Author Topic: Excited and a little confused -- help me think through/optimize our strategy?  (Read 1733 times)

spirotot

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Hey all,

Been a MMM reader for a little while now -- always been relatively frugal (my nickname in highschool was 'Frugal' for a while...).

Here's what I think one's average priorities should roughly be, based on what I've read here and elsewhere:

1. Pay off high-interest debt.
2. Max-out tax-advantaged retirement accounts (401k/403b's, IRA's, etc.), or AT LEAST enough to get the maximum employer match.
3. Pay off any other non-mortgage debt.
4. Start paying extra on mortgage (especially if interest rate is higher than 3-4%).
5. Invest whatever you have available in non-tax-advantaged accounts (in our case, things like Betterment and Vanguard).

My wife and I are both 23, and between us we have a pretty good household income, and will continue to into the foreseeable future. We also have no debt... except for a mortgage of $355k that we just took out to buy our first house last week. We have a decent interest rate (3.75%), and we are paying PMI up until we hit 20% equity (PMI is $185/mo, or so) on the original loan amount ($355k, as mentioned above). If for some reason you guys need more details to answer my questions, then I can provide some more details... but I think this is enough, for now.

Now, here are my questions:

* Who here has actually done or is doing the 403(b) -> Traditional IRA -> Roth IRA conversion stuff? I'm talking about THIS. I get that, in theory, this strategy is hugely advantageous. However, I'm worried about the complexity. What if I get audited? Additionally, can I even count on these conversion paths still being there in ~15-20 years? It would suck to get to FIRE-time well before age 59.5 and find that all my money is locked behind a penalty wall with no conversion routes available...

* Should we pay extra on our mortgage, or not? In our case, I guess the answer to this depends mostly on the answer to the previous question -- if the conversion stuff is not overly complex in practice, and, most importantly, reliable... then I guess we'll work on maxing out our tax-advantaged accounts, and going down the conversion route. If it's not so easy, or not reliable... then we'll just work on simply paying down the mortgage.

Looking forward to hearing any thoughts and experiences you guys are willing to share. Thanks!!
« Last Edit: March 05, 2015, 10:38:35 AM by spirotot »

Psychstache

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Welcome, congrats on jumping in and seeking answers.

1. I can't really see how it makes sense for the to shut down the conversion process. It creates an opportunity for people to create a higher tax liability aka more money for the government. They don't really shut down gravy trains, especially when 98% of the population don't know about or are effected by it.

2. Personally, I would pay down until you can get PMI removed, then do the min through the remaining life of the loan. I have a 30 yr Fixed @ 3.75% and haven't (and don't plan to) pay any extra towards it ever.

spirotot

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Welcome, congrats on jumping in and seeking answers.

Hey, thanks! Lots of valuable stuff here -- and a great community, too. Fun to be a part of. :)

1. I can't really see how it makes sense for the to shut down the conversion process. It creates an opportunity for people to create a higher tax liability aka more money for the government. They don't really shut down gravy trains, especially when 98% of the population don't know about or are effected by it.

How does it create an opportunity for a higher tax liability? The whole point of the conversion process is to keep your tax brackets low (avoiding capital gains taxes, etc.), and basically avoiding income tax by withdrawing/converting less than your standard deduction each year. So for us (married filing jointly), when FIRE-time is getting close, the strategy would be to start converting something like ~12k/year (whatever's less than the standard deduction), and then have enough income from long-term capital gains/dividends to cover the rest of our annual living expenses (let's say an additional $33k, or something). Because our 'income' is only ~$12k, that $33k is not taxed -- and we pay no annual taxes, even though we have $45k of effective income.

2. Personally, I would pay down until you can get PMI removed, then do the min through the remaining life of the loan. I have a 30 yr Fixed @ 3.75% and haven't (and don't plan to) pay any extra towards it ever.

Yeah, I have thought about that as well -- psychologically, it would feel good to not have PMI (just like not having a mortgage/rent payment would feel good), but similar to the "don't pay down your mortgage if you have a low interest rate" strategy, I wasn't sure if it made sense to pay down quickly to avoid PMI... so I did some math (see below), and I think I confirmed that it doesn't quite make sense.

Scenario 1:
If we save that $250/mo as cash in our checking account, we'll pay $20,240 in PMI, but will have $27.5k in cash (takes 110 months until we hit 20% equity, and stop paying PMI). If we invest that $250/mo and get 5% returns annually, that $27.5k would actually be $34,940.84 after 110 months.

Scenario 2:
If instead of saving that $250/mo, we put it towards our mortgage, so we'll pay $14,536 in PMI, and will have put $19750 towards our mortgage principal in the 79 months it will take for us to hit 20% equity of the loan amount. Ok, so we're done with PMI at month 79 -- let's quit paying extra on our mortgage, and invest that $184/mo PMI + $250 extra principal (total: $434/mo) at 5% for 31 months until month 110 (from our previous example). We'd have $14,389.46 at month 110. Yikes! That's a lot less...

Let's play this out to 30 years from now, though, just to see what happens.

Scenario 1:
$34,940.85 + $250/mo + 184/mo (what we were paying for PMI) compounded at 5% for 250 more months = $289,981.63 in the bank, and a paid-off house.

Scenario 2:
$14,389.46 + $434/mo compounds at 5% for another 220 months, until the loan is paid off (110 + 220 = 330, or 30 months early, thanks to the $19570 in extra principal we put down) = $192,410.33, and a paid-off house.
Mortgage is paid off, so $192,410.33 + $1649.41/mo (monthly principal + interest payment) + $434/mo compounds at 5% for another 30 months (up until year 30) = $284,675.80 in the bank, and a paid-off house.


So if I did all my math correctly (I'm not a mathematician...), it looks like Scenario 2 does catch up a bit by year 30 -- but it's still a few thousand dollars behind, and will therefore never totally catch up to Scenario 1, much less surpass it. Adding more than $250/mo (e.g. $500/mo) to the Scenario 2 principal and the Scenario 1 savings only exacerbates the difference, as does a better interest rate on investments (e.g. 6%).