Traditional, Roth, or Taxable Acct. advice

[TheChzBurger]

Hi,  I'm new to MMM and have being reading a lot about ER and different strategies. I'm looking for some advice on where to put extra money to invest.   Traditional IRA,  Roth IRA, or Taxable?

Backgound: My wife and I are both 26, have an annual household income of 70K(pre-tax) and want to go into ER around 45 but will both still work part-time. We both contribute 5% and our employers match 5% to our 401Ks.  We've both contributed to a roth IRA in the past but are not currently. We bought a house last year and are making extra payments to pay that off in 8 years.  After those extra payments and our other expenses we'll have around $4k to invest a year until the mortgage is paid. After the mortgage is paid we should be able to invest $22k a year.

Looked into putting it into a traditional IRA then doing the roth conversion ladder at ER. I've read a lot about the conversion and was wondering if it worth it for someone that is in the 15% tax bracket now and will be during the conversion?  Plus there's the 5 year wait before I can withdraw it. We will be doing the conversion ladder for our 401ks.

The roth IRA seems to be a good option because the money can grow tax free in the account and we can withdraw the contribution at anytime.  The contribution withdraws will be helpful while we wait the 5 years for the conversion ladder of our 401ks. My only thought is, will just the contributions be enough to cover our expenses for 5 years.  That's why I thought a taxable account might be good since my tax rate is only 15% and then we could withdraw contributions and earnings.

Just looking for advice on which account to invest in? 

Thanks in advance!


Update: Thanks for getting back to me! Not sure what all information you need but here's some more, I went off the case study post.  If there's any other specifics that would help let me know.

Status: Married filing jointly
Kids: 0
Location: South Dakota, USA
Gross: $70k
AGI: $64K(Last years tax return)
Taxes: 15%, No state tax

Expenses: Just started tracking this on Mint a couple months ago so my expenses are a work in progress. I've always had a budget but just for the necessities.

$1900/month (The necessities:  Mtg, Utilities, Car Ins., Groceries, Phone, Fuel, Internet) 
$650/month(everything else:  Eating out, clothes, gifts, hygiene, car maintenance, entertainment, pharmacy, chiropractor, etc.) This is just what's left over every month, goes into checking and rolls into next month if its not spent. Some of this ends up going to vacation fund. 
$300/month (Vacation)
$833/month (extra payments to mortgage)
$300/month (investing money)
Total: $3983

Expected ER Expenses: About the same as above minus Mtg, Extra payments to mortgage, and investing money. So around $2,150/month.

Assets:
House  $205k
Vehicles $18K
401ks $26k (most of this is Roth, switched to traditional recently)
Roth IRA $12K
HSA $3k

Liabilities:
Mortgage $134k  3.875%  $962/month (includes Ins. and Property tax) 30yrs

[MDM]

Traditional IRA,  Roth IRA, or Taxable?
My wife and I are both 26, have an annual household income of 70K(pre-tax) and want to go into ER around 45

TheChzBurger, welcome to the forum.

Really need more information but from what you posted, traditional is probably best for you.

See http://forum.mrmoneymustache.com/investor-alley/investment-order/ for more DIY info, and http://forum.mrmoneymustache.com/ask-a-mustachian/how-to-write-a-'case-study'-topic/ (including the spreadsheet linked there) as well.

[kpd905]

I've read a lot about the conversion and was wondering if it worth it for someone that is in the 15% tax bracket now and will be during the conversion?  Plus there's the 5 year wait before I can withdraw it. We will be doing the conversion ladder for our 401ks.

Even if you are in the 15% brackets before and after retirement, you will still get to withdraw income to fill up the 0% and 10% brackets, which is currently $39,450.  That is all before you even touch the 15% bracket again.  And any capital gains or dividends in a taxable account would be taxed at 0% if you have that income, similar to how Go Curry Cracker has ~$100k in income with no tax.

[MDM]

Even if you are in the 15% brackets before and after retirement, you will still get to withdraw income to fill up the 0% and 10% brackets....

This one is a little tricky.  If you "are" (meaning you expect to be, based on investments already made, pension or SS already earned) in the 15% bracket after retirement, the 0% and 10% brackets "are" already full - by definition.

I'm guessing the OP isn't there yet, so traditional is still appropriate even though the current marginal rate may be only 15%.

GCC also gets this wrong - it's a not uncommon error.  See Taxes in Early Retirement (GoCurryCracker Links).

[boarder42]

i've read the boggle heads posts on this MDM and i still cant wrap my head around how the math works that if i'm saving money now at 15% and withdrawing still in the 15% bracket.  some of those withdraws will be 0 or 10% tax.

[TheChzBurger]

Updated info in original post.

[Hotstreak]

I've read a lot about the conversion and was wondering if it worth it for someone that is in the 15% tax bracket now and will be during the conversion?  Plus there's the 5 year wait before I can withdraw it. We will be doing the conversion ladder for our 401ks.

Even if you are in the 15% brackets before and after retirement, you will still get to withdraw income to fill up the 0% and 10% brackets, which is currently $39,450.  That is all before you even touch the 15% bracket again.  And any capital gains or dividends in a taxable account would be taxed at 0% if you have that income, similar to how Go Curry Cracker has ~$100k in income with no tax.

Also not sure why OP thinks they will be in the 15% bracket retirement.  Based on the pose their projected annual expenses/withdrawals are $25,800.  With standard deduction and exemptions for a married couple, they would be under the 15% bracket.




Advice for OP:  Don't make such large payments to your mortgage.  Invest that money instead, and you can expect to have more money for retirement (or be able to retire sooner). 

[TheChzBurger]

Also not sure why OP thinks they will be in the 15% bracket retirement.  Based on the pose their projected annual expenses/withdrawals are $25,800.  With standard deduction and exemptions for a married couple, they would be under the 15% bracket.

Advice for OP:  Don't make such large payments to your mortgage.  Invest that money instead, and you can expect to have more money for retirement (or be able to retire sooner).

I guess I'm not sure why I thought we would be in the 15% tax bracket at retirement.  Probably forgot about deductions/never really looked at it on paper. Still new to the FI thinking.  Thanks for bring that up.

As far as paying off the mortgage, we would be saving more money by paying it off early.  3.875% of 134K is a lot more than 7% of 833/month.

Our total extra payments will be $103k over 9 years which will save us $77k in interest. Investing that same 103K at 7% over 9 years would only get us $47k.  That's an additional $30k more.  Am I think of this right? 

[MDM]

i've read the boggle heads posts on this MDM and i still cant wrap my head around how the math works that if i'm saving money now at 15% and withdrawing still in the 15% bracket.  some of those withdraws will be 0 or 10% tax.

Good question.  It is important to distinguish between investments you have already made vs. an investment choice you have now.

Let's say you are a single person and have already made enough traditional investments in 2016 and previous years that, allowing for real growth, you expect your traditional account to have $500K when you retire.  You assume a 4% withdrawal ratio (WR), so $20K/yr.  That will put you in the 15% bracket.

Now you have to decide traditional vs. Roth for 2017.  Any traditional contribution will only increase your expected traditional retirement balance, and thus the withdrawal amount you can take using the 4% WR.  Your 2017 traditional contribution causes an increase in withdrawals that will all be taxed at 15%, because the 0 and 10% buckets were already full.

Does that make sense?

[Hotstreak]

Also not sure why OP thinks they will be in the 15% bracket retirement.  Based on the pose their projected annual expenses/withdrawals are $25,800.  With standard deduction and exemptions for a married couple, they would be under the 15% bracket.

Advice for OP:  Don't make such large payments to your mortgage.  Invest that money instead, and you can expect to have more money for retirement (or be able to retire sooner).

I guess I'm not sure why I thought we would be in the 15% tax bracket at retirement.  Probably forgot about deductions/never really looked at it on paper. Still new to the FI thinking.  Thanks for bring that up.

As far as paying off the mortgage, we would be saving more money by paying it off early.  3.875% of 134K is a lot more than 7% of 833/month.

Our total extra payments will be $103k over 9 years which will save us $77k in interest. Investing that same 103K at 7% over 9 years would only get us $47k.  That's an additional $30k more.  Am I think of this right?

Your extra mortgage payments get you a guaranteed rate of return of 3.875% (principal you don't pay interest on anymore).  Putting that money in the stock market would get you a rate of return equal to whatever the market does (7% in your example).  Since you're early in your career you can ride out market swings, and almost certainly do better than 3.875%.


Here's an article MMM wrote about it: http://www.mrmoneymustache.com/2012/02/24/pay-down-the-mortgage-or-invest-more-a-winwin-question/ .  The question of "should I pay off this debt or invest instead" has also been discussed on the forums a few times, if you can find the old posts.

[MDM]

As far as paying off the mortgage, we would be saving more money by paying it off early.  3.875% of 134K is a lot more than 7% of 833/month.

Our total extra payments will be $103k over 9 years which will save us $77k in interest. Investing that same 103K at 7% over 9 years would only get us $47k.  That's an additional $30k more.  Am I think of this right?

I think you might have the right general idea, but I'm not sure of your specific numbers.  Let's take a closer look.

A $134K mortgage financed at 3.875% over 30 years has a required payment of $630.12/mo.  The tax and insurance escrow amounts are irrelevant for this comparison.  This will pay the mortgage in 30 years, and require $92,842 paid as interest.

Now we assume an extra $833/mo is available, either to pay down the mortgage principal or to invest.  Thus total available cash is $630.12 + $833 = $1,463.12/mo.
If an extra $833/mo is paid toward the principal, the mortgage is paid in 9 years and 1 month.  The final month's total payment is ~$1,100.  The total amount of extra payments will be ~$90,430, and total interest paid is ~$25,118.  This saves ~$67,724 interest.

If one takes the extra $363 available in month 109, plus the entire $1,463.12/mo available in months 110 to 360, and invests that at 7%, there will be ~$831K in the investment account after 30 years.

If, instead of paying down the mortgage principal, that $833/mo had been invested for all 360 months, there will be ~$1,016K in the investment account after 30 years.

Putting your money into the highest after-tax interest rate always comes out best.  The trick for investments is that you don't know for sure what that interest rate will be.  Once you make that future interest rate assumption, however, the answer is "pick whichever is highest."

[TheChzBurger]

As far as paying off the mortgage, we would be saving more money by paying it off early.  3.875% of 134K is a lot more than 7% of 833/month.

Our total extra payments will be $103k over 9 years which will save us $77k in interest. Investing that same 103K at 7% over 9 years would only get us $47k.  That's an additional $30k more.  Am I think of this right?

I think you might have the right general idea, but I'm not sure of your specific numbers.  Let's take a closer look.

A $134K mortgage financed at 3.875% over 30 years has a required payment of $630.12/mo.  The tax and insurance escrow amounts are irrelevant for this comparison.  This will pay the mortgage in 30 years, and require $92,842 paid as interest.

Now we assume an extra $833/mo is available, either to pay down the mortgage principal or to invest.  Thus total available cash is $630.12 + $833 = $1,463.12/mo.
If an extra $833/mo is paid toward the principal, the mortgage is paid in 9 years and 1 month.  The final month's total payment is ~$1,100.  The total amount of extra payments will be ~$90,430, and total interest paid is ~$25,118.  This saves ~$67,724 interest.

If one takes the extra $363 available in month 109, plus the entire $1,463.12/mo available in months 110 to 360, and invests that at 7%, there will be ~$831K in the investment account after 30 years.

If, instead of paying down the mortgage principal, that $833/mo had been invested for all 360 months, there will be ~$1,016K in the investment account after 30 years.

Putting your money into the highest after-tax interest rate always comes out best.  The trick for investments is that you don't know for sure what that interest rate will be.  Once you make that future interest rate assumption, however, the answer is "pick whichever is highest."

MDM, Thanks for the calculations, they are pretty close to my situation. One thing you missed was that we want to ER at age 45, therefor we wouldn't be putting additional funds into investment and withdrawing 4% at age 45.

So now running the calculations from you post.

Paying $833/mo extra will pay the mortgage off in 9yr 1mo (which will be early 2024 and we'll be 33), saving $67,724 in interest. Then investing the entire $1,463 for 12yrs at 7%, would be worth $328k in investments.

Totaling both to $396K in savings plus having our mortgage paid.

Or, investing the $833/mo until 45, 19 years at 7%, would be worth $395k.

Then using the 4% rule at age 45, with paying off the mortgage, I could withdraw $13,120/yr($328k x 4%). With just investing it all, I could withdraw $15,800/yr($395k x 4%) but would still have to pay the $630 mortgage every month($7,560/yr).

[Hotstreak]

Then using the 4% rule at age 45, with paying off the mortgage, I could withdraw $13,120/yr($328k x 4%). With just investing it all, I could withdraw $15,800/yr($395k x 4%) but would still have to pay the $630 mortgage every month($7,560/yr).

Given retirement is scheduled in 20 years, run the comparison between the 9 year payoff and a 20 year payoff.  If you're inclined to have no mortgage in retirement then that is the comparison to look at.  The benefit of investing vs additional principal payments will be less, but there will still be a benefit, since the underlying principles aren't changing.


As an alternative, you could invest enough to keep making mortgage payments for the rest of the 30 years, then end up with just enough money to use a 4% rule going forward.  That's starting to get unnecessarily complicated though, & given the relatively small size of your mortgage I don't think it would really save you much.

[MDM]

MDM, Thanks for the calculations, they are pretty close to my situation. One thing you missed was that we want to ER at age 45, therefor we wouldn't be putting additional funds into investment and withdrawing 4% at age 45.

Ok, we can work with that.

Paying $833/mo extra will pay the mortgage off in 9yr 1mo (which will be early 2024 and we'll be 33), saving $67,724 in interest. Then investing the entire $1,463 for 12yrs at 7%, would be worth $328k in investments.

I'm guessing, based on early 2024 being ~7 years away, you have already been paying extra for ~2 years...?  If so, we should restate the length of your current mortgage to whatever a monthly payment of $630.12/mo and 3.875% interest requires to pay the current principal.  E.g., if you have paid $833/mo for exactly 24 months, current principal is ~$108,330.  It would take ~21 years to pay off $108,330 at $630.12/mo and 3.875%.

Totaling both to $396K in savings plus having our mortgage paid.

Don't add "interest you didn't pay" to "investment balance."  You have a paid mortgage, plus $328K in investments.  That's it.

Or, investing the $833/mo until 45, 19 years at 7%, would be worth $395k.

Yes.

Then using the 4% rule at age 45, with paying off the mortgage, I could withdraw $13,120/yr($328k x 4%). With just investing it all, I could withdraw $15,800/yr($395k x 4%) but would still have to pay the $630 mortgage every month($7,560/yr).

But now your mortgage balance is down to ~$14.1K.  You could pay off the mortgage and still have $380.9K, which is much better than $328K.

If you do get 7% return, investing beats paying a 3.875% mortgage no matter how you look at it.

[boarder42]

i've read the boggle heads posts on this MDM and i still cant wrap my head around how the math works that if i'm saving money now at 15% and withdrawing still in the 15% bracket.  some of those withdraws will be 0 or 10% tax.

Good question.  It is important to distinguish between investments you have already made vs. an investment choice you have now.

Let's say you are a single person and have already made enough traditional investments in 2016 and previous years that, allowing for real growth, you expect your traditional account to have $500K when you retire.  You assume a 4% withdrawal ratio (WR), so $20K/yr.  That will put you in the 15% bracket.

Now you have to decide traditional vs. Roth for 2017.  Any traditional contribution will only increase your expected traditional retirement balance, and thus the withdrawal amount you can take using the 4% WR.  Your 2017 traditional contribution causes an increase in withdrawals that will all be taxed at 15%, because the 0 and 10% buckets were already full.

Does that make sense?

Yes I thought that was what they were indicating but thank you for laying it out in layman's terms for me.

[TheChzBurger]

MDM and Hotstreak, 

Thanks for helping me out with this. Your advice makes sense. Putting money into investments at 7% will beat paying off the mortgage early.  Just when I ran the number it came out to looking like a better deal. Sometimes it's hard to see all of the different options you can do.  I just needed someone to debunk my thinking, which you guys did.

As for my original post, we got kind of side tracked, I think the Traditional IRA would be best. I've done some more reading since then, and with hotstreaks help, realized we wouldn't be in the 15% tax bracket at retirement.

I really appreciate your guys help, thanks again!

[MDM]

MDM and Hotstreak, 

Thanks for helping me out with this. Your advice makes sense. Putting money into investments at 7% will beat paying off the mortgage early.  Just when I ran the number it came out to looking like a better deal. Sometimes it's hard to see all of the different options you can do.  I just needed someone to debunk my thinking, which you guys did.

As for my original post, we got kind of side tracked, I think the Traditional IRA would be best. I've done some more reading since then, and with hotstreaks help, realized we wouldn't be in the 15% tax bracket at retirement.

I really appreciate your guys help, thanks again!

You're welcome - good luck with your plans!

For Married Filing Jointly, it would take a $981,250 traditional balance in today's dollars (assuming no other income and a 4% withdrawal rate) to reach the 15% bracket.  Until it appears you are going to reach that amount, traditional is indeed better if your marginal rate is 15% now.

[boarder42]

MDM and Hotstreak, 

Thanks for helping me out with this. Your advice makes sense. Putting money into investments at 7% will beat paying off the mortgage early.  Just when I ran the number it came out to looking like a better deal. Sometimes it's hard to see all of the different options you can do.  I just needed someone to debunk my thinking, which you guys did.

As for my original post, we got kind of side tracked, I think the Traditional IRA would be best. I've done some more reading since then, and with hotstreaks help, realized we wouldn't be in the 15% tax bracket at retirement.

I really appreciate your guys help, thanks again!

You're welcome - good luck with your plans!

For Married Filing Jointly, it would take a $981,250 traditional balance in today's dollars (assuming no other income and a 4% withdrawal rate) to reach the 15% bracket.  Until it appears you are going to reach that amount, traditional is indeed better if your marginal rate is 15% now.

and it takes ~1.875MM to reach the 25% threshold correct.  just dont want to over do my tax deferred as i have an Scorp ESOP i belong to at work.

[MDM]

and it takes ~1.875MM to reach the 25% threshold correct.  just dont want to over do my tax deferred as i have an Scorp ESOP i belong to at work.

Actually $2.4MM, assuming standard deduction for a couple under age 65 (it's $2,462,500 if both are 65 or older).

Yes, other annual ordinary income will decrease the threshold by 25X the other annual ordinary income.

[boarder42]

and it takes ~1.875MM to reach the 25% threshold correct.  just dont want to over do my tax deferred as i have an Scorp ESOP i belong to at work.

Actually $2.4MM, assuming standard deduction for a couple under age 65 (it's $2,462,500 if both are 65 or older).

Yes, other annual ordinary income will decrease the threshold by 25X the other annual ordinary income.

ahh yes deductions i always forget about.  i have no chance of reaching that then.  so i should be good to go maxing tax deferred as planned.