Author Topic: Beginner advice re: 401(k) and IRA  (Read 3638 times)

senecaur

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Beginner advice re: 401(k) and IRA
« on: January 07, 2015, 05:22:50 AM »
I have just moved permanently to the US and will be starting a new job very soon.  My employer offers both Traditional and Roth 401(k) options, although with very small (<10%) matched contributions.  My salary will be high enough and living expenses low enough that I anticipate being able to max out my allowed contributions to both the 401(k) and an IRA and have a further $3.5K a month to save.  I am 33 and starting from a baseline of having no retirement savings in the US, no debt of any kind and about $10K cash saved in the bank.  I do not own my home and will be renting for at least the next year; however, I anticipate wanting to buy a home in a couple of years time when my location is settled.

My questions are:

1. Should I choose the traditional or Roth IRA options?  How do I decide this?
2. What should I do with the rest of the money I have to save?  I have looked at Vanguard investment options, which seem promising, but want to make sure that I will be able to withdraw money without penalty for a house down-payment in a couple of years time.

Thanks in advance for any help!

wtjbatman

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Re: Beginner advice re: 401(k) and IRA
« Reply #1 on: January 07, 2015, 06:53:51 AM »
My questions are:

1. Should I choose the traditional or Roth IRA options?  How do I decide this?
2. What should I do with the rest of the money I have to save?  I have looked at Vanguard investment options, which seem promising, but want to make sure that I will be able to withdraw money without penalty for a house down-payment in a couple of years time.

Thanks in advance for any help!

1) That usually depends on your income and tax rate. Generally if you are being taxed higher than 15% you want to invest in Traditional (with the assumption you will pay less in taxes in the future/in retirement), if 15% or lower you may want to invest in Roth instead (with the assumption you will pay less in taxes in the future). I'm at 15% but I still invest in Traditional... but that's because I'm trying to lower my taxable income as much as possible. There is no one size fits all.

2) If you're saving for a house down payment you expect to need in the next couple of years, I'd stick to saving it in a "high yield" savings account and avoid investing it. The last thing you want to happen is for the market to crash just before you try to buy a house, and suddenly you lose 20-50% of your house down payment. We are saving ours at Capital One 360. There may be options with slightly higher interest rates (Ally).

notsofast

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Re: Beginner advice re: 401(k) and IRA
« Reply #2 on: January 07, 2015, 07:08:07 AM »
First project out your taxes and understand which marginal bracket you will be in and what your estimated effective rate will be.  your contributions to the pre-tax 401(k) will receive the benefit of the marginal rate but when investing in a roth you are betting that your effective rate in retirement is higher than your marginal rate today.   This is assuming you have to pick between the two in making contributions.  You may decided to diversify your tax portfolio with both due to the other advantages afforded by Roth's which are 1) no required RMD in retirement, 2) access to contributions if you ever leave your job and roll it to IRA.  Only you can look at those benefits and value them in making the decision. 

Indexer

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Re: Beginner advice re: 401(k) and IRA
« Reply #3 on: January 07, 2015, 07:11:46 AM »
1.  Lets just do a breakdown.
Traditional IRA/401k:  Money goes in pre tax, you get a tax deduction, so you save tax money this year.  Money grows tax deferred, you pay taxes when you take it out.  If you take it before 59 1/2 plan on paying a 10% additional tax penalty.  Great if you think you pay higher taxes now than in retirement. 
Roth:  Money goes in post tax.  No tax deduction now.  Money grows tax free and you pay no taxes in retirement.  If you take out the CONTRIBUTIONS early no problems.  If you take the EARNINGS out before 59 1/2(and having had the account 5 years) plan on paying taxes plus penalty.  Roth is normally better if you are paying less in taxes now rather than retirement.

Curve ball:  If you are MAXING out the accounts the Roth is normally better.  Putting 5500 in after tax money into an account is not the same as putting 5500 into a pre tax account.  From a time value of money standpoint the Roth lets you shelter more money on a tax adjusted basis if you are maxing out the contributions.  So even if you are in a 25% tax bracket and plan on being in a lower one in retirement the Roth is often times still better if you are trying to put away as much money as possible.  If you are in the 38% tax bracket the traditional might still be better.

2.  If you want 100% safety go with a high yield savings account.  If you are ok with a possible 5% swing in a bad year you might also want to look at short term bond funds.  If you are ok delaying the house purchase because of market conditions and/or you can handle a 10% dip in the value in the short term you might also want to look at VASIX.  Its 80% bonds 20% stocks, uses index funds for its diversification, its very low cost, its liquid(you can w/d funds with no penalty), and in 2008 it was down about 10%(the only year its been down.. I think ever).  Its very conservative.  80% bond and 20% stocks is a pretty good ratio if you want to minimize volatility.  The small % of volatile stocks help hedge the big basket of bonds against interest rate swings, but the stocks make up such a small piece of the pie that the bonds hedge away most market fluctuations.  I personally use it as my emergency fund.  Its low risk but long term it should beat the pants off any savings account.

senecaur

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Re: Beginner advice re: 401(k) and IRA
« Reply #4 on: January 07, 2015, 08:03:48 AM »
I am in the 28% tax bracket now and would expect to stay there or possibly move slightly up throughout my career.  I'm not sure I understand what that will mean for my tax rate in retirement though.

Thanks for the advice on protecting the house down-payment - I will look into high-yield savings accounts, although I didn't realise there was such a thing anymore!

MetalCap

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Re: Beginner advice re: 401(k) and IRA
« Reply #5 on: January 07, 2015, 08:10:43 AM »
One other detail: Contribute just enough to get the full employer match.  It is a better return (100%) than any other investment. Other than that the other contributors are far more knowledgable than any advice I could give.

rocksinmyhead

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Re: Beginner advice re: 401(k) and IRA
« Reply #6 on: January 07, 2015, 08:37:30 AM »
If you're single and in the 28% tax bracket and you have an employer provided 401k, you're not gonna get any tax benefit from a traditional IRA: http://www.irs.gov/Retirement-Plans/2015-IRA-Deduction-Limits-Effect-of-Modified-AGI-on-Deduction-if-You-Are-Covered-by-a-Retirement-Plan-at-Work

I am in the 28% tax bracket now and would expect to stay there or possibly move slightly up throughout my career.  I'm not sure I understand what that will mean for my tax rate in retirement though.

Well, obviously we can't predict what overall tax rates will be when we retire, but if you are living a low-cost mustachian lifestyle (or even pseudo-mustachian like myself), it's a reasonable bet you will be in a lower bracket in retirement since your income (which will just be whatever you need to withdraw to live on) will be much lower. Personally I am in the same tax bracket and I do traditional 401k contributions. I also am saving for a house downpayment, so I second wtjbatman's post... my house stash is with Ally (don't get excited, the interest rates aren't THAT high, still less than 1% :)).

senecaur

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Re: Beginner advice re: 401(k) and IRA
« Reply #7 on: January 07, 2015, 09:19:09 AM »
@rocksinmyhead  I am married, but even so according to that link I/we have no deduction.  Does that mean that an IRA offers me no benefit over just saving/investing then?

rocksinmyhead

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Re: Beginner advice re: 401(k) and IRA
« Reply #8 on: January 07, 2015, 10:06:31 AM »
@rocksinmyhead  I am married, but even so according to that link I/we have no deduction.  Does that mean that an IRA offers me no benefit over just saving/investing then?

I'm pretty sure it means that you get no tax benefit from a traditional IRA, but that a Roth would still be beneficial. And you should still be able to contribute to a Roth:
http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2015

Someone correct me if I'm wrong!