Looking for advice for a young man starting out on his own

[matthiasak]

I am here to ask for advice for a young gentleman starting out on his own (or is relatively new to the independent world). I am turning 24 soon, graduated from Univ. of Texas at Austin with a degree in Computer Science, and have already been working fulltime since May 2011.

I have been successful with getting jobs, and worked my way through college. I worked at two startups, one after the other, and in time each fell through so I got an actual steady job at an IT consulting firm here in Houston. Great job, great pay, great benefits.

However....

Even though I have already paid off an engagement ring and a car, I am getting married in February, and still want to consider saving money for a rainy day and putting money away. I have a 401k (not Roth) with my company, where I am putting away 14% total (4% match).

I have been considering multiple options for generating money, and I am still not entirely sure which route to take *first*. An investment account would be ideal, and given that I already have my 401k with Fidelity, it would be nice to continue using Fidelity with a separate non-retirement account. Then there is Vanguard ETFs (https://personal.vanguard.com/us/whatweoffer/etfs?WT.mc_id=MIS1x1s) and other services like LendingClub (https://www.lendingclub.com/home.action).

Finally I want to open a Roth IRA, and maybe even switch my 401k over to a Roth 401k.

So which route would you recommend that I take first? And more importantly, why? :)

[tannybrown]

Typically, the advice goes like this:

-Max out your 401k first (max is $17k contributions per year), because you are likely to be taxed at a lower effective rate in retirement than you are now.
-Then, max out your Roth IRA (for tax diversification and, even if you're paying higher taxes now than you would in retirement, it's a good thing to let your funds grow tax free)
-Only after those two are maxed, invest in a taxable brokerage account

[JohnGalt]

Finally I want to open a Roth IRA, and maybe even switch my 401k over to a Roth 401k.

So which route would you recommend that I take first? And more importantly, why? :)

The roth vs traditional will depend on a few things:

You'll want to compare your current marginal tax rate to what you expect your effective tax rate to be on money withdrawn.  This is mostly dependent upon your current income vs withdrawal period income.  My rule of thumb... if you plan on a ERE/MMM style retirement and are in the 25%+ marginal tax bracket today, you're very likely to come out way ahead on the taxes with a traditional 401k/IRA rather than a roth. 

Eligibility - traditional IRA deductions end at some income point so you might only be eligible for roth (roth ends at a higher point, but right now there's a loophole that let's any income contribute to a roth).

Flexibility - roth IRA funds can be withdrawn tax/penalty free at anytime.  I think roth 401k funds act the same way after you've left your job but you may want to check.  traditional IRA/401k funds are harder to withdraw before retirement age (though there are handy ways to get access to it for early retirement, you can search through the forum to find plenty of examples for how it works).

As far as the order goes - I like Tanny's recommendation - as long as you don't have any short term goals that need to be saved for first. 

[Jaherman99]

Roth contributions are post tax, and the gains are tax free.  For the sake of easy math, if you put 5k in your Roth at a 7% return a year for 30 tears, you will walk away with About 360,000 bucks of tax free money.  Way better than a 401k, which will tax you on every dollar you withdraw.

My advice:
contribute to your 401 k to the company match to get the free money
Max your Roth
Put the rest into a regular taxable account because you'll need acces to your money when you retire early long before you reach retirement age where you can access the 401 and Roth.

[tannybrown]

Three things:

1) Any retirement account we're discussing is really just a decision on when you will pay taxes.  So, yes, with a 401k you pay taxes when you withdraw in retirement, but for people on this forum, typically you're going to have much less taxable income in retirment than you are now, while you work.  Should taxes stay flat (*assumption alert*), it's generally better to defer paying income tax on 401k withdrawls than paying income tax today. 

2)The five year Roth IRA pipeline is a popular method for getting to your 401k dollars in a really tax efficient way (ie. - retire early, pull out one year of expenses and roll into the Roth, pay income taxes on that small amount since you don't have work income, let that money sit for 5 years, then withdraw the funds from the Roth tax free...repeat the rollover of one year's expenses every year.)  If your living expenses are fairly low, you may only be withdrawing between $20k-$30k and paying very little taxes on that money during its lifetime, after deductions/exemptions.  The rub is: how do you live for those first 5 years?

3)The taxable account (along with your Roth contributions) may be a good way to get through those 5 years but I'd say your taxable account is akin to an 8 cylinder SUV sitting in your garage: it's inefficient and you only use it as much as absolutely necessary.  If the 401k is not desirable because of taxes paid when withdrawn, the taxable account is even less desirable because you pay income tax on the money before it goes in, and then pay capital gains on top of that.  No fun.

[cats]

I just thought I would chime in about Lending Club, as you mention you are considering it.  I invested $1k with them ~3yrs ago and while I have not lost money, I am also taking in a LOT less than originally projected (6% vs. 13%), due to a higher than average default rate on my loans (and no, it's not because I went and chose a bunch of super risky loans, even an "A" loan has defaulted).  They do recommend investing more than I did if you want a more certain return (i.e., the more notes you have, the more likely it is your portfolio will be a good reflection of their average conditions), so of course this may simply be my punishment for being cautious.  Anyway, I'm not saying don't do LC at all, but do be aware that they potentially aren't *quite* as awesome and high-return/low-risk as they like to make out.

[matthiasak]

Anyway, I'm not saying don't do LC at all, but do be aware that they potentially aren't *quite* as awesome and high-return/low-risk as they like to make out.

Thanks for the advice and feedback from your experience. They do recommend an initial investment of around $25k (following the fine print :/ )

As far as the other posts, I do intend for my tax bracket to increase. Right now I'm in the 25% bracket, but even as soon as December I might be moving to the next bracket.

I don't intend for the MMM style retirement, as I like what I do and I definitely would want to keep myself busy :)

So I definitely see a plan of action:

1. Max out IRA ($5k)
2. Max out 401k ($17k from me, up to $33k from company (right now at ~$3k)

So with my own expectations laid out above (expected increase tax bracket, not retiring MMM style), would it be more advisable to move to a Roth 401k?

Also, I will be planning to buy a house in some years, maybe a used car, but I'm mostly a bang-fr-the-buck kind of person looking to generate some extra passive income, too. Taxable brokerage/stock accounts seem to take quite the hit, but let's say I'd like to put accrue up to $200k in ten years from either an investment account working with stocks, or with CDs. Does anyone have a preference to these methods?

[Jamesqf]

An investment account would be ideal, and given that I already have my 401k with Fidelity, it would be nice to continue using Fidelity with a separate non-retirement account.

I'd suggest keeping the non-retirement account with another company.  Otherwise, if something happens to Fidelity (like the managers cooking the books), then all your money goes down the drain.

[JohnGalt]

An investment account would be ideal, and given that I already have my 401k with Fidelity, it would be nice to continue using Fidelity with a separate non-retirement account.

I'd suggest keeping the non-retirement account with another company.  Otherwise, if something happens to Fidelity (like the managers cooking the books), then all your money goes down the drain.

I suppose this is possible... but I would put the possibility of you actually losing that money at close enough to 0 to not have to worry about it.  Your cash and equity would still be there even if Fidelity went under. 

[MooreBonds]

As far as the other posts, I do intend for my tax bracket to increase. Right now I'm in the 25% bracket, but even as soon as December I might be moving to the next bracket.

I don't intend for the MMM style retirement, as I like what I do and I definitely would want to keep myself busy :)

I'm a big believer in diversification among investments as well as tax liabilities. Not only could my tax bracket stay the same, but I'm also hedging against tax rates going up down the road, along with means-testing of account balances.

So, my plan is to try and have my balances in my ROTH IRA/ROTH 401(k) accounts be somewhat close in value to my various tax-deferred accounts. That way, just like with having some index funds to have a market-return (instead of swinging for the fences and risking failure), I'm 'guaranteed' to be able to take advantage of whatever tax policies/rates do in the completely unknown future of the political realm - where common sense rarely wins out over various special interests on both sides of the aisle. After you retire (or if you work part-time), if your income happens to be lower one year, you can convert some tax-deferred funds to a ROTH. Conversely, if something crazy happens and they somehow tax ROTH balances, you aren't screwed with having 95% of your retirement accounts in ROTHs.*

Also, because I hope to retire early, I need a heavier balance in my taxable accounts, since the ability to withdraw funds from your 401ks before 55/59.5 is limited to a relatively small SEPP amount.


*While it could seem impossible the gov't would do this, remember that SS benefits were, at one time, only 50% taxable - the theory being that you already paid income taxes on your 50% contribution from your paycheck, while your employer's 50% contribution was untaxed. However, back in the 80s/90s, that changed such that up to 85% of your SS benefits are taxable. So you're getting double-taxed on up to 35% of your SS benefits. And corporate dividends are double taxed at both the corporate level and on the individual level when you receive them. Just like with those examples of double taxation, your ROTH could get hit with a sort of direct tax, or a means-testing indirect tax down the road.

[tannybrown]

Anyway, I'm not saying don't do LC at all, but do be aware that they potentially aren't *quite* as awesome and high-return/low-risk as they like to make out.

Thanks for the advice and feedback from your experience. They do recommend an initial investment of around $25k (following the fine print :/ )

As far as the other posts, I do intend for my tax bracket to increase. Right now I'm in the 25% bracket, but even as soon as December I might be moving to the next bracket.

I don't intend for the MMM style retirement, as I like what I do and I definitely would want to keep myself busy :)

So I definitely see a plan of action:

1. Max out IRA ($5k)
2. Max out 401k ($17k from me, up to $33k from company (right now at ~$3k)

So with my own expectations laid out above (expected increase tax bracket, not retiring MMM style), would it be more advisable to move to a Roth 401k?

I would not.  You're already at a high tax bracket at 25% and are likely to move even higher.  Wanting to invest in a Roth 401k is saying that you anticipate being taxed at a higher rate than that in retirement.

If that's true, and you think you'll be paying 30% plus in income taxes in retirement, then yes, switch to a Roth 401k.  If you think you'll be paying lower than 25% in retirement, then stick with a traditional 401k.