Author Topic: Help with following optimal investment order  (Read 1247 times)

PhillyFIRE

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Help with following optimal investment order
« on: November 09, 2018, 01:55:34 PM »
Hi!
I've been following the FIRE community for a few years now and have a FIRE date of year-end 2021. I realize I have not been utilizing tax advantages to the maximum and am hoping to rectify the situation. Maybe proper optimization could move my goal up by a couple months or just provide a larger cushion in my stash.
I am in my mid-30s, and married, filing jointly. My SO also works but we utilize my employer for health insurance/HSA.
Below is my current status in regard to following the optimal investment order. I greatly appreciate any insight and corrections to where I may be going wrong.

0. Establish an emergency fund to your satisfaction.
(COMPLETE - have sufficient funds in checking and high-yield savings accounts)
1. Contribute to your 401k up to any company match.
(COMPLETE - my employer matches 100% up to 3% and 50% after up to 5%. So I currently contribute 5% and receive an effective 4% employer match. Those dollar amounts annually are ~$3,400 and ~$2,700.)
2. Pay off any debts with interest rates ~5% or more above the current 10-year Treasury note yield.
(COMPLETE- no debt)
3. Max Health Savings Accounts (HSA) if eligible.
(COMPLETE - my employer seeds up to $1,000 so I personally contribute $5,900 annually, with employer contribution of $1,000 then bringing me to the $6,900 limit.)
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level.
(INCOMPLETE)
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for a tIRA deduction, swap #4 and #5).
(INCOMPLETE)
6. Fund a mega backdoor Roth if applicable.
(INCOMPLETE)
7. Pay off any debts with interest rates ~3% or more above the current 10-year Treasury note yield.
(COMPLETE - no debt)
8. Invest in a taxable account and/or fund a 529 with any extra.
(COMPLETE - Any leftover funds after expenses have been going into Vanguard ETFs through Robinhood.)

So that's the current situation. If I'm understanding correctly (not a given), my next three steps should be as follows:
- Open a traditional IRA (through Vanguard?) and contribute $5,500 annually.
- Increase my 401k contributions up to the $18,500 limit (up from ~$3,400).
- Start a mega backdoor Roth. I'm a little fuzzy on this, but I believe I would need to open a Roth IRA with a minimum deposit (having already also opened a traditional IRA for Step 4). Then, I can contribute up to ~$33,800 in after-tax contributions to my 401k ($55,000 limit minus $18,500 personal pre-tax contribution minus ~$2,700 employer pre-tax contribution). At the beginning of the calendar year, I would do an in-service rollover from my 401k to have the pre-tax contributions go to my traditional IRA and the post-tax to the Roth IRA.
Note: I realize I wouldn't be able to reach all the way up to $33,800 given my available income post-expenses, but let's just consider that an optimal scenario for the sake of discussion.

Do I have everything right? Should those be my next three steps? Am I missing anything obvious?
Thank you very much for your help!

terran

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Re: Help with following optimal investment order
« Reply #1 on: November 09, 2018, 02:07:33 PM »
Sounds about right.

Have you checked with your 401(k) plan administrator to make sure they allow both after tax (not Roth) contributions and in service withdrawals? Not all do.

Is your income within the IRA deduction limits? https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work

If you're retiring that soon and haven't been maxing out tax advantaged accounts you must have a large balance in taxable accounts? If so, consider selling off some of that and living off it if necessary to fully max out tax advantaged space while still having enough to live on.

Boofinator

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Re: Help with following optimal investment order
« Reply #2 on: November 09, 2018, 02:56:09 PM »
To echo Terran, max the tax-deductible 401k and traditional IRA (check first to see if you meet the IRS gross income requirement for IRA deduction: https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-covered-by-a-retirement-plan-at-work; I would check last year's 1040 to see your situation).

If you can't deduct Traditional IRA, then a Roth IRA may or may not be worth it to you. As for the mega backdoor IRA, it is not available to everyone, so you need to look into whether your employer allows it. In my opinion, the savings from Roth aren't that great over a taxable account for Mustachians.

PhillyFIRE

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Re: Help with following optimal investment order
« Reply #3 on: November 09, 2018, 05:30:03 PM »
Thank you for the replies!

No, I had not checked with the plan administrator regarding after-tax contributions and in-service withdrawals. I will look into it first thing Monday. If they do not do either thing, that means Step 6 would not be applicable and I would bypass, correct? My plan is through TransAmerica, if anyone has experience doing this with them.

We are over the $121k limit combined. So this would mean I should bypass Step 4 in the investment order as it's not applicable, correct? Or does that mean I should only be looking into a Roth, and what is the criteria for determining whether the Roth is worth it for me?

Yes, I have a few hundred thousand dollars in taxable accounts. I always liked following stocks, even as a kid, and started investing as a pre-teen with my father as a custodian on the account. I continued to buy even more once I entered the work force full-time and only shifted to ETFs and more tax-advantaged accounts once I started reading about FIRE. I am definitely going to use those first to sell-off and live on once I FIRE. Terran, is that what you meant by fully maxing out tax advantaged space? Or is there some advantage to selling off while I'm still working?

Sorry if these are the sorts of things that have been answered countless times. Thanks again for any help.

Boofinator

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Re: Help with following optimal investment order
« Reply #4 on: November 09, 2018, 06:10:08 PM »
We are over the $121k limit combined. So this would mean I should bypass Step 4 in the investment order as it's not applicable, correct? Or does that mean I should only be looking into a Roth, and what is the criteria for determining whether the Roth is worth it for me?

Here's the deal with Roth: You pay tax now, but you don't pay tax when you take it out (you knew this). In theory, a Roth and Traditional result in equivalent final expected values given identical tax brackets when contributing and when retired. (Actually, if you use the assumption of equal tax brackets, you should go Roth, since you can invest more.) But for most Mustachians, tax brackets are expected to be much lower if not nonexistent during retirement (if you FIRE early), or you're going to be so wealthy that paying a bit of taxes in retirement are immaterial. So this is the reason to fill Traditional as much as you can.

After you've filled your Traditional bucket(s), you have the choice of Roth versus Taxable.
Roth pros: All investment gains are tax free forever. You can pull out contributions any time without penalty if necessary (some people use it as an emergency fund).
Taxable pros: Tax loss harvesting. All money is available. If FIREd, you'll likely be in the 0% dividend and long-term CG tax bracket.
Taxable cons: Very small dividend tax drag (15%*~1%=~0.15%). Larger tax drag if needing to pull money out (but still pretty small if pulling recent contributions).

If you had to choose between Roth and Taxable, it's probably debatable which one to choose (tax-free vs TLH). If you can do both, that's my recommendation, and it is my approach.

MDM

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Re: Help with following optimal investment order
« Reply #5 on: November 09, 2018, 08:29:03 PM »
Another Roth benefit comes later, when Roth withdrawals have no impact whatsoever on the taxation of Social Security benefits.

Qualified dividends and long term capital gains may, considered in isolation, be taxed lightly, but the marginal rates can be high when combined with SS.

terran

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Re: Help with following optimal investment order
« Reply #6 on: November 10, 2018, 07:58:32 AM »
Thank you for the replies!

No, I had not checked with the plan administrator regarding after-tax contributions and in-service withdrawals. I will look into it first thing Monday. If they do not do either thing, that means Step 6 would not be applicable and I would bypass, correct? My plan is through TransAmerica, if anyone has experience doing this with them.

Right, mega backdoor Roth only works if your plan administrator allows both after-tax contributions and in-service withdrawals. This is employer specific (not administrator specific) as it's based on the plan documents your employer has adopted.

We are over the $121k limit combined. So this would mean I should bypass Step 4 in the investment order as it's not applicable, correct? Or does that mean I should only be looking into a Roth, and what is the criteria for determining whether the Roth is worth it for me?

I would contribute to Roth before contributing to taxable. I might contribute to your 401(k) before contributing to a Roth IRA, however, depending on the investments you have available (and the fees those investments carry).

Remember that the $121k in MAGI, not gross income, so you can subtract things like 401(k) contributions, paycheck deducted health insurance premiums, etc.

Also, if your spouse is not covered by a retirement plan at work, they're still eligible for deductible IRA contributions up to a MAGI of $189k even though you are covered: https://www.irs.gov/retirement-plans/plan-participant-employee/2018-ira-contribution-and-deduction-limits-effect-of-modified-agi-on-deductible-contributions-if-you-are-not-covered-by-a-retirement-plan-at-work -- They can contribute even if they don't have their own income based on your earned income.

These limits will also go up for 2019.

Yes, I have a few hundred thousand dollars in taxable accounts. I always liked following stocks, even as a kid, and started investing as a pre-teen with my father as a custodian on the account. I continued to buy even more once I entered the work force full-time and only shifted to ETFs and more tax-advantaged accounts once I started reading about FIRE. I am definitely going to use those first to sell-off and live on once I FIRE. Terran, is that what you meant by fully maxing out tax advantaged space? Or is there some advantage to selling off while I'm still working?

Not exactly. I actually meant that if you aren't otherwise able to max out tax advantaged accounts (because you don't make enough to do so while paying for current expenses), then you might consider maxing out the accounts and selling some taxable funds to pay for current expenses, effectively transferring money (through the intermediary of your paycheck deductions) from taxable to tax advantaged.

MustacheAndaHalf

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Re: Help with following optimal investment order
« Reply #7 on: November 10, 2018, 11:31:44 AM »
You're contributing ~$4k/year to 401(k) and retiring in 3 years (2021)?  Something tells me you should double check your numbers, to make sure your stash is sufficient for retiring - or not needing to work again.

Vanguard's Nest Egg calculator has just the critical controls, and runs thousands of simulations based on historical data.  It can provide the percentage chance your nest egg will be there your entire retirement.
https://www.vanguard.com/nesteggcalculator

If your 401(k) plan has poor expense ratios (mostly 0.75% or higher), you might prioritize an IRA first, and then contributions to the 401(k).

Another trick with IRAs: contribute to a Traditional IRA now, and after you retire, convert it to a Roth IRA (usually in steps, to get the lowest tax bracket).

PhillyFIRE

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Re: Help with following optimal investment order
« Reply #8 on: November 13, 2018, 06:26:48 AM »
Hi, to follow-up, I read through my 401(k) plan documents yesterday and it does allow for after-tax contributions and in-service withdrawals. Other items:
I confirmed it was our MAGI over the limit, not just AGI (my SO makes a decent amount more than I do). She also does contribute to her employer's 401(k) plan.
MustacheAndaHalf, I've run the calculations and am comfortable with my endpoint. As mentioned, I have a significant amount in taxable accounts from my pre-FIRE reading days. I also make ~$20k/year as a freelance writer, which I enjoy and plan to continue doing even in FIRE so I've factored that in as an additional cushion.
My immediate action items are:
Max out 401(k)
Set up a Roth to maximize that annual contribution.
From there, I will likely re-evaluate my cash flow for a few cycles and then begin the process of starting the Mega Backdoor Roth.

Thanks so much, I greatly appreciate all the feedback!