Author Topic: Need some advice on what investments, in which order  (Read 1815 times)

Drakmon

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Need some advice on what investments, in which order
« on: April 16, 2015, 10:33:00 AM »
Hi folks,

We started our MMM journey in January, and we've already made a ton of changes, including having a clear idea where all our money is and how much of it is working for us. Now, we want to start optimizing the process, and I'm running up against some knowledge hurdles that I'm hoping I can get assistance with. Here's a summary of where we are at:

  • We're saving about $10,000/month right now. (My wife and I both make $150k+)
  • 401k contributions are maxed out ($3k of the $10k).
  • The remaining $7k/month is available for investment.
  • Our savings will be maxed out at $30k in a few months, after being decimated by moving expenses (to a cheaper place!).

Here's how we currently have our investments split up:
  • My 401k: $4k
  • Spouse 403b: $8.5k
  • My IRA: $14.6k
  • Spouse IRA: $5.3k
  • Spouse Old 401k: $66k

Our IRAs are funded completely by rollover contributions. We have never directly contributed to an IRA before.
All investments are in S&P or Large+Mid Cap index funds, with a very small % of bonds mixed in for flavor. We are full-on aggressively pursuing FIRE (~$2.5MM).

So, to questions:

  • My wife's old 401k is making money hand-over-fist. Should we even bother rolling it over to her IRA account, since it's performing so well?
  • The month after our savings is maxed out, what should I contribute to first? $5k each into our respective IRAs? My 401k supports backdoor Roth contribs (up to $52k), so should I do that first instead?
  • At what point should I start putting money into my general (non-IRA) Betterment account? After 401ks/IRAs/Backdoor Roth contribs are all used up? Before that?
  • Would there ever be a case where a regular after-tax investment would be better than a backdoor Roth?
  • Any other advice or thoughts on how we could optimize our investment strategy?

Thanks, all!
« Last Edit: April 16, 2015, 11:00:13 AM by Drakmon »

seattlecyclone

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Re: Need some advice on allocations
« Reply #1 on: April 16, 2015, 11:15:10 AM »
Good job on saving so much! $10k/month is something many of us can only aspire to saving. $2.5 million is an aggressive goal. You're new at this, so I'd bet you'll be able to adjust that downward over the years as you re-evaluate your spending habits and realize you can probably be quite happy spending less than $100k during retirement.

My guess is that your income is high enough that direct Roth IRA contributions are not going to be an option for you ($183k max AGI for a full contribution), and deductible IRA contributions are right out ($98k max AGI for a full deductible contribution since you both have retirement plans at work). Therefore if you want to contribute to an IRA, the backdoor Roth is probably going to be your only option. To do this effectively, you'll need to first clear out your existing pre-tax IRA balances by rolling them into your 401(k)/403(b) accounts if your plans permit that. If they don't, it's probably best to forget about IRA contributions for now. Since you have after-tax 401(k) contributions available to you, this wouldn't be the end of the world.

To address your specific questions:
1) My wife's old 401k is making money hand-over-fist. Should we even bother rolling it over to her IRA account, since it's performing so well?

Don't necessarily be fooled by good performance. The market has been doing great lately in general, so even a bad set of stock funds should be giving pretty good returns. Instead take a look at the expense ratios of the funds in this plan. How high are they? If they're under 0.2%, you have a pretty nice set of funds and should be in no hurry to roll it over.

If they're higher than that, you have some options. You can look into rolling the balance into her current 403(b). Only do this if the 403(b) fund options actually have lower expense ratios than her old 401(k). You can roll the account into her IRA, but as I mentioned before this will thwart backdoor Roth IRA contributions. Alternatively you can leave the money where it is and keep paying the high fees until you no longer care about making backdoor Roth IRA contributions.

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2)The month after our savings is maxed out, what should I contribute to first? $5k each into our respective IRAs? My 401k supports backdoor Roth contribs (up to $52k), so should I do that first instead?

After-tax 401(k) contributions are a nice option. The limit on these contributions is not $52k, it's ($53k - your pre-tax/Roth contributions - your employer's matching contributions). I would go with that first. That should give you some time to roll your IRAs into your work plans to prepare for backdoor Roth IRA contributions.

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3)At what point should I start putting money into my general (non-IRA) Betterment account? After 401ks/IRAs/Backdoor Roth contribs are all used up? Before that?

I max out my tax shelters before doing taxable investing. I think that's a good strategy for higher-income folks.

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4) Would there ever be a case where a regular after-tax investment would be better than a backdoor Roth?

Yes, but not really. Principal in a Roth account can be withdrawn tax-free at any time. Earnings can only be withdrawn before age 59 if you're willing to pay income tax on the full amount plus a 10% early withdrawal penalty, therefore you should avoid getting into a situation where you would have to withdraw this money early. There are some theoretical edge cases where an early retiree could be using the Roth pipeline strategy and exhausts all of their money except for Roth earnings. If you're planning to retire with a significant portion of your investments in taxable accounts anyway, you're very unlikely to fall into this scenario. Max out the backdoor Roth, both through your 401(k) and IRA.

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5) Any other advice or thoughts on how we could optimize our investment strategy?

  • Come up with an asset allocation that you're comfortable with. Decide what percentage of your money (if any) that you want to have in domestic stocks, international stocks, domestic bonds, international bonds, real estate, etc.
  • Once you do that, use these guidelines to implement your asset allocation in a tax-efficient way. In a nutshell, your taxable accounts should be stock-heavy, and you should try to implement your bond and REIT allocation entirely in your tax-sheltered accounts if possible.
  • Rebalance your accounts a couple of times a year to ensure you're sticking with the asset allocation you chose.
  • Ditch Betterment. Open a taxable account with Vanguard and put all of your taxable money in VTSAX and/or VTIAX, as determined by your desired asset allocation.
  • Keep on saving, and never stop looking for ways to optimize your spending. By cutting your budget now, you not only save more per month, but you decrease the amount you need to save before reaching FIRE. Good luck!

Drakmon

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Re: Need some advice on what investments, in which order
« Reply #2 on: April 16, 2015, 01:28:01 PM »
Wow, this is a really great response, and exactly the kind of guidance I was looking for. Thanks!

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$2.5 million is an aggressive goal. You're new at this, so I'd bet you'll be able to adjust that downward over the years as you re-evaluate your spending habits and realize you can probably be quite happy spending less than $100k during retirement.

We've reduced our monthly expenses from $12k/month down to $6800/month so far this year, $3300 of which is our NYC apartment. So, we're technically down to $42k/year in non-housing related expenses now. I think we could retire at $2MM, or even less, but we need to do some long-term thinking and soul-searching as to what our FIRE life will look like, especially in terms of housing (ex. buy a place outright and stop renting).

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My guess is that your income is high enough that direct Roth IRA contributions are not going to be an option for you ($183k max AGI for a full contribution), and deductible IRA contributions are right out ($98k max AGI for a full deductible contribution since you both have retirement plans at work).

While I knew about the Roth limit, I really wasn't aware of "Why" someone would use an IRA till now... for tax reasons! It's actually really good to know that an IRA is effectively useless for us, because it simplifies the field greatly.

I'll have to see tonight if my wife's 403(b) allows for IRA rollovers. I'm pretty sure it does, which will help considerably.

This is, by far, the takeaway I'm most excited about.

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Don't necessarily be fooled by good performance. The market has been doing great lately in general, so even a bad set of stock funds should be giving pretty good returns. Instead take a look at the expense ratios of the funds in this plan. How high are they? If they're under 0.2%, you have a pretty nice set of funds and should be in no hurry to roll it over.

We only consider investments that have low expense ratios like this. Her old 401(k) was originally set up with a ton of random funds, so we rebalanced it all into the Vanguard Target 2040 Fund (https://personal.vanguard.com/us/funds/snapshot?FundId=0696&FundIntExt=INT), which is a mix of VTSAX and VTIAX. It's actually better than her 403(b) in that respect. I think, given your advice, we'll keep it where it is for now.

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After-tax 401(k) contributions are a nice option. The limit on these contributions is not $52k, it's ($53k - your pre-tax/Roth contributions - your employer's matching contributions). I would go with that first. That should give you some time to roll your IRAs into your work plans to prepare for backdoor Roth IRA contributions.

Great! Now I just need to re-read that whole guide on how to do the backdoor Roth. I remember it seeming really complicated and intimidating when I read it a few months back. I've got to do it, though, so I guess it's time to just push through.

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Principal in a Roth account can be withdrawn tax-free at any time. Earnings can only be withdrawn before age 59 if you're willing to pay income tax on the full amount plus a 10% early withdrawal penalty, therefore you should avoid getting into a situation where you would have to withdraw this money early. There are some theoretical edge cases where an early retiree could be using the Roth pipeline strategy and exhausts all of their money except for Roth earnings.

Ahhhh... gotcha. So in FIRE, we would theoretically focus on leaving Roth withdrawls till "last", and if need be we would draw down on the principal before ever touching the earnings, unless we had already hit 59 1/2 (we're planning on FIRE in 10 years, so we'll only be 45-ish).

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Come up with an asset allocation that you're comfortable with. Decide what percentage of your money (if any) that you want to have in domestic stocks, international stocks, domestic bonds, international bonds, real estate, etc.

Is it "wrong" that I'm comfortable with 90% stocks and 10% bonds/REIT? I'm comfortable with the risk since our timeframe is longer, but I also don't want to make intentionally dumb decisions.

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Ditch Betterment.

Based on the results I've seen others have, it seemed roughly analogous to what folks were seeing from Vanguard. Is VTSAX preferable just for the more predictable growth (since it's a pure market index fund) and predictably-lower expense ratio?
« Last Edit: April 16, 2015, 02:02:42 PM by Drakmon »

seattlecyclone

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Re: Need some advice on what investments, in which order
« Reply #3 on: April 16, 2015, 02:36:36 PM »
Ahhhh... gotcha. So in FIRE, we would theoretically focus on leaving Roth withdrawls till "last", and if need be we would draw down on the principal before ever touching the earnings, unless we had already hit 59 1/2 (we're planning on FIRE in 10 years, so we'll only be 45-ish).

Generally...yes. During retirement you might have some competing goals when trying to optimize your income, taxes, and expenses. You might want to convert some money from your traditional IRA to Roth to get cheaper access to that money in five years. You might want to keep your income under 200% of the federal poverty level to get really cheap health insurance on your local exchange. And of course, you have to withdraw enough to pay your bills.

The exact trade-offs you'll make will depend on your personal situation, what percentage of your money you have in which types of accounts, etc. I plan to withdraw mostly from taxable accounts to start. I'll try to sell my least-appreciated shares to pay the bills. If that leaves me short of 200% of the FPL, I'll probably do some Roth conversions to get my income up (and pay very little tax on the conversion). If withdrawing only from taxable would put me over that line, I might consider taking out some tax-free HSA money or Roth principal to make up the gap.

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Is it "wrong" that I'm comfortable with 90% stocks and 10% bonds/REIT? I'm comfortable with the risk since our timeframe is longer, but I also don't want to make intentionally dumb decisions.

Not wrong at all! The key thing here is that you need to stay the course when the market goes down. You might even find yourself selling bonds to buy stocks during this downturn in order to keep your asset allocation where you want it to be. If you think there's even the slightest chance that you won't actually keep up your 90/10 ratio when the next bear market comes around, you should re-evaluate your decision and pick an allocation that you'll be comfortable staying with even in a downturn.

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Ditch Betterment.

Based on the results I've seen others have, it seemed roughly analogous to what folks were seeing from Vanguard. Is VTSAX preferable just for the more predictable growth (since it's a pure market index fund) and predictably-lower expense ratio?

Betterment isn't magic. They're investing in index funds, the same as you can do yourself. They then add in an additional 0.25% on top of the expense ratios of the underlying funds, just so you don't have to buy and sell shares yourself. The thing is that sending Betterment $7k/month to invest on your behalf really isn't any easier than sending Vanguard $7k/month and telling them to put it in VTSAX. Also with Betterment you don't have that much control over the underlying asset allocation, so you might end up with bonds or REITs in your taxable account even when you might prefer to keep these in your 401(k) for tax reasons.

Betterment, Wealthfront, etc. are certainly better than advisors who charge you 1% management fees to sell you funds with high loads and high expense ratios. You should be able to do even better by opening an account with Vanguard and picking a couple of funds yourself.