Author Topic: % Towards Investments/% Towards Debt - How Much?  (Read 5548 times)

6leakertweeker

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% Towards Investments/% Towards Debt - How Much?
« on: October 22, 2016, 03:22:13 PM »
Hello folks,
     
     Last question for awhile.  Thank you so much for all the previous replies to my other posts. 

     Currently I'm at about 15% of my earnings towards debt and 15% towards my 401(K).  The biggest chunks of my debt are from heart problems before I had insurance and I'm paying 8% interest on it. 

     It doesn't feel like I'm gaining much ground.  Should I adjust those percentages at all or just keep my head down and plow through it?

FWIW, net worth has increased around 17% month over month and net earnings are about 13.8%. 

 

FINate

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #1 on: October 22, 2016, 03:38:13 PM »
Need more details to comment: Do you get an employer match on 401(k) contributions? Are you maxing out 401(k) contributions at 15% of your earnings? What is your combined marginal income tax rate (state and fed). Have you looked into the possibility of refinancing the medical debt to a lower rate, or using a HELOC (should be at around 4.5%) to pay it off?

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #2 on: October 22, 2016, 03:54:25 PM »
Need more details to comment: Do you get an employer match on 401(k) contributions? Are you maxing out 401(k) contributions at 15% of your earnings? What is your combined marginal income tax rate (state and fed). Have you looked into the possibility of refinancing the medical debt to a lower rate, or using a HELOC (should be at around 4.5%) to pay it off?

Yes I do. 3% Match.

No, I don't make that much.  I won't max my 401(K) for awhile. 

I have.  There are two large debts. One of them is at the 8% and the other is interest free.  I've basically allocated my funds towards the interest debt.  The non-interest debt I am making payments on but it is a very very small contribution.  Just enough that they leave me alone.  I've thought about re-financing quite a bit but just wasn't sure if was a good idea or not.  The thought seemed redundant to get a loan to pay off debt(debt for debt).    I didn't think I would be able to get a lower interest loan for something like that with having these debts on my credit.  I was also too scared to actually apply and have a hard inquiry on my credit also.

Edit: Regarding the HELOC.  Left my wife a few months ago with the house and everything in it.  So, I don't believe I'm a candidate for a HELOC.
« Last Edit: October 22, 2016, 03:58:52 PM by 6leakertweeker »

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #3 on: October 22, 2016, 04:28:04 PM »
Based on what you're showing here:

1. Contribute to your 401k up to the employer match.
2. Pay down your debt

The 401k match is free money and 100% return immediately on whatever you put in.

However, if you're currently in a low tax bracket the remainder of your 401k contribution isn't doing that much for you. Yes it's tax deferred, but if you're in the 10-15% bracket you're not gaining much, as the key term in 401ks and traditional IRAs is 'tax-deferred', you eventually pay tax on the withdrawals. There are substantial benefits to tax-free growth and it's a huge bonus if you're going to be in a much lower bracket down the road. But the guaranteed 8% return from paying off your debt is better than the benefits of the tax-free growth. And it doesn't sound like you're in a position for tax bracket arbitrage.

If the rate were lower or if you were in a higher bracket it would be closer to a tossup, but 8% in this environment while in a low tax bracket is a fairly easy call. But as the previous poster said, I'd look into figuring out some way to get a lower rate. 8% is high right now. Pay that off first however you can.
« Last Edit: October 22, 2016, 04:35:56 PM by Grizzly Dad »

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #4 on: October 22, 2016, 04:42:06 PM »
Based on what you're showing here:

1. Contribute to your 401k up to the employer match.
2. Pay down your debt

The 401k match is free money and 100% return immediately on whatever you put in.

However, if you're currently in a low tax bracket the remainder of your 401k contribution isn't doing that much for you. Yes it's tax deferred, but if you're in the 10-15% bracket you're not gaining much, as the key term in 401ks and traditional IRAs is 'tax-deferred', you eventually pay tax on the withdrawals. There are substantial benefits to tax-free growth and it's a huge bonus if you're going to be in a much lower bracket down the road. But the guaranteed 8% return from paying off your debt is better than the benefits of the tax-free growth. And it doesn't sound like you're in a position for tax bracket arbitrage.

If the rate were lower or if you were in a higher bracket it would be closer to a tossup, but 8% in this environment while in a low tax bracket is a fairly easy call. But as the previous poster said, I'd look into figuring out some way to get a lower rate. 8% is high right now. Pay that off first however you can.

I mis-spoke I apologize.  I am meeting the maximum match of my employer.  They match 3% I'm contributing 15%.  I won't reach the $18,000.00 annual cap on 401(k). 

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #5 on: October 22, 2016, 04:50:18 PM »
Thanks. My recommendation is still the same. You should pair back to just the level at which they match. Dump the rest into the debt. Once that's gone go back funding up to the level of which you're able to, preferably the full $18k.

However, just another note. If you're in a low tax bracket you're potentially better off using ROTH contributions rather than traditional tax-deferred contributions.

FINate

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #6 on: October 22, 2016, 05:24:12 PM »
Grizzly Dad is correct if you are in a low tax bracket. However it really depends on your individual situation so I would play around with a 401(k) calculator to verify because your tax rate (including state/local) and other factors influence the outcome.

Put in all your detailed information (make sure to expand the "Filing status and withholdings" and "Retirement plan information" sections), then enter different values for "Retirement savings current" and "Retirement savings new" to see how changes will affect your take home pay (e.g. 6% vs 15%). Depending on your details (this example assumes about 60k income), you might find that the difference between 6% and 15% results in something like $70 less weekly take home pay, yet contributing $100 more before employer match (.15*GrossPay - 0.06*GrossPay). In other words, at 15% vs 6% you might contribute an additional $100 per week at an additional cost to you of just $70, and then the employer match is on top of that.

If your income is more like 40k then, as Grizzly Dad points out, the tax advantages aren't that great (contribute an additional $70 at a cost to you of about $57 - still an advantage, but not that significant).

I agree with Grizzly Dad that you should at least take advantage of the employer match. Beyond that it really depends on your individual income and tax situation, and what benefit you get from pre-tax contributions relative to the interest you're paying on the medical debt.

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #7 on: October 22, 2016, 06:28:02 PM »
Grizzly Dad is correct if you are in a low tax bracket. However it really depends on your individual situation so I would play around with a 401(k) calculator to verify because your tax rate (including state/local) and other factors influence the outcome.

Put in all your detailed information (make sure to expand the "Filing status and withholdings" and "Retirement plan information" sections), then enter different values for "Retirement savings current" and "Retirement savings new" to see how changes will affect your take home pay (e.g. 6% vs 15%). Depending on your details (this example assumes about 60k income), you might find that the difference between 6% and 15% results in something like $70 less weekly take home pay, yet contributing $100 more before employer match (.15*GrossPay - 0.06*GrossPay). In other words, at 15% vs 6% you might contribute an additional $100 per week at an additional cost to you of just $70, and then the employer match is on top of that.

If your income is more like 40k then, as Grizzly Dad points out, the tax advantages aren't that great (contribute an additional $70 at a cost to you of about $57 - still an advantage, but not that significant).

I agree with Grizzly Dad that you should at least take advantage of the employer match. Beyond that it really depends on your individual income and tax situation, and what benefit you get from pre-tax contributions relative to the interest you're paying on the medical debt.

Think you're complicating things unnecessarily. While everything always depends on individual tax situations. Above any employer match, the variable with the highest sensitivity in this full picture is the assumed rate of return on the investments. Assuming a 7% rate of return is VERY optimistic given the current economic environment.

There are few circumstances in which it would make more sense to contribute above that employer match vs. paying down a high-interest debt. Yes, there are a few, and I'll caveat with the mandatory 'you should look at your individual tax situation', but above 8% debt while in the 10-15% tax bracket is getting pretty close to a no-brainer.
« Last Edit: October 22, 2016, 06:59:16 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #8 on: October 22, 2016, 07:38:23 PM »
However it really depends on your individual situation so I would play around with a 401(k) calculator to verify because your tax rate (including state/local) and other factors influence the outcome.
If one is going to do that type of calculation (and I agree it can be worthwhile), then using something that considers all (or at least the most common) credits, phaseouts, etc. is probably better than one (such as the one linked) that does a "plain vanilla" tax calculation.

FINate

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #9 on: October 23, 2016, 06:04:02 PM »
Grizzly Dad is correct if you are in a low tax bracket. However it really depends on your individual situation so I would play around with a 401(k) calculator to verify because your tax rate (including state/local) and other factors influence the outcome.

Put in all your detailed information (make sure to expand the "Filing status and withholdings" and "Retirement plan information" sections), then enter different values for "Retirement savings current" and "Retirement savings new" to see how changes will affect your take home pay (e.g. 6% vs 15%). Depending on your details (this example assumes about 60k income), you might find that the difference between 6% and 15% results in something like $70 less weekly take home pay, yet contributing $100 more before employer match (.15*GrossPay - 0.06*GrossPay). In other words, at 15% vs 6% you might contribute an additional $100 per week at an additional cost to you of just $70, and then the employer match is on top of that.

If your income is more like 40k then, as Grizzly Dad points out, the tax advantages aren't that great (contribute an additional $70 at a cost to you of about $57 - still an advantage, but not that significant).

I agree with Grizzly Dad that you should at least take advantage of the employer match. Beyond that it really depends on your individual income and tax situation, and what benefit you get from pre-tax contributions relative to the interest you're paying on the medical debt.

Think you're complicating things unnecessarily. While everything always depends on individual tax situations. Above any employer match, the variable with the highest sensitivity in this full picture is the assumed rate of return on the investments. Assuming a 7% rate of return is VERY optimistic given the current economic environment.

There are few circumstances in which it would make more sense to contribute above that employer match vs. paying down a high-interest debt. Yes, there are a few, and I'll caveat with the mandatory 'you should look at your individual tax situation', but above 8% debt while in the 10-15% tax bracket is getting pretty close to a no-brainer.

A single filer gets to 25% marginal rate pretty quickly (~38k), then add 3.4% for the flat state income tax, plus any local additions (looks like OP is in IN). Pre-tax contributions at 28.4% is nothing to sneeze at. Agree with MDM that one should look at phaseouts/deductions so maybe there are better tax calculators out there, though assuming the standard deduction should be sufficient for most people at the lower and middle income levels. Sucks that our tax code is so damn complicated :(

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #10 on: October 24, 2016, 07:45:08 AM »
Grizzly Dad is correct if you are in a low tax bracket. However it really depends on your individual situation so I would play around with a 401(k) calculator to verify because your tax rate (including state/local) and other factors influence the outcome.

Put in all your detailed information (make sure to expand the "Filing status and withholdings" and "Retirement plan information" sections), then enter different values for "Retirement savings current" and "Retirement savings new" to see how changes will affect your take home pay (e.g. 6% vs 15%). Depending on your details (this example assumes about 60k income), you might find that the difference between 6% and 15% results in something like $70 less weekly take home pay, yet contributing $100 more before employer match (.15*GrossPay - 0.06*GrossPay). In other words, at 15% vs 6% you might contribute an additional $100 per week at an additional cost to you of just $70, and then the employer match is on top of that.

If your income is more like 40k then, as Grizzly Dad points out, the tax advantages aren't that great (contribute an additional $70 at a cost to you of about $57 - still an advantage, but not that significant).

I agree with Grizzly Dad that you should at least take advantage of the employer match. Beyond that it really depends on your individual income and tax situation, and what benefit you get from pre-tax contributions relative to the interest you're paying on the medical debt.

Think you're complicating things unnecessarily. While everything always depends on individual tax situations. Above any employer match, the variable with the highest sensitivity in this full picture is the assumed rate of return on the investments. Assuming a 7% rate of return is VERY optimistic given the current economic environment.

There are few circumstances in which it would make more sense to contribute above that employer match vs. paying down a high-interest debt. Yes, there are a few, and I'll caveat with the mandatory 'you should look at your individual tax situation', but above 8% debt while in the 10-15% tax bracket is getting pretty close to a no-brainer.

A single filer gets to 25% marginal rate pretty quickly (~38k), then add 3.4% for the flat state income tax, plus any local additions (looks like OP is in IN). Pre-tax contributions at 28.4% is nothing to sneeze at. Agree with MDM that one should look at phaseouts/deductions so maybe there are better tax calculators out there, though assuming the standard deduction should be sufficient for most people at the lower and middle income levels. Sucks that our tax code is so damn complicated :(

FINATE,   I am in Indiana.  I'm at the 25% rate sadly.  The 2016 Key Facts & Figures sheet shows the standard deduction is $6,300 which is more than I could itemize. 

With all of your folks advise, I understand that I'll need reduce my 401(K) contributions (probably drop it to 7%) and move those funds towards debt reduction.  That is what you guys recommend correct?

FINate

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #11 on: October 24, 2016, 01:58:16 PM »

FINATE,   I am in Indiana.  I'm at the 25% rate sadly.  The 2016 Key Facts & Figures sheet shows the standard deduction is $6,300 which is more than I could itemize. 

With all of your folks advise, I understand that I'll need reduce my 401(K) contributions (probably drop it to 7%) and move those funds towards debt reduction.  That is what you guys recommend correct?

Now that we have more details that's not what I would do :)

This assumes your medical debt is fixed at 8%, and that you don't already have too much saved in retirement accounts, and you're reasonably good at managing your investments, and you're not planning on touching your retirement savings for 10 years or more:

You should be able to achieve or exceed an average long-term nominal (not inflation adjusted) return of 8% in your retirement account. Whatever's going on in the market today isn't relevant if you're invested for the long term - some years will be down, others up, but on average 8-10% before inflation is fairly conservative.

The tax advantages of a 401(k), even if relatively modest, are icing on the cake.

As an example, let's say you got a $100 bonus and you get to choose to take it as income and pay down your debt, or invest pre-tax in your 401(k). Since you're in the 25% fed tax bracket, and you pay IN flat 3.4% income tax, you would pay 28.4% of this amount in taxes, leaving you with about $72 of take home pay (assuming that the standard deduction or other offsetting factors doesn't take you into a lower bracket).

So what would you choose: Invest $100 at +8% return over the long term, or pay down a 8% debt by $71?

In this situation I would prioritize retirement savings.

 

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #12 on: October 24, 2016, 02:16:16 PM »
Good thing I haven't made any changes yet then.  Thank you for clarifying that.  I had originally thought of this the way you just explained it, however I'm relatively new at all this. 

My original plan was to be at 25% contribution by the end of Q1 17 and to be at 45% at the end of 2017.  I was using a gradient as debt decreases to slowly increase contributions.  I'm currently living off of a small amount of my income so I didn't think all this was going to be an issue.  The 401(K) has been growing at a faster rate than the debt was declining and that is what my original concern was.  I have several income changes coming up that I'm sure will push me up a tax bracket.  Should I re-consult with you again at that point? 

All your folks advice has been great.  You guys are awesome.  Thank you for taking the time out of your day to offer me help. I appreciate that!

zephyr911

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #13 on: October 24, 2016, 02:46:42 PM »
It doesn't feel like I'm gaining much ground.
Quote
FWIW, net worth has increased around 17% month over month and net earnings are about 13.8%.
I can't reconcile these two statements.

I think you're doing fine. Even if earnings drop to historical averages, you're not losing anything by allocating evenly. And pumping your NW by double digits every month is great.

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #14 on: October 24, 2016, 02:52:21 PM »
It doesn't feel like I'm gaining much ground.
Quote
FWIW, net worth has increased around 17% month over month and net earnings are about 13.8%.
I can't reconcile these two statements.

I think you're doing fine. Even if earnings drop to historical averages, you're not losing anything by allocating evenly. And pumping your NW by double digits every month is great.

Thank you!  That means a lot. 

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #15 on: October 24, 2016, 05:39:48 PM »
Good thing I haven't made any changes yet then.  Thank you for clarifying that.
Well, at the risk of unclarifying things, let's assume...:

- Debt is $10,000 at 8% payable monthly over 10 years.  That gives a minimum monthly payment of $121.33.
- $1500/mo pre-tax is available; marginal rate is 28.4%

With this much, you could
1) put $1330.55/mo into the 401k and use the remaining after-tax ($1,500 - $1,330.55) * (1 - .284) = $121.33 for the minimum debt payment, or
2) put the entire $1,500 * (1 - .284) = $1,074.00/mo toward debt payment, or
3) something in between - in other words, pay some extra on the loan and contribute something less than the maximum to the 401k.

With option #1, the loan is paid after 120 months and the 401k has some balance, depending on investment returns.

With option #2, the loan is paid after 10 months (with a payment of $693.03 in the last month).  401k contributions start in month 10 with $532.08, and continue at $1500/mo for months 11-120. After month 120 the 401k has some balance, depending on investment returns.

For an example option #3, if $500/mo extra is paid to the loan, the loan is paid after 18 months (with a payment of $51.05 in the last month).  401k contributions are $633.22/mo for months 1-17, $1428.70 in month 18, and $1500/mo for months 19-120.  After month 120 the 401k has some balance, depending on investment returns.

In sum, no matter which of the 3 options one chooses, after 120 months the debt is paid and there is some balance in the 401k account.  We could look at all possible debt payments between $121.33/mo and $1,074/mo to see which gives the highest 401k balance after 120 months.

Of course, there is one other assumption to make: the return in the 401k.

We then find three possibilities:
1) If the 401k return is less than the debt interest, the best thing to do is put all the money toward the debt
2) If the 401k return is greater than the debt interest, the best thing to do is make the minimum debt payment and put the rest of the money to the 401k.
3) If the 401k return equals the debt interest, all choices give the same result.

Although it is possible to have 401k returns exceeding 8%, the odds are much lower than for a similar "pay debt vs. invest" analysis around mortgage pre-payments when mortgage rates are ~3.5%.

Personally, I'd take the guaranteed 8%.

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #16 on: October 24, 2016, 05:47:02 PM »

FINATE,   I am in Indiana.  I'm at the 25% rate sadly.  The 2016 Key Facts & Figures sheet shows the standard deduction is $6,300 which is more than I could itemize. 

With all of your folks advise, I understand that I'll need reduce my 401(K) contributions (probably drop it to 7%) and move those funds towards debt reduction.  That is what you guys recommend correct?

Now that we have more details that's not what I would do :)

This assumes your medical debt is fixed at 8%, and that you don't already have too much saved in retirement accounts, and you're reasonably good at managing your investments, and you're not planning on touching your retirement savings for 10 years or more:

You should be able to achieve or exceed an average long-term nominal (not inflation adjusted) return of 8% in your retirement account. Whatever's going on in the market today isn't relevant if you're invested for the long term - some years will be down, others up, but on average 8-10% before inflation is fairly conservative.

The tax advantages of a 401(k), even if relatively modest, are icing on the cake.

As an example, let's say you got a $100 bonus and you get to choose to take it as income and pay down your debt, or invest pre-tax in your 401(k). Since you're in the 25% fed tax bracket, and you pay IN flat 3.4% income tax, you would pay 28.4% of this amount in taxes, leaving you with about $72 of take home pay (assuming that the standard deduction or other offsetting factors doesn't take you into a lower bracket).

So what would you choose: Invest $100 at +8% return over the long term, or pay down a 8% debt by $71?

In this situation I would prioritize retirement savings.

If you're in the 25% bracket I would agree with Finate as well. You're better off maxing out the retirement savings right now, as you're more likely to be in a tax rate arbitrage scenario in the future.

However, Finate there's one thing you're forgetting in your calculation that's important to consider. You still have to pay taxes on every penny that goes into the retirement accounts. You just pay it at the backend. It's not as simple as saying $100 at +8% forever. If you are 100% certain that you will be in in the lowest tax bracket and/or in possession of enough deductions/credits to eliminate any taxes then this is accurate. Otherwise, it is not.

Additionally, you are also making an assumption that there will be no increases in tax rates in the future, which is by no means a certain outcome.

Additionally, there are MANY people (some very smart) that would argue that your assumption of a long term +8% nominal return is optimistic. Sure, US historical nominal rates are around 10%. But that's across all periods and economic conditions. When adjusted for PE ratios that we see within the current market, even the LONG term rates of return from that point are lower.

Finally, and I feel this is unlikely, but I'll add it for completeness. You're also assuming that the tax structure for tax-advantaged accounts stays the same. This is not certain.

If you want to complicate a situation, just make sure you include ALL of the complications. Your calculation attempts to paint a best case scenario of one option vs. the certain scenario of the other option.
« Last Edit: October 24, 2016, 06:10:44 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #17 on: October 24, 2016, 06:09:49 PM »
If you're in the 25% bracket I would agree with Finate as well. You're better off maxing out the retirement savings right now.
Does the tax bracket matter?

See this post.  Always possible there was a mistake in the analysis, but if not then it's only the debt interest vs. the investment return that matters.

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #18 on: October 24, 2016, 06:15:50 PM »
If you're in the 25% bracket I would agree with Finate as well. You're better off maxing out the retirement savings right now.
Does the tax bracket matter?

See this post.  Always possible there was a mistake in the analysis, but if not then it's only the debt interest vs. the investment return that matters.

It only matters if there is tax bracket arbitrage. I.e. if you're contributing in a high bracket but plan on withdrawing in a low bracket. If you're going to be in the same bracket in both time frames then you are correct, it does not matter.

This arbitrage is fairly significant for some folks. For instance, right now we're in the 40% bracket living in California and am currently paying AMT. In about two years I'm going to be retired, in the 10-15% bracket, and living in Kansas. You can be damn sure that I'm maxing out all of my tax deffered options right now:)

However, if you're in the opposite scenario, low bracket now, high bracket later the calculation is flipped. This is the basic thought experiment you have to go through in figuring out ROTH vs traditional, but it's similar here.

Getting very technical you can even describe scenarios where you're actually worse off as a result of putting money into a tax-deferred plan. E.g. you are currently in a very low tax bracket paying 0 tax. You decide to invest in stocks that will solely provide returns through capital gains. You end up in the 15% bracket paying some tax. In this case, you would then be paying 15% on everything you withdraw from the IRA. However, your long term capital gains rate on the gains in the taxable account would be 0%. Thus you just screwed yourself by using the tax-deferred plan. This is a contrived example and it's almost always best to utilize the tax-advantaged options, but you should always recognize all the variables.
« Last Edit: October 24, 2016, 06:23:55 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #19 on: October 24, 2016, 06:23:30 PM »
It only matters if there is tax bracket arbitrage. I.e. if you're contributing in a high bracket but plan on withdrawing in a low bracket.
That seems reasonable, but I'm not sure it's correct.  Note that the example assumed nothing about withdrawal rates, but merely looked at the accumulated pre-withdrawal balance.  Regardless of one's marginal withdrawal rate, having a higher balance in the given account is better than having a lower balance.

Agree completely that for the traditional vs. Roth analysis one should look at marginal contribution vs. withdrawal rates.  For debt payoff vs. investing, however, the tax bracket seems irrelevant.

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #20 on: October 24, 2016, 06:26:09 PM »
It only matters if there is tax bracket arbitrage. I.e. if you're contributing in a high bracket but plan on withdrawing in a low bracket.
That seems reasonable, but I'm not sure it's correct.  Note that the example assumed nothing about withdrawal rates, but merely looked at the accumulated pre-withdrawal balance.  Regardless of one's marginal withdrawal rate, having a higher balance in the given account is better than having a lower balance.

Agree completely that for the traditional vs. Roth analysis one should look at marginal contribution vs. withdrawal rates.  For debt payoff vs. investing, however, the tax bracket seems irrelevant.

If all you're looking at is the balances then you're right. But you can't just look at the balances, you also have to look at what you'd actually be able to extract, and that requires making assumptions about tax rates in the future. I.e. those balances in the tax-deferred account aren't all yours, uncle sam still gets his cut, that cut will depend on your tax bracket.
« Last Edit: October 24, 2016, 06:28:40 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #21 on: October 24, 2016, 06:43:52 PM »
If all you're looking at is the balances then you're right. But you can't just look at the balances, you also have to look at what you'd actually be able to extract, and that requires making assumptions about tax rates in the future. I.e. those balances in the tax-deferred account aren't all yours, uncle sam still gets his cut, that cut will depend on your tax bracket.
Yes, not arguing about the effects of tax rates on spendable amount (i.e., what uncle sam doesn't take).  Just saying that, whatever the future tax rate, having a higher investment balance is better than having a lower investment balance.

The current scenario of "pay debt vs. invest" admits only one debt and one investment.  When the debt is fully paid, there is only the investment, and whatever the future tax rate, ....

For traditional vs. Roth, Traditional versus Roth - Bogleheads is the best reference I know - and I don't think we have any disagreement about that advice. :)

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #22 on: October 24, 2016, 06:52:14 PM »
For anyone interested, below is the start of the spreadsheet used.  Copy, paste into cell A1, then copy the last line down to row 131 so cell B9 has the ending investment balance.

If you then see what I saw, you'll see that the marginal tax rate has no effect on whether "pay debt" or "invest" leads to a higher final balance.  All that matters are the interest and return rates.  Of course, if there is an error in the calculations then all bets are off. ;)

Loan amt10000$
Loan int0.08%
Loan length10yr
Min. pmt.=PMT(B2/12,B3*12,-B1)
Pre-tax/mo available=1500
Extra to loan/mo500
Marginal tax0.284
401k return0.08
Final balance=J131
- - - - - - - - - -
MonthBeg. Loan PLoan EOMPmt.After pmt.Pre-tax pmt.Beg. 401k401k EOM401k contrib.After contrib.
1=B1=(1+$B$2/12)*B12=MIN(C12,$B$4+$B$6)=C12-D12=D12/(1-$B$7)0=(1+$B$8/12)*G12=$B$5-F12=H12+I12
2=E12=(1+$B$2/12)*B13=MIN(C13,$B$4+$B$6)=C13-D13=D13/(1-$B$7)=J12=(1+$B$8/12)*G13=$B$5-F13=H13+I13
3=E13=(1+$B$2/12)*B14=MIN(C14,$B$4+$B$6)=C14-D14=D14/(1-$B$7)=J13=(1+$B$8/12)*G14=$B$5-F14=H14+I14

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #23 on: October 24, 2016, 06:53:50 PM »
Take an extreme situation as an example. Let's say our hypothetical taxpayer in sitting in the 10% bracket right now and has this decision to make. And in the future, he has met with a stroke of luck (or an extreme version of Bernie Sanders is elected) and finds himself in the 40% bracket. What happens between these two hypothetical situations. Let's assume for simplicity that the return on the investments is 8% to match the debt and the amount of debt is $1000, which he can pay off immediately. And the experiment only lasts for one year. He also starts out at exactly -$1000 net worth, the amount of the debt. His taxable income in year 1 is $1111. He has no deductions or credits available.


Scenario 1 - invest

Year 0 - $1111 placed in a tax-deferred account. Let the $1000 in debt ride at 8%.
Year 1 - $1200 in tax-deferred savings, 8% return. Withdraw entire amount at 40% marginal rate. Leaving you with $720 after taxes and $1008 in debt. -$288 net worth

Scenario 2 - Pay off the debt immediately
Year 0 - Pay off the $1000 in debt with post-tax income, invest nothing
Year 1 - $0 Net worth. $288 better than the invest option.

This is extreme but illustrative of the point.
« Last Edit: October 24, 2016, 07:02:01 PM by Grizzly Dad »

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #24 on: October 24, 2016, 07:04:10 PM »
For anyone interested, below is the start of the spreadsheet used.  Copy, paste into cell A1, then copy the last line down to row 131 so cell B9 has the ending investment balance.

If you then see what I saw, you'll see that the marginal tax rate has no effect on whether "pay debt" or "invest" leads to a higher final balance.  All that matters are the interest and return rates.  Of course, if there is an error in the calculations then all bets are off. ;)

Loan amt10000$
Loan int0.08%
Loan length10yr
Min. pmt.=PMT(B2/12,B3*12,-B1)
Pre-tax/mo available=1500
Extra to loan/mo500
Marginal tax0.284
401k return0.08
Final balance=J131
- - - - - - - - - -
MonthBeg. Loan PLoan EOMPmt.After pmt.Pre-tax pmt.Beg. 401k401k EOM401k contrib.After contrib.
1=B1=(1+$B$2/12)*B12=MIN(C12,$B$4+$B$6)=C12-D12=D12/(1-$B$7)0=(1+$B$8/12)*G12=$B$5-F12=H12+I12
2=E12=(1+$B$2/12)*B13=MIN(C13,$B$4+$B$6)=C13-D13=D13/(1-$B$7)=J12=(1+$B$8/12)*G13=$B$5-F13=H13+I13
3=E13=(1+$B$2/12)*B14=MIN(C14,$B$4+$B$6)=C14-D14=D14/(1-$B$7)=J13=(1+$B$8/12)*G14=$B$5-F14=H14+I14

Your calculations are correct. You're just forgetting to add in an assumption on the marginal rate at the point of withdrawal from the tax-deferred account. It's tax-deferred, not tax-free.

The reason it's often confused is simply that many retirees find themselves in very low tax brackets when they finally quit their jobs. And once you're retired, with maybe a small business on the side, it's actually a lot easier to manipulate the tax code to end up in that low bracket where you're paying 0 in taxes. However, just because this is typical doesn't mean it's always the case.
« Last Edit: October 24, 2016, 07:08:47 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #25 on: October 24, 2016, 07:13:16 PM »
Your calculations are correct. You're just forgetting to add in an assumption on the marginal rate at the point of withdrawal from the tax-deferred account. It's tax-deferred, not tax-free.
Not arguing tax deferred vs. tax free.

How will the strategic answer (pay debt vs. invest) change if we multiply cell B9 by a fixed number other than 1?  The strategy that maximizes B9*1 will also maximize B9*X, as long as X>0.

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #26 on: October 24, 2016, 07:31:07 PM »
Take an extreme situation as an example. Let's say our hypothetical taxpayer in sitting in the 10% bracket right now and has this decision to make. And in the future, he has met with a stroke of luck (or an extreme version of Bernie Sanders is elected) and finds himself in the 40% bracket. What happens between these two hypothetical situations. Let's assume for simplicity that the return on the investments is 8% to match the debt and the amount of debt is $1000, which he can pay off immediately. And the experiment only lasts for one year. He also starts out at exactly -$1000 net worth, the amount of the debt. His taxable income in year 1 is $1111. He has no deductions or credits available.


Scenario 1 - invest

Year 0 - $1111 placed in a tax-deferred account. Let the $1000 in debt ride at 8%.
Year 1 - $1200 in tax-deferred savings, 8% return. Withdraw entire amount at 40% marginal rate. Leaving you with $720 after taxes and $1008 in debt. -$288 net worth

Scenario 2 - Pay off the debt immediately
Year 0 - Pay off the $1000 in debt with post-tax income, invest nothing
Year 1 - $0 Net worth. $288 better than the invest option.

This is extreme but illustrative of the point.
This example is a good illustration of traditional vs. Roth, not so much pay debt vs. invest.  E.g., let's assume the investment went into a Roth instead of a traditional account.  Then we would have

Scenario 1 - invest

Year 0 - $1111 income, 10% tax paid, $1000 placed in a Roth account. Let the $1000 in debt ride at 8%.
Year 1 - $1080 in Roth savings, 8% return. Withdraw entire amount at 0% marginal rate (because it's a Roth). Leaving you with $1080 after taxes and $1080 in debt.  $0 net worth

Scenario 2 - Pay off the debt immediately
Year 0 - Pay off the $1000 in debt with post-tax income, invest nothing
Year 1 - $0 Net worth.  Same as the invest option.

The strategies provide equal results because the interest and return rates are equal.  Change one of the 8% numbers and the one having the higher rate becomes the preferred target.


Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #27 on: October 24, 2016, 07:52:05 PM »
But you just switched the scenario.

I 100% agree that putting it into a Roth is the same as paying down the debt. Those are both after tax $.

My point was simply about tax-deferred accounts vs. paying off the debt. And with tax-deferred accounts, it very much matters what your tax rate is upon withdrawal. How can you argue that it doesn't? And it affects the answer as to what is best, tax-deferred account vs. paying off debt.

Now the question of what is best among the three -  tax-deferred vs. roth vs. paying off debt - is a much more complicated question. But we've gone pretty far afield of me saying I didn't want to complicate things!

Ultimately, for this guy it probably doesn't matter that much. 8% is the level at which I think any scenario is probably going to be about equivalent.
« Last Edit: October 24, 2016, 08:23:58 PM by Grizzly Dad »

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #28 on: October 24, 2016, 08:56:11 PM »
But you just switched the scenario.

I 100% agree that putting it into a ROTH is the same as paying down the debt. Those are both after tax $. Showing that those are equivalent is trivial.

My point was about tax-deferred accounts. And with tax-deferred accounts, it very much matters what your tax rate upon withdrawal is. How can you argue that it doesn't?

Ok, let's back up.  Right now it seems I'm saying the sky is blue and you're saying the grass is green - or vice versa if you prefer.  ;)

This thread topic is "% Towards Investments/% Towards Debt - How Much?"  Usually that implies one has an income stream and wants to know how much to apply towards investment and how much toward debts.  In other words, this is for someone still in the accumulation phase.

It gets more complicated if we consider switching from accumulation to withdrawals in the middle of the debt payments.  Now we have not only investment vs. debt, but "what type of investment?" vs. debt.  As any alternative will look sufficiently good if compared with another that is sufficiently bad, we shouldn't use an investment known to be bad when comparing vs. debt payments.

For example, if we know that we would be saving 10% but paying 40% on withdrawal for a traditional account, then using a traditional account is a bad idea, period.  Roth would be best, and even taxable would be better than traditional.  E.g., see To 401k or not to 401k? That is the question.

So I'm not arguing that, for traditional vs. Roth, the withdrawal tax doesn't matter.  It certainly does. 

For investment vs. debt payments, however, we shouldn't use a known poor investment strategy for comparison.  A conclusion is only as good as the assumptions used to frame the problem.  For many readers, assuming an income stream from which debt may be paid or investments may be made is likely appropriate.  Does that make sense?

Do you concur with the difference between assessing "traditional vs. taxable vs. Roth for investment" (in which case contribution and withdrawal tax rates are paramount), vs. assessing "investment vs debt payment" (in which case interest and return rates are paramount)?


Mariposa

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #29 on: October 24, 2016, 09:21:29 PM »
Without parsing out the excel equation, I think what MDM says makes intuitive sense: You can direct more money to a tax-advantaged account now and pay the loan off over a longer period of time = less money overall to tax-advantaged account overall (more interest paid on debt), but longer accumulation. OR, you can concentrate on debt payment now, become debt-free, and subsequently contribute MORE money to tax-advantaged account (less interest paid on debt), but shorter accumulation. With 8% interest on debt, the latter would probably be the better option.

If you have variable marginal tax rates from year to year, though, I think this might mess things up.

My other advice to the OP: are you paying your medical debt directly to the clinic or hospital? How long have you been making payments? If you haven't done it already, it's almost always possible to talk to the billing department and reduce what you owe. The prices for medical care in this country are astronomical beyond what others living in first-world countries typically pay, and they bear a relationship to nothing at all.

Grizzly Dad

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #30 on: October 24, 2016, 09:59:06 PM »
But you just switched the scenario.

I 100% agree that putting it into a ROTH is the same as paying down the debt. Those are both after tax $. Showing that those are equivalent is trivial.

My point was about tax-deferred accounts. And with tax-deferred accounts, it very much matters what your tax rate upon withdrawal is. How can you argue that it doesn't?

Ok, let's back up.  Right now it seems I'm saying the sky is blue and you're saying the grass is green - or vice versa if you prefer.  ;)

This thread topic is "% Towards Investments/% Towards Debt - How Much?"  Usually that implies one has an income stream and wants to know how much to apply towards investment and how much toward debts.  In other words, this is for someone still in the accumulation phase.

It gets more complicated if we consider switching from accumulation to withdrawals in the middle of the debt payments.  Now we have not only investment vs. debt, but "what type of investment?" vs. debt.  As any alternative will look sufficiently good if compared with another that is sufficiently bad, we shouldn't use an investment known to be bad when comparing vs. debt payments.

For example, if we know that we would be saving 10% but paying 40% on withdrawal for a traditional account, then using a traditional account is a bad idea, period.  Roth would be best, and even taxable would be better than traditional.  E.g., see To 401k or not to 401k? That is the question.

So I'm not arguing that, for traditional vs. Roth, the withdrawal tax doesn't matter.  It certainly does. 

For investment vs. debt payments, however, we shouldn't use a known poor investment strategy for comparison.  A conclusion is only as good as the assumptions used to frame the problem.  For many readers, assuming an income stream from which debt may be paid or investments may be made is likely appropriate.  Does that make sense?

Do you concur with the difference between assessing "traditional vs. taxable vs. Roth for investment" (in which case contribution and withdrawal tax rates are paramount), vs. assessing "investment vs debt payment" (in which case interest and return rates are paramount)?

Yes. The last sentence sums it up. Interest rates are going to be the primary driver under most circumstances.

But I'll add that I think you're placing too much certainty on the rates in the future. The scenario I laid out is only a poor investment strategy if you have a crystal ball and know your future tax rates. They're not as certain as many suppose. For someone sitting at a 25% rate the choice between a Roth IRA and a traditional IRA is not obvious (or in this case between debt payments vs. traditional IRA vs. Roth IRA). I know everyone likes to break everyone's life into two discrete chunks and just say you're in either the accumulation phase of the withdrawal phase. Real life doesn't work that way.

For instance, in my life, there is a VERY good chance that after my kids are all in school that I'll want to put my nose back to the grindstone in something that I really enjoy. There's a pretty good chance that I will be highly paid for doing that and that I would want to do this far into the ages of 'traditional' retirement, and so as a result would end up in a high tax bracket when I'm forced to draw down balances. Or I might not! Who knows. But as a result, the choice between after or before tax contributions is by no means an obvious choice. I choose before tax for now. But when making a decision I have to acknowledge that the future tax rates I might face add another element of uncertainty to the choice.

My example was not to compare a 'bad' case vs. a not bad case. But simply to compare a possible case vs. a possible case using extreme examples to demonstrate the point.

MDM

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #31 on: October 24, 2016, 10:47:46 PM »
...I think you're placing too much certainty on the rates in the future.
The sayings Itís Difficult to Make Predictions, Especially About the Future and You pays your money and you takes your chances seem appropriate here.

In that vein, OP, good luck!

6leakertweeker

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Re: % Towards Investments/% Towards Debt - How Much?
« Reply #32 on: October 25, 2016, 08:24:23 AM »
...I think you're placing too much certainty on the rates in the future.
The sayings Itís Difficult to Make Predictions, Especially About the Future and You pays your money and you takes your chances seem appropriate here.

In that vein, OP, good luck!

You guys definitely took it to the next level.  Haha.  I appreciate all the advice from you guys.