Tax advantaged accounts - Where should I put my raise?

[Fatmouse]

Talk about a good "problem" to be thinking through on this beautiful Saturday!

I just got a $15k raise (annual gross salary), effective June 1! As a Mustachian, of course this will be saved and invested, but I have a few different options about where/ how.  This question is mainly about tax advantaged accounts, not what to actually invest in.

Vital stats relevant to my options:  Age 30, high income, new homeowner, only mortgage debt.

Also, my 401k investment options are quite good, very low fees and better performance than I have been able to achieve compared to investments I manage in my non-retirement account (even though I invest in low cost index funds, and asset allocation is similar in both accounts).

I am on track to contribute approximately $10k into my 401k this year (not including employer match), which leaves me about $7.5k away from the IRS contribution limit for tax advantaged retirement account contributions.

Options for where to put extra money:

Option 1:  401k Roth - I currently save 10% of my gross income in a Roth option in my 401k.  At this rate, I get the benefit of all available employer matching, but I am not hitting the IRS annual limit for contributing to my retirement account. (This option means I pay taxes now, but later I will not be taxed on withdrawals or earnings.)

Option 2: 401k Deferred Compensation - I am in a high income tax bracket, but I currently do not have any accounts that defer my taxes owed.  I could put my raise into the "deferred compensation" option in my 401k, again until I hit the IRS annual limit.

Option 3:  Extra mortgage payments - Last year, my fiancé and I bought a 1 bedroom condo in an expensive city/ neighborhood (with 20% down payment), at a 3.25% 5/1 ARM mortgage.  We only plan to live here for approximately 5 years.

Option 4: Non-retirement investment account - My balance in my non-retirement investment account is currently very modest, and fiancé has no non-retirement investments.  Investing in a non-retirement account would improve liquidity and build up nest egg for potential years of FI before I can access retirement accounts.

Obviously, I can divvy up my $15k raise among these options as well.

What should I do, Mustachians?  There are no bad options, but this is a tough decision for me!

[Thedudeabides]

Congrats on your raise!

Really it all depends on what your goals are for the next few years.

In this case, you have a guaranteed 25% on $7500 of the raise if you put it in the 401k assuming a 25% tax bracket.

Option 3 doesn't seem that great because you're going to move in a few years and the interest rate is so low.

So I would recommend $7500 pretax to the 401k and the after tax balance to start building up your investment account.

Either this, or max out the regular 401k at $17,500 saving you $4300 in taxes (if in the 25% tax bracket) and then contribute $5500 to a regular ROTH if you qualify. If you don't qualify, you could do a traditional IRA and convert to a ROTH. The extra $162 you have left over after taxes could fund the investment account.

[Joel]

What is your total taxable income? Is your marginal tax rate at 25%? If so, I would make sure that you are maximizing the 17,500 going into a regular 401k in which none of the dollars are Roth. It only makes sense to use Roth during the lower earning years of your career, when your marginal tax rate is at it's lowest.

[Fatmouse]

What is your total taxable income? Is your marginal tax rate at 25%? If so, I would make sure that you are maximizing the 17,500 going into a regular 401k in which none of the dollars are Roth. It only makes sense to use Roth during the lower earning years of your career, when your marginal tax rate is at it's lowest.

My gross salary with the new raise is $110,000.  Considering fiance's income (getting married in two months!), we will not qualify for Roth IRA for the 2014 tax year (which thedudeabides mentioned as an option).

Does the Roth 401k really not make sense in my situation?  I found it attractive because I understood the earnings are not taxed this way.  Basically, even though I am taking a tax hit up front, I get decades of the magic of compounding that will never be subject to capital gains.  (At least I sorely hope I am right about this!)

Also, yes, tax bracket is 25%, and also a whopper of DC state and local income taxes at 8.5% (marginal rates).

So, the tough part for me is that I am hoping the magic of compounding tax free makes up for the up-front tax hit.

[Thedudeabides]

The answer is...it depends.

If you are in the 25% tax bracket, then I would definitely max out tax deferred first and forego the ROTH altogether for now.

The reason for this is that you can always convert to ROTH later and while you will pay taxes on the conversion if your tax rate is extremely low due to FI/RE, then you'd come out ahead.

The mad fientist has a great article on this: http://www.madfientist.com/retire-even-earlier/

Of course, all situations vary.

With the left over funds, you can still contribute to a traditional IRA for the remainder and opt to convert to ROTH later.

[brewer12345]

What is your total taxable income? Is your marginal tax rate at 25%? If so, I would make sure that you are maximizing the 17,500 going into a regular 401k in which none of the dollars are Roth. It only makes sense to use Roth during the lower earning years of your career, when your marginal tax rate is at it's lowest.

My gross salary with the new raise is $110,000.  Considering fiance's income (getting married in two months!), we will not qualify for Roth IRA for the 2014 tax year (which thedudeabides mentioned as an option).

Does the Roth 401k really not make sense in my situation?  I found it attractive because I understood the earnings are not taxed this way.  Basically, even though I am taking a tax hit up front, I get decades of the magic of compounding that will never be subject to capital gains.  (At least I sorely hope I am right about this!)

Also, yes, tax bracket is 25%, and also a whopper of DC state and local income taxes at 8.5% (marginal rates).

So, the tough part for me is that I am hoping the magic of compounding tax free makes up for the up-front tax hit.

In your situation I would not even consider a Roth.  Get the deduction up front with a traditional 401k.

[surfhb]

Personally I'd always put money into a ROTH no matter what.    That's tax free investment money!    It's like a free "gift" from Uncle Sam.  :)

So it looks like 12k into 401k and 5500 into a ROTH

[Fatmouse]

Thanks all!  This has been eye-opening.  I was not expecting so many strong votes for traditional tax-deferred 401k over the Roth 401k option.

Option 2 is the winner.  :)

This is why one asks Mustachians.

(But if there are other latecomers, keep the advice and perspectives coming!)

[Joel]

At that income level you should probably change your entire retirement contribution to the 401k and not the Roth 401k. Rough rule of thumb, You need over a million dollars in tax deferred assets before your marginal tax rate upon retirement is equal to what it is now when you are over a 25% marginal tax rate.

[surfhb]

Thanks all!  This has been eye-opening.  I was not expecting so many strong votes for traditional tax-deferred 401k over the Roth 401k option.

Option 2 is the winner.  :)

This is why one asks Mustachians.

(But if there are other latecomers, keep the advice and perspectives coming!)

seriously consider a separate ROTH too!    Imagine what $100k growing tax free would be like when you retire. :)

[Joel]

Surfhb - why would you pay 33% tax now, when you could avoid that and pay nothing in the future?

[Fatmouse]

seriously consider a separate ROTH too!    Imagine what $100k growing tax free would be like when you retire. :)
[/quote]

Acknowledging completely that this is a good problem to have, we cannot do this.  My income is $110,000.  My fiancé and I combined have a joint income over $190k, the joint limit for contributing to a Roth IRA for married folks.

[surfhb]

seriously consider a separate ROTH too!    Imagine what $100k growing tax free would be like when you retire. :)

Acknowledging completely that this is a good problem to have, we cannot do this.  My income is $110,000.  My fiancé and I combined have a joint income over $190k, the joint limit for contributing to a Roth IRA for married folks.
[/quote]

Ahh gotcha!   It be nice to to bring down that taxable income number or maybe file separately to enjoy that benefit? ;)    Either way you're doing good

[Gin1984]

How much is the fiancee making?  Because if you are making $110,000 but put the max in your 401k, your taxable drops to $92500.  She would need to be making over $98500 for you not be able to put something in a Roth IRA.  Personally, I'd max out the 401k, make sure the fiancee is maxing her's and any left over put into a Roth IRA to the limit (which may be less than $5500 at your income level) and then the rest in a taxable.  I would not pay down the mortgage.

[Thedudeabides]

If you don't have any other traditional IRAs, then you could still contribute to a ROTH. You would just need to contribute to a traditional IRA first and then convert it.

If you have other IRAs, then you'll need to get rid of those first. A good option would be rolling it into your employers 401k plan. Then you could contribute to an IRA then convert to ROTH.

[MDM]

There is no one-size-fits-all answer.  Fatmouse, with your combined income it appears you will be in either the 28% or 25% tax bracket, depending on how much you might have in itemized deductions.  If you are in the 28% bracket now, and will be in the 25% bracket at retirement, then your results will be almost identical regardless of whether you choose traditional or Roth.

Before anyone jumps on this, note the qualifiers above and see http://forum.mrmoneymustache.com/investor-alley/ira-max and http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758.

From one of the Bogleheads topic posts:
"Calculations below assume i=5% and n=25 years. Just to give a few examples:
[If current tax rate]=28%, [taxable investments pay 15%], the [after retirement tax rate below which a traditional approach is better is somewhere between]...25.3% and...24.0%."

The OP and fiancé should judge what post-retirement tax bracket they will most likely inhabit, compare to current tax bracket, then act accordingly.

Of course, if after considering the qualifiers, the analysis above is wrong - then do jump all over it!

[Joel]

MDM - keep in mind that not all of your income is taxed at your marginal tax rate. Your first 10k in income is tax free every year for example. It's almost always best to defer taxes now unless you are a low income earner. Or if you have maxed your 401k, are not eligible for IRA contributions, but still eligible for Roth IRA contributions. Then the Roth IRA contributions are better than keeping that money in a taxable account.

[MDM]

MDM - keep in mind that not all of your income is taxed at your marginal tax rate. Your first 10k in income is tax free every year for example. It's almost always best to defer taxes now unless you are a low income earner. Or if you have maxed your 401k, are not eligible for IRA contributions, but still eligible for Roth IRA contributions. Then the Roth IRA contributions are better than keeping that money in a taxable account.

The bolded statement is certainly true.  For the purposes of analyzing what to do regarding traditional vs. Roth (either 401k or IRA), however, it is also irrelevant.

When one fills out form 1040, one starts with total gross income.  Any deductions come off the top, where the marginal rate applies.  That makes the marginal rate the correct one to use when analyzing these alternatives.

It gets a little more complicated if deductions take one across tax brackets.  E.g. the OP may drop from 28% to 25%, but a 3% difference is probably within the margin of error when they predict after-retirement tax bracket, so close enough....

[MDM]

Don't forget state/local income taxes.

Good point Knaak.

Using the calculation in the Bogleheads thread, for someone with a current marginal tax rate of (28% + 8.5%) = 36.5%, and all taxable investment returns taxed at 15% (i.e., all qualified dividends and long term capital gains - this may not apply at the state level...?), if the after-retirement marginal tax rate drops to ~32% or lower then traditional plans are better.  Otherwise, for a maximum contribution, Roth is better.

Still hard for me to get all the comments I've heard over the years about "lower tax rate in retirement means traditional is better, higher means Roth is better, and equal tax rate means it doesn't matter" out of my head.  But both the old MMM topic and the Bogleheads site show math that seems right, so it's time to learn new tricks.

[milesdividendmd]

Congrats on your raise!

Really it all depends on what your goals are for the next few years.

In this case, you have a guaranteed 25% on $7500 of the raise if you put it in the 401k assuming a 25% tax bracket.

Option 3 doesn't seem that great because you're going to move in a few years and the interest rate is so low.

So I would recommend $7500 pretax to the 401k and the after tax balance to start building up your investment account.

Either this, or max out the regular 401k at $17,500 saving you $4300 in taxes (if in the 25% tax bracket) and then contribute $5500 to a regular ROTH if you qualify. If you don't qualify, you could do a traditional IRA and convert to a ROTH. The extra $162 you have left over after taxes could fund the investment account.

I heartily agree with thedudeabides.

Assuming that you don't have access to an HSA I think that one size (almost) fits all in your shoes.

The single best option for a high income Mustachian like you is to max out your traditional 401K, then take the remaining 5500 and put it into a Roth, (or a backdoor Roth). And another 2000 into a Roth for your wife.

If you have an HSA, I  would strongly consider maxing that out after the 401K and before the Roth. (No taxes going in, untaxed growth, and untaxed withdrawals if offset by medical expenses. )

[rmendpara]

1) Max out 401k. This is a no brainer, especially at your upper-middle class income level.
2) Put the rest of your additional monthly income into a taxable account (various ETFs) which you will be mostly tax free.
    a) Alternatively, put some of the excess into a HSA account.
    b) Maybe put some into a 529 account for kids? $100/mo for the next 18 years will do wonders and never be painful at all.

My thoughts anyway. Happy investing!

[Joel]

If one only has retirement funds in Roth accounts, they will not be able to take advantage of taxable income at the 0%, 10%, and 15% marginal tax rates. It takes a sizable amount or tax deferred savings, or ordinary income upon retirement to push someone out of the lower marginal rates. With no other income upon retirement, you can have into the 2 million range in tax deferred assets before your marginal tax rate exceeds 25%.

[milesdividendmd]

1) Max out 401k. This is a no brainer, especially at your upper-middle class income level.
2) Put the rest of your additional monthly income into a taxable account (various ETFs) which you will be mostly tax free.
    a) Alternatively, put some of the excess into a HSA account.
    b) Maybe put some into a 529 account for kids? $100/mo for the next 18 years will do wonders and never be painful at all.

My thoughts anyway. Happy investing!

Rmendeparra,

Why would you invest your money in a taxable account before investing in an HSA or a ( backdoor) Roth?

The only reason I can think to do this would be if I was retiring this year and had already hit my goal for retirement in my retirement accounts, and had insufficient taxable money to fund my retirement before my ROTH ladder matured.

What are your thoughts here?