401k Questions - Feeling overwhelmed

[mango]

Hi everyone!

I need advice on my employer's 401k offerings. It's serviced by Fidelity and when I register/enroll there are 3 options for contributions:

- before tax
- after tax
- roth basic

Currently my salary is 56k a year and there is a company match of 6%. They offer:

- Lifestyle funds (all Vanguard Target Retirement)
- Index Funds (such as: VIIIX, VMCPX, VSCIX, VTPSX, VBMPX)
- Actively Managed funds (a few Vanguard but mostly Fidelity offerings)

Right now I have $0 saved for retirement which includes IRAs, I'm turning 24 before the end of this year. I know I should make the 6% contribution to get the match but where should the contribution go? Divide it between the 3 of those options? All 6% in one option?? After I figure that out, what funds do I pick? Do I pick just one or can/should I chose multiple? Are Vanguard Target Retirement funds also considered index funds or are they mutual funds? I know I need to start a Roth IRA and will probably pick Vanguard but again, feeling really overwhelmed...

[beltim]

Hi Mango!

Don't worry, you don't have to make all the right decisions now.  Far and away the most important factor in how much money you wind up with in a 401k is how much money you put into it.  You know you are going to, so you've got the first and most important step taken care of.

Next, the decision is whether to contribute pre- or post-tax dollars.  This varies depending on whether you think your marginal tax rate will be higher in retirement than it is now.  Basically, if you think you'll spend more in retirement than you currently make, you're better off with a Roth.  If you think you'll spend less in retirement than your current salary, you're better off going with a traditional 401(k) using pre-tax dollars.

Next, the question is what do you invest that money in?  The Vanguard Target Retirement funds are best thought of as "set it and forget it" retirement funds.  They're great choices if you don't want to have to worry about rebalancing stocks and bonds at regular intervals.  They consist of Vanguard index funds (domestic and international stocks, domestic and international bonds) and automatically rebalance and adjust for risk as you get closer to retirement.  These are good choices for someone just starting out.

Feel free to ask more questions, and congratulations on getting a great start!

[tomsang]

As a single guy, you are probably in the 25% bracket.  If you plan on retiring on a small expense level, then the Roth does not make sense as you will be taxed at less than 25%.  The Roth and regular 401k have the same mathematical outcome if tax rates don't change. 

If you are truly Mustachian you will put 30% in each of the categories you mentioned and live off of 10%. :) 

At your age, I would be heavily invested in equities.(like 90%+), but I am pretty risk tolerant.  In my warped world, if equities do as they have done over the past 100 years, then you can retire a few years early.  If they dive over the next 20 years, then you may need to work a year or two longer. 

Good luck.  Crank up the savings now!

[seattlecyclone]

If the "after tax" option is what I think it is, you don't want to pick that one. The law allows a 401(k) plan to allow you to make after-tax contributions, where you still pay tax on the contributions in the year you earned them, and then you will pay tax on any earnings when you withdraw the funds. There's no real good reason to pick this option until you have already maxed out the limit on one of the other two options. Even then, you'll often do better putting this after-tax money in a taxable account because the long-term capital gains rates are lower than what you'll pay on the profits from after-tax 401(k) contributions. Most companies don't even let you make this type of contribution because it is so rarely a good idea.

So, the only two real choices are the "before tax" and "roth basic" options. Pick "before tax" if you think your tax rate will be lower when you retire, or "roth basic" if you think your tax rate will be higher when you retire. If you assume tax rates will stay about where they are for the foreseeable future, and you assume your income will be lower in retirement than it is now, the "before tax" option will probably be a better deal.

[mango]

Thanks for the replies so far everyone!

I guess much of my confusion/anxiety stems from being forced to guesstimate at what my future circumstance will be like when I retire. How will I know how much I'll need? It would be a complete crapshoot guess. Does the advice change if I say I most likely will retire and live out my days in the DC/NoVa area? Does the advice change if I'm expecting to get married within the next 4 or 5 years? My boyfriend right now makes significantly less than I do (tomsang, I'm a woman) and I don't expect his earning potential to increase (by his choice, which I'm fine with) past 30k a year (its about half that now).

Also, I'm attempting to become more mustachian but I'm not sure how much of it I can actually do (like socking away 90% into a 401k as tomsang mentions) between trying to kill my student loans (a little under $13k; plan is to kill off the high interest ones in the next 12 months...$5.5k) and fully maxing out a Roth IRA (that's recommended right? $5500)

I guess right now I know I'll go with a Vanguard Target Retirement fund but I'm still torn between the contribution tax options! Beltim, it's like you read my mind, I feel like I have to make The Right Decision or Else!

[Mayan]

One thing to remember is that the simple fact that you're saving and paying down debt is going to matter MUCH more than your selection of Roth vs Traditional 401k in the long run.  You're at an income level where it's something of a toss-up as far as which is preferable.  In your position, I'd be inclined to do the deductible 401k and take advantage of a Roth for after-tax savings. 

As far as how much to contribute goes, you don't have to know your exact needs in retirement - as you point out, things like marriage, home ownership, kids, etc can make it something of a moving target.  What you should focus on is how much you need to live (and how you can reduce that number!) and then try to funnel the rest into savings/debt repayment.  Depending on the interest rates and how debt-averse you are, I might prioritize the student loans over the Roth for this year. 

If you're new to investing or want something low-maintenance, the target retirement funds are a decent option.  They are mutual funds, but not index funds as they don't passively track a particular category of stocks.  Some, such as Vanguard's, are made up of index funds and so you still get a lower expense ratio compared with more typical actively managed funds 

[beltim]

Does the advice change if I say I most likely will retire and live out my days in the DC/NoVa area?

If you're planning on working and retiring in the same area, the area doesn't matter.  Even in the rare case where it does matter, it probably doesn't make a difference in planning at this stage.

Does the advice change if I'm expecting to get married within the next 4 or 5 years? My boyfriend right now makes significantly less than I do (tomsang, I'm a woman) and I don't expect his earning potential to increase (by his choice, which I'm fine with) past 30k a year (its about half that now).

This is a good question!  As a single woman making 56k, you're in the 25% tax bracket.  As a married couple, you'd be in the 25% tax bracket if the two of you earn more than 75k a year.  So no, this doesn't affect your decision.
This is a little off topic, but if your boyfriend makes 15k per year, he's eligible for the Retirement Savers Tax Credit if he contributes to a traditional or Roth IRA.  This is a tax credit worth 50% of his contribution up to $2k if he makes under $17,250, and 10% if he makes $18750 to $28750.  I've never been able to take advantage of this credit because I'm a student, but it's a great way for lower-income Mustachians to jumpstart their retirement savings.

I guess right now I know I'll go with a Vanguard Target Retirement fund but I'm still torn between the contribution tax options! Beltim, it's like you read my mind, I feel like I have to make The Right Decision or Else!

Since you're currently in the 25% tax bracket, expect to be for a while, and are unsure of your mustachian status, I would recommend starting off in the pre-tax (or traditional) 401(k) option.  The 25% tax bracket goes up to $70k for a single person and $140k for a married couple, and it sounds like you think it's unlikely you'll make more than $140k as a couple, and from that I can infer that it's unlikely you'll need more than $140k per year in retirement.

If you're not convinced, or if anything is unclear, ask more questions.  And remember, a suboptimal decision now is better than no decision!

[musty$]

If the "after tax" option is what I think it is, you don't want to pick that one. The law allows a 401(k) plan to allow you to make after-tax contributions, where you still pay tax on the contributions in the year you earned them, and then you will pay tax on any earnings when you withdraw the funds. There's no real good reason to pick this option until you have already maxed out the limit on one of the other two options. Even then, you'll often do better putting this after-tax money in a taxable account because the long-term capital gains rates are lower than what you'll pay on the profits from after-tax 401(k) contributions. Most companies don't even let you make this type of contribution because it is so rarely a good idea.

So, the only two real choices are the "before tax" and "roth basic" options. Pick "before tax" if you think your tax rate will be lower when you retire, or "roth basic" if you think your tax rate will be higher when you retire. If you assume tax rates will stay about where they are for the foreseeable future, and you assume your income will be lower in retirement than it is now, the "before tax" option will probably be a better deal.

Pick "before tax" all the way. Then when you retire early, convert the entire 401K to a traditional IRA. Then slowly over the early retirement years, convert the IRA to Roth IRA to stop taxes on withdrawal. This is clearly explained in the Mad Fientist website.

Advantages of "Before Tax"
1. No tax on contribution (tax free going in)
2. Can be converted to IRA after terminating work
3. Can be trickle converted to Roth IRA to reduce tax on withdrawal (tax free taking out)

This makes Roth Basic or Roth 401K moot, if trickle conversion applies to you early retirees.

I personally use After-tax 401K since I earn enough to max my total 401K to 50K/year (17.5K to before-tax contribution, and 31.5K after-tax). (I also max out my taxable portfolio too)

When I retire early, the After-tax contributions goes straight to a Roth IRA. So its like supercharging a Roth IRA without the 17.5K/yr limitation. And convert the After-tax earnings to a Traditional IRA to not pay any income tax.

[mango]

So it looks like After Before Tax is the way to go! Thanks everyone!!

I'm dithering back and forth but now it's asking me how I want my contributions invested, it should all probably go into the Vanguard Target right? I also clicked on managing my own investments instead of having it managed for me, the Target fund will work the same way (getting more conservative as time goes on) right?

Right now I'm in a position where I can save very aggressively but there are competing needs/wants. I'm thinking about contribution 10% before tax... is that too low?

- 13k in student loans. 5.5k at 6% and 6.8% which I want to pay off within 12 months (might put it on a 0% 12/18 month credit card, good idea?) and the rest at 4.5% and 3.5% which..is really low priority just because I want to build up credit (want to buy a modest home at some point within next 4-5 years).
- no rent to pay! still living with my parents and plan to do so for at least another 2 years....probably should build up some savings for when I move out with the BF into our own place.
- a commute that's about 45-50 minutes in the car...google maps tells me that biking to work will take me 1hr and 25 minutes (15 miles)...the need for so much gas makes me and my wallet sad. I don't know what my monthly gas needs are yet but I'm guessing it won't be pretty.
- a small grocery budget, mostly for lunch and breakfast so maybe around $100 for my bf and I.
- 2k spread over 3 credit cards (oops). 1k due to dental work (600) and work clothes (400). the other 1k...poor self control.
- want lasik badly...exercising without glasses would be really nice.
- travel to at least one cool place a year (i have never had the money or opportunity to travel)

Beltim, I had no idea about that Tax Credit! I will read more about it and also tell the bf to motivate him more with retirement savings. Thanks for mentioning it!

[tomsang]

So it looks like After Tax is the way to go! Thanks everyone!!

Hopefully, that was typo.  I think based on your tax rate, you should be putting everything in your 401k pre-tax.  Sorry about calling you a he.  I always forget the sexes of fruit.

Good Luck!

[mango]

LOL! It was...note to self: don't immediately do anything after getting home from the 1hr commute...