Help with savings, contributions, investments

[bradindenver]

Hello Mustachian Community, and thank you in advance for your help and knowledge.

I am 45 years old and ready for retirement as soon as it is feasible, ideally within 5 years.  I became concerned about the stability of my job over the last few years and with the market downturn I started thinking about many things and changing many things, just as so many people have.

Here is my current situation.  Any advice is greatly appreciated.

-My current annual total expenses are $20,000. This includes everything: housing, utilities, fuel, clothing, food, etc. I am working very diligently to reduce this amount.

-I have no debts of any kind.

-I have no assets other than those listed below.

-I earn $65,000 gross a year.

-I have $173,000 in a 401k account. This account has no company matching, but is obviously pre-tax.  I currently contribute $7,800 per year to the account. Currently weighted pretty heavy in bonds, but I'm not certain of the actual allocation.

-I have $72,000 in an ING savings account earning next to nothing.

-I have $9,500 dollars in an ING ShareBuilder Roth IRA account, full amount is held in SDY.

How I got here: I felt I was doing really well over the years. Contributed regularly to my 401k, eventually maxing out contributions for several years and just plugging along. I was spending all my other wages on lots of gifts, meals out, some travel, etc. Then the recession hit. My 401k took a 45% hit and for the first time in my life I felt poor and afraid.  I had no cash savings at the time and felt very vulnerable. Since then my 401k is just recently back at the amount prior to the recession. I reduced my contribution amount and put the rest into savings, reduced expenses and put even more into savings. I have to say having that cash makes me feel a little more secure, but I know it is losing value sitting there.

How would you all recommend I move forward and why?

Max out the 401k again, then max out my Roth IRA each year, then invest in a taxable account? If so, what allocations and investments would you recommend? All with the ultimate goal being early retirement and being able to access the monies.

Thank you my Mustachians!

[MrSaturday]

My strategy lately has been to max the 401k for the tax savings, then the Roth, then put a good chunk in I-bonds.

For any excess cash an account at TIAA-CREF (1.25% for who knows how long) or Alliant CU (.95% and very steady) would be an improvement.

[elysianfields]

I believe that tax rates are headed up, first in 2013 (if the Congress doesn't act), and over the long term (to cover SocSec and Medicare) as well.  Therefore, I think you should max out your Roth IRA and consider a Roth option if your 401(k) offers it.

If you're 45, you need some growth in your portfolio and the bonds in your 401(k) and the cash in ING won't provide it.  I recommend moving some of your cash in both of those buckets into stocks, in whatever way you feel comfortable.  I read a lot of annual reports and take the time to research companies, so I'm comfortable with individual stocks.  If you're not comfortable with that and won't take the time to do your homework, invest in some Vanguard and Fidelity stock funds.  Spread your equities among US and foreign, large and small companies.  Economic growth is coming from Asia these days (esp. China & India) rather than the industrialized world, so you should diversify in my view.

A very simple portfolio that I've used for one of my buckets is as follows (all Vanguard funds):

20% 500 Index (Large-cap)
20% Mid-Cap Index
20% Small-Cap Index
10% REIT Index
10% European Stock Index
10% Pacific Stock Index
10% Emerging Markets Index

I'm overweighting the medium and small cap stocks on purpose.  I think I'm a bit overweight on the US and underweight on overseas, especially emerging markets and should probably adjust this.

[bradindenver]

Thank you so much for your response, I really appreciate it.

I will continue to max out the Roth IRA for sure, and no my 401k does not offer a Roth feature at this time. Do you feel I should still max that out as well even without the Roth advantages?

I am thinking to re-balance the 401k to a 60/40 mix. It's a very simple plan with very few options. Here is the breakdown at this time: RLLSX 10.13%, RRLSX 10.27%, and RZLRX 79.60%. All of my current contributions are going to RLLSX and RRLSX, about $3,500 each per year.

I like the idea of the Vanguard funds. Sadly at this point I am so mentally burnt out that at times it's a challenge to think, much less to think, analyze and make decisions! Shame on me for letting it get this bad. I need to remedy this situation soon before I'm a total vegetable.

Any other ideas Mustachians?

[elysianfields]

Thank you so much for your response, I really appreciate it.

I will continue to max out the Roth IRA for sure, and no my 401k does not offer a Roth feature at this time. Do you feel I should still max that out as well even without the Roth advantages?

It depends on your current tax bracket and the tax bracket you'll be in when you retire, as well as the availability of other tax-deferred vehicles or tax-saving options.  You save taxes on your contributions up front but then pay them when you withdraw the cash from your 401(k).  You also have the use of the saved taxes to invest in the meantime.

I'm currently in the 25% bracket and believe taxes are headed higher over the long term.  However, I think I can make some money with the savings in the meantime, and/or convert my TSP (gov't equivalent of the 401(k)) to a Roth TSP when I retire and have less income, and thereby come out ahead.

Are you renting or do you own your lodgings?  Depending on your tax bracket, the mortgage interest deduction can be very valuable.

I am thinking to re-balance the 401k to a 60/40 mix. It's a very simple plan with very few options. Here is the breakdown at this time: RLLSX 10.13%, RRLSX 10.27%, and RZLRX 79.60%. All of my current contributions are going to RLLSX and RRLSX, about $3,500 each per year.

RZLRX is intended for people who are already retired and living off the income.  RLLSX has a majority of its funds invested in bonds.  You need equities for growth.  Do you have any other options?  If not, take your Lifetime fund option with the longest horizon, which will likely have more equities in the portfolio.  RRLSX (the 2030 strategy) has 68% equities, 22% bonds, 10% real estate.

I like the idea of the Vanguard funds. Sadly at this point I am so mentally burnt out that at times it's a challenge to think, much less to think, analyze and make decisions! Shame on me for letting it get this bad. I need to remedy this situation soon before I'm a total vegetable.

Set aside some time, download the materials, open a bottle of wine and study your options.  Keep a notebook of your thoughts as you read through.  Try to figure out your own risk/return comfort level, and find funds that fit well with that.  You have plenty of time, don't rush in and make mistakes.

[bradindenver]

I am currently in the 25% tax bracket and will be in the 15% tax bracket when I retire. Sounds like I need to max out that traditional 401k again to save on current taxes. I didn't know you could convert a traditional 401k to a Roth IRA after retirement. I'll clearly be looking into that, and thank you.

I do not rent or own a home. I live together with my parents and pay all the household bills (utilities, cable, phone, security, etc.). They are retired and this allows them a little extra to spend each month on things they enjoy doing. My total cost is about $400-$450 a month, which is a deal for me as well. Being a Little Mustache myself I would not have cable, phone, security and a LOT less each month on utilities but there is of course trade-offs! I feel I would be paying at least that much even renting an all inclusive room from someone, plus I love being with my folks at this point in my life. I am truly very fortunate.

I had ended up with the majority of my 401k in RZLRX due to several factors. The market volatility at the time was killing me and I just felt I needed some 'time out' from the craziness of it all, plus I had started to thinking about an early exit and asset preservation was in the front of my mind. I understand the need for equities for growth and now of course I have seen the other side of the recession with the increase of the markets over the last several years back up to the current level. All new monies will go into RRLSX, 68% equities, 22% bonds, 10% real estate. Sadly, the options are very limited.

So here is what I'm thinking so far: $16,500 to RRLSX in my traditional 401k going forward, $5,000 to my Roth IRA in SDY. I should then also have an additional $5,000 to $10,000 to invest in a taxable account at Vanquard, using your suggestions but with changes to allocations. Does this all make sense? Anyone else have ideas to look into?

[velocistar237]

It depends on your current tax bracket and the tax bracket you'll be in when you retire

I hear this all the time, but to be more specific, it depends on the weighted-average tax rate on that particular pile of money. For example, if you're $1000 into the 25% tax bracket, and you put $2000 in your 401k, then the tax rate on that money would be 20%, since the next lower bracket is currently 15%. This is also influenced by deductions. If you've decided to have a mortgage and give charitable contributions, etc., and that takes you down into the 10% tax bracket, then a Roth might be better than a regular 401k.

This matters even more on the future end. When retired, your deductions will probably be lower, so that you take the standard deduction (Rebel Spy excepted; he will be paying $1M in mortgage interest every year). The first pile of money up to the standard deduction will be taxed at zero, and the next at whatever that rate is at the time, say 15% (right now, it's 10%). Suppose the future brings you a standard deduction of $12K and expenses of $30K, then your weighted-average tax rate would be only 9%.

The take-away is that for someone with a high savings rate, it's probably always better to have a traditional rather than a Roth. Future taxes just won't increase enough on the low end to make a Roth worth it. I don't know whether or how FICA and state taxes would affect this analysis.

Maybe one strategy would be to split. Use a regular 401k down to the tax bracket that makes sense, and then use a Roth 401k for the rest. When you retire, use the regular 401k up through the standard deduction and the Roth for the rest. Has anyone heard of this before? It seems a little complicated, and I'm not sure it gets you much, unless tax rates in the lowest brackets increase. Maybe if someone goes part-time later in their career, they could use a regular 401k to push their income down into the 10% bracket, should it still exist, and then continue with the Roth if so desired.

The other advantage of a Roth 401k, which I think someone mentioned, is that you can withdraw the principal without tax or penalty (I think?), which would help someone get through the first five years of their Roth rollover pipeline.

[elysianfields]

So here is what I'm thinking so far: $16,500 to RRLSX in my traditional 401k going forward, $5,000 to my Roth IRA in SDY. I should then also have an additional $5,000 to $10,000 to invest in a taxable account at Vanquard, using your suggestions but with changes to allocations. Does this all make sense? Anyone else have ideas to look into?

Just to point out that the maximum 401(k) deferral amount this year is $17,000, an increase from the $16,500 level last year.

You've got a great situation, living with your parents at such low expenses, as it doesn't work for everyone.

[elysianfields]

It depends on your current tax bracket and the tax bracket you'll be in when you retire

I hear this all the time, but to be more specific, it depends on the weighted-average tax rate on that particular pile of money. For example, if you're $1000 into the 25% tax bracket, and you put $2000 in your 401k, then the tax rate on that money would be 20%, since the next lower bracket is currently 15%. This is also influenced by deductions. If you've decided to have a mortgage and give charitable contributions, etc., and that takes you down into the 10% tax bracket, then a Roth might be better than a regular 401k.

This matters even more on the future end. When retired, your deductions will probably be lower, so that you take the standard deduction (Rebel Spy excepted; he will be paying $1M in mortgage interest every year). The first pile of money up to the standard deduction will be taxed at zero, and the next at whatever that rate is at the time, say 15% (right now, it's 10%). Suppose the future brings you a standard deduction of $12K and expenses of $30K, then your weighted-average tax rate would be only 9%.

The take-away is that for someone with a high savings rate, it's probably always better to have a traditional rather than a Roth. Future taxes just won't increase enough on the low end to make a Roth worth it. I don't know whether or how FICA and state taxes would affect this analysis.

Maybe one strategy would be to split. Use a regular 401k down to the tax bracket that makes sense, and then use a Roth 401k for the rest. When you retire, use the regular 401k up through the standard deduction and the Roth for the rest. Has anyone heard of this before? It seems a little complicated, and I'm not sure it gets you much, unless tax rates in the lowest brackets increase. Maybe if someone goes part-time later in their career, they could use a regular 401k to push their income down into the 10% bracket, should it still exist, and then continue with the Roth if so desired.

The other advantage of a Roth 401k, which I think someone mentioned, is that you can withdraw the principal without tax or penalty (I think?), which would help someone get through the first five years of their Roth rollover pipeline.

You're right that it's more complex than I made it seem, especially since the Bush tax cuts are slated to expire at the end of this year.  If the Congress doesn't act, the 10% tax rate will disappear, the 25% bracket will increase to 28%, the 28% rate reverts to 31%, 33% reverts to 36%, and the 35% rate reverts to 39.6%.  Capital gains rates also revert to their previous level in 2000, the special treatment of dividends disappears, and estate taxes also revert.

Furthermore, and unrelated to the Bush tax cuts, a 3.9% investment surtax on investment income above $250,000 will come into effect in 2013.

It's so complicated, and so difficult to predict future tax rates and treatments, that you're probably right, one should hedge one's bets between pre-tax and post-tax contributions to tax-deferred savings vehicles.