put whats left into the 457's.

One advantage of traditional vs. Roth is the first dollar/last dollar dichotomy. Each dollar you deduct from your taxes now is being taxed at your highest marginal rate, whereas each dollar you withdraw in retirement is starting at your lowest marginal rate. The pensions complicate things depending on how long you plan on working there. Traditional IRAs will have required minimum distributions, while a Roth will not. If your plan is to let the pensions fully support your expenses, the Roth IRA will let you pass down wealth tax free and can sit there until and unless you need it. If you are planning on only working 10-20 years before retiring early, your pensions probably won't provide enough taxable income to worry about form traditional IRA withdraws. Another option if you're planning to retire early is to go traditional now and do Roth conversions between when you retire and when your pensions kick in, since you should have really low "income". 

Congrats on the debt payoff and good luck.

[MDM]

One advantage of traditional vs. Roth is the first dollar/last dollar dichotomy. Each dollar you deduct from your taxes now is being taxed at your highest marginal rate, whereas each dollar you withdraw in retirement is starting at your lowest marginal rate.

While traditional is better from the "better downside if wrong" perspective (see posts above), it is not magically good.

In other words, each dollar you withdraw in retirement is not starting at your lowest marginal rate.  That would be a neat trick, but the IRS doesn't allow it.  Yes, the very first traditional contribution you ever make might be withdrawn at 0%, but withdrawals from subsequent contributions come on top of withdrawals from previous contributions.

Withdrawals you can make based on previous years' contributions are essentially identical to a defined benefit pension payment, in that they cause withdrawals from this year's contributions to be taxed at the marginal withdrawal rate.

[SmallTownDA]

One advantage of traditional vs. Roth is the first dollar/last dollar dichotomy. Each dollar you deduct from your taxes now is being taxed at your highest marginal rate, whereas each dollar you withdraw in retirement is starting at your lowest marginal rate.

While traditional is better from the "better downside if wrong" perspective (see posts above), it is not magically good.

In other words, each dollar you withdraw in retirement is not starting at your lowest marginal rate.  That would be a neat trick, but the IRS doesn't allow it.  Yes, the very first traditional contribution you ever make might be withdrawn at 0%, but withdrawals from subsequent contributions come on top of withdrawals from previous contributions.

Sorry if that was unclear. I wasn't saying that each individual dollar would be taxed at your absolute lowest rate. Each additional dollar is taxed at the rate that you are pushing yourself into with your withdrawals, but you start at the lowest marginal rate. When withdrawing from a traditional IRA while retired, you need to fill up your 10% bucket before being taxed at 15%. Then you need to fill up your 15% bucket before being taxed at 25%, and so on. You start at the bottom and work your way up as necessary. If you don't need the next dollar, you don't withdraw it. When working, each tax deduction is taken from the highest marginal rate you are paying. You deduct each dollar from what you were paying 33% on before you start deducting from the dollars you were paying 28% on, and so on. Deductions start at the top and work their way down.

While retired, income=expenses. You don't withdraw more than you need. While working, income=expenses+savings. You earn more than you need because you are saving part of it. Unless the plan is to spend significantly more while retired that you were earning while working (and assuming your income qualifies), a fully deductible traditional IRA is almost certainly the right call.

[MDM]

Each additional dollar is taxed at the rate that you are pushing yourself into with your withdrawals,

Yes.

but you start at the lowest marginal rate.

That would be great, but unfortunately it doesn't work that way.  When choosing traditional vs. Roth for this year, one needs to recognize that withdrawals based on this year's traditional contribution (if any) will start at whatever marginal rate would happen if no further traditional contributions are made.  That is not necessarily "the" lowest marginal rate.

This is perhaps the main point: the withdrawal rate for this year's traditional contribution depends on what other retirement income will be available if one does not make a traditional contribution this year.  That other income could be from pensions, taxable account dividends, Social Security...and the withdrawal amounts already available from previous years' traditional contributions.

When withdrawing from a traditional IRA while retired, you need to fill up your 10% bucket before being taxed at 15%. Then you need to fill up your 15% bucket before being taxed at 25%, and so on.

That is indeed how tax brackets work - although marginal rates, which are what really matter, are not so orderly.  Tax law can drive very high marginal rates in otherwise low tax brackets.

You start at the bottom and work your way up as necessary. If you don't need the next dollar, you don't withdraw it.

Unless of course you are required to withdraw it, as with Required Minimum Distributions (RMDs).  One nice thing about a Roth is that RMDs do not apply to the contributor.

When working, each tax deduction is taken from the highest marginal rate you are paying. You deduct each dollar from what you were paying 33% on before you start deducting from the dollars you were paying 28% on, and so on. Deductions start at the top and work their way down.

Yes, although there are marginal rate differences from tax brackets on the contribution side, just as on the withdrawal side.

While retired, income=expenses. You don't withdraw more than you need. While working, income=expenses+savings. You earn more than you need because you are saving part of it. Unless the plan is to spend significantly more while retired that you were earning while working (and assuming your income qualifies), a fully deductible traditional IRA is almost certainly the right call.

Yes, but....  The "but" includes both the RMD issue for the original contributor and the "what happens to an inherited IRA?" issue.  As one's beneficiaries could be in any tax bracket, adding the inherited IRA issue makes things very complex.  One can go down that rabbit hole, but "whatever is contributed will be withdrawn by the contributor" is the usual assumption for the traditional vs. Roth contribution analysis.

All this is not to say "Roth is better than traditional."  For most, traditional will be better than Roth.  For those with already-large traditional balances or pensions, etc., however, Roth may in fact be preferable.