Author Topic: No clue where to invest; rethinking my 401(k) contribution  (Read 2610 times)

SyZ

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No clue where to invest; rethinking my 401(k) contribution
« on: September 18, 2016, 12:11:14 AM »
I am currently putting $18k a year into the 401(k), but the company only matches up to 5%. I am not sure why I am not putting the rest into a standard brokerage account. Can somebody please explain the difference? My understanding is that in exchange for not facing any tax penalties until I withdraw my money, I can't withdraw it until 59.5. If I put it into a brokerage account instead, I can withdraw earlier but will have to pay taxes on the gains. Why, then, does everyone advocate maxing the 401(k) contribution if everyone on here wants to retire by 40?

Separate from that, I'm looking at Vanguard funds in case I decide to move the difference from the 18k max and the 5% match into a brokerage account. How in the world is a BOND fund tracking over 10% returns for almost 10 years? https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0930#tab=1 - and how is it classified as high risk? U.S. bonds are literally the safest investment on earth because if the government actually runs out of money (and the world doesn't collapse as a result) they just print more and continue to pay me.


badbear

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #1 on: September 18, 2016, 03:28:29 AM »
Typically the early retirement strategy of investing in a tradition 401k/IRA is to do a Roth IRA conversion each year during retirement when you will pay little tax on the conversion. After 5 years you can withdraw the converted amount from the Roth IRA tax free to pay for living expenses. This is known as a roth conversion ladder. It's also probably a good idea to have investments in a taxable brokerage account to live off of during the 5 years until you can withdraw from the Roth. An alternative is to take substantially identical withdrawals (known as 72t distributions) from the 401k/Traditional IRA without penalty every year, but you'll have to keep this up until you reach 59.5.

The bond fund you mention is a long term treasury bond fund. Long term bond are highly sensitive to interest rate fluctuations. When interests rates fall, as they have been for quite a long time, the value of higher interest rate long term bonds go up. If interest rates rise again in the next few years, you can expect the long term bond fund to fall in value. Given that interest rates are at historic lows, now likely would be a pretty bad time to buy into a long term bond fund. Intermediate term bonds, like Vanguard Total Bond, are less sensitive to interest rates because they have a much shorter duration, but will still go down in value with rising interest rates. Hopefully that will be made up for in increased bond yield from buying new higher-yielding bonds.

AdrianC

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #2 on: September 18, 2016, 07:00:05 AM »
Why, then, does everyone advocate maxing the 401(k) contribution if everyone on here wants to retire by 40?

You aren't paying income tax now on that $18K.

seattlecyclone

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #3 on: September 18, 2016, 09:07:54 AM »
You can withdraw from your 401(k) at any time after you leave your company, regardless of age. If you do it "right" (Roth conversion ladder or Substantially Equal Periodic Payments) you'll only pay your regular tax rate on the withdrawal. If not, you'll pay an extra 10%. If you're like most of us and expecting a significantly lower income during retirement, the Roth ladder is almost certainly a better deal than using a taxable brokerage account now.  If you expect to have a marginal tax rate at least 10% lower, you can even do better than a brokerage account by doing regular withdrawals and paying the 10%.

SyZ

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #4 on: September 18, 2016, 03:26:47 PM »
So how do I save for a home at this point in time? I need to put 18k in the 401(k), then invest on top of that in a brokerage account, and then once I have enough I need to withdraw from the brokerage, which is also subject to tax penalties?

When do I need to start doing this Roth conversion?

I anticipate retiring anywhere between 50-55, but I currently have no brokerage account and all my retirement money is in the 401(k). There is also a strong possibility I will leave my job within a year. I can't imagine taking out more than $30-$40k a year in retirement (in today's money), so would I want to continue to ignore a Roth component as I pay more on taxes later than now?

badbear

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #5 on: September 18, 2016, 04:03:49 PM »
So how do I save for a home at this point in time? I need to put 18k in the 401(k), then invest on top of that in a brokerage account, and then once I have enough I need to withdraw from the brokerage, which is also subject to tax penalties? 

If you sell investments in your taxable brokerage account you will need to pay long term capital gains tax if you have held the investment for more than a year (or short term capital gains at a higher tax rate if held for less than a year). Basically you pay tax on the increase in value of the shares since you bought them. The tax rate depends on your tax bracket. Long term cap gains rates are 0% if you are in the 15% tax bracket or lower, or 15% rate in the 25% or higher tax bracket. Short term capital gains tax rates are a bit higher, so that should be avoided if possible.

MustacheAndaHalf

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #6 on: September 19, 2016, 02:14:44 AM »
How in the world is a BOND fund tracking over 10% returns for almost 10 years? https://personal.vanguard.com/us/funds/snapshot?FundIntExt=INT&FundId=0930#tab=1 - and how is it classified as high risk? U.S. bonds are literally the safest investment on earth because if the government actually runs out of money (and the world doesn't collapse as a result) they just print more and continue to pay me.
You only referred to one kind of risk: default risk, where the U.S. government will repay the bond on the exact date specified.  But what if you won't wait 25 years to sell?  The U.S. government won't buy it back before then.

The flip side is interest rate risk over the term of the bond.  If everyone else has worse bonds, yours go up in value.  If you hold a 3% bond when similar bonds earn 2%, your bond's value rises in market value to act like it's a 2% bond.  But it holds true in reverse - holding that 3% bond in a 4% environment causes a fall in value until your bond looks like a 4% bond.  You can multiply by duration to see the impact.  If everyone else has 1% worse bonds, a 25 year duration fund gains +25%.  And when rates rise, a fund like Extended Duration Treasury (EDV) loses -25%.

So the first answer is that fund doesn't actually have a 10 year track record.  But it was created at the end of 2007 when 30-year treasuries earned 4.49%, and today 30-year treasuries earn 2.44%.  All that drop in interest rates has benefited the bond fund.  But now that we're at 2.44% rates, do you expect them to fall another 2% down to 0.44% for 30 year bonds?  If not, don't expect the same performance going forward.

I would argue that certificates of deposit (CDs) are probably safer than U.S. treasury bonds, but not as easily cashed.  With a CD, you won't lose money.  The government guarantee (FDIC) applies, and if you see rising rates you have the option to trade a penalty to get higher rates.  With a bond fund, you just lose market value in that same situation.

Heckler

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #7 on: September 19, 2016, 08:41:20 AM »
http://canadiancouchpotato.com/2015/05/18/how-changing-interest-rates-affect-fixed-income/

Heres a great article that helped me understand how bonds work.

jjandjab

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #8 on: September 19, 2016, 09:06:24 AM »
The other folks gave some great info on bonds - I had similar feelings to yours in the past about the long term bond funds until I figured out they were far more complex than I had thought, and they are not always the "safe" investments that the basic investor believes. A broad bond index fund, with a relatively short duration is pretty safe, but at this point the long term bond fund are really a gamble and all up to the Fed...

In terms of your 401k, the major reason you want to contribute as much as you can - as AdrianC said - is that it decreases your current income by the full 18k, saving a significant amount on taxes. Say you pay 25% fed and 5% state tax - you get an instant 30% return on that 401k money.

Now whether you want to continue to do that much really depends on whether you have "emergency funds", especially if you are going to leave your job soon as you say... Then it might be in your best interest to start saving some more outside of the 401k if that is your only source of savings. Same if you are starting to save for a house. Also look at Roth IRAs, since you can withdraw contributions for a house, etc...

SyZ

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #9 on: September 19, 2016, 10:50:11 PM »
So is this how it all works? Assuming $100k income, 25% tax bracket, exact same investments across all accounts, a full emergency fund in cash, $30k flat yearly expenses including food, rent/mortgage, insurance, gas, any outstanding debt, etc., all just for the purposes of simplification.

$100k income
-$18k in 401(k)

$82k income
-$20.5k in taxes

$61.5k left
-$30k expenses

$31.5k left
-$5.5k Roth 401(k) / traditional Roth

$26k left
$26k into mutual funds / ETFs

So, at the end of the day, $18k is in a 401(k), $5.5k is in a Roth 401(k) / traditional Roth, $26k is in mutual funds / ETFs

The $18k is designed to grow continuously until retirement, at which point withdrawals will be made regularly, and taxed at the income at retirement, which includes total income from pensions, social security, and all three of these accounts. If it's less than $100k, I pay less in taxes than if I had not invested this in the 401(k) and instead added it to the $26k. If it's more than $100k, I pay more in taxes than if I had not invested this in the 401(k) and instead added it to the $26k. This money is very hard to access quickly pre-retirement, and requires years of backdoor shenanigans to convert it to the Roth account.

The $5.5k is designed to grow continuously until retirement, but I have already paid taxes on this income and therefore when I go to withdraw the money at retirement it is tax-free. The balance of this account will be much less than the above and below accounts as it's limited to $5.5k a year due to this tax-advantage. This money is also hard to withdraw before retirement, and I have a breakdown on how I get access to it.

The $26k is 'left-over' money that is not allocated above. Essentially, I needed $74k to break even with all my expenses and maxing the above two accounts, but have an extra $26k. Instead of leaving it in the bank or under my bed, I invest it in ETFs or mutual funds. This is after-tax money, like with the Roth, but any gains I make on these investments will be taxed again (wtf?) depending on how much the gain is and how long I held the investment. In addition, I need to pay a yearly expense ratio, further cutting into any potential profit. This money is relatively liquid, in the sense I can sell a portion of my portfolio and have access to the money within a day or so.

badbear

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #10 on: September 20, 2016, 03:32:31 AM »
A couple of things to note:

A Traditional IRA decreases your taxable income by the amount you contribute. A Roth is after tax money that will never be taxed again as long as you follow the rules for withdrawals. The limit on combined contributions to IRAs is currently $5500, but that money can split between Roth and Traditional however you like. If you have both a Roth 401k and Traditional 401k you can also contribute to both, but the total 401k contributions are limited to $18000. You can adjust what your taxable income will be by varying the amount of Traditional contributions, potentially reducing it by up to $23500.

If you max all traditional 401k/IRA, assuming a $100,000 single person, you will pay $7450 (7.45%) in SS/Medicare tax + $12,315 income tax on your $76,500 taxable income. That comes to a total tax of $19,765. This assumes standard deduction/exemption. State taxes and unemployment insurance may be additional for you, I don't know where you live.

If you are single, maxing all traditional accounts, and making $100,000 then it saves you $5875 in taxes all in the 25% tax bracket. A married couple at that income could potentially get down into the 15% tax bracket, where long term capital gains and qualified dividends are not taxed at all.

Since total stock market index funds almost exclusively pay qualified dividends, you'll want to have those preferentially in your taxable accounts. Unlike in your retirement accounts, in taxable you can take advantage of tax loss harvesting to offset some income, and losses can be carried over to future years.

If you FIRE young with a stash and lifestyle like MMM you will almost certainly be in a lower tax bracket in retirement, so traditional makes sense. You can fill up your 0% and 10% and some or all of your 15% bracket with Roth conversions or capital gains from selling taxable investments. If you stay in the 15% bracket, you pay almost no tax on the taxable account as long as you don't keep things like bonds, active mutual funds, or REITs in there. If you hold an international stock index fund, taxable accounts are a good place for them since you can get a tax credit for taxes paid to foreign governments by the fund (max $300 IIRC) and they also mostly have qualified dividends (not taxed in 15% bracket). Bonds and REITs whose distributions are taxed at income tax rates are best kept in your retirement accounts.

The other advantage to holding stock funds in taxable is that when you die, your heirs receive a stepped up cost basis on the value of the shares. I.e. it's as if they purchased them for the price on the day of your death. Potentially this avoids a TON of tax if you held those shares most of your lifetime.

Depending how soon you want to make a home purchase you might just want to keep those savings earmarked for it in the best savings account you can find for now. If it will be in the next year or two I think I'd leave it out of the market. It would suck if the market tanked right before you were looking to buy.

Hope that helps.

seattlecyclone

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Re: No clue where to invest; rethinking my 401(k) contribution
« Reply #11 on: September 20, 2016, 09:15:40 AM »
So is this how it all works? Assuming $100k income, 25% tax bracket, exact same investments across all accounts, a full emergency fund in cash, $30k flat yearly expenses including food, rent/mortgage, insurance, gas, any outstanding debt, etc., all just for the purposes of simplification.

Close, but not quite. It's really more like this:

Quote
$100k income
-$18k in 401(k)
Remember payroll tax! 7.65% off the top, before making 401(k) contributions = $7,650.

Quote
$82k income
-$20.5k in taxes

25% tax bracket does not mean you pay 25% of your total income. Instead it means that if you earned an extra dollar, you would pay 25 more in taxes. The way you really calculate it is more like this:
Assuming you're single and don't itemize your deductions, this means you get to subtract a $6,300 standard deduction and $4,050 personal exemption.
This leaves a taxable income of $71,650. This income level is in the 25% bracket, but this does not mean you pay 25% of $71,650 in taxes.

Instead you pay the amount for each bracket, meaning:
10% of first $9,275 = $927.50
15% between $9,275 and $37,650 = $4,256.25
25% of the amount above $37,650 = $8,500.00
Total federal income tax = $13,683.75

This is a simplification that fails to account for any number of deductions and credits that you may qualify for, but it's a start.

Quote
$61.5k left $100k - $18k - $7,650 - $13,683.75 = $60,666.25 left
-$30k expenses

$31.5k left $30,666.25 left
-$5.5k Roth 401(k) / traditional Roth

You have already completed your $18k of 401(k) contributions, so you can't contribute more to your Roth 401(k). There's no such thing as a "traditional Roth" either. This $5,500 would go to a Roth IRA. If you earned a bit less you could perhaps contribute to a traditional IRA instead (which is pre-tax), but it has an income limit of $61,000 for single people to make a full contribution.

Quote
$26k left $25,166.25 left
$26k $25,166.25 into mutual funds / ETFs

So, at the end of the day, $18k is in a 401(k), $5.5k is in a Roth 401(k) / traditional Roth Roth IRA, $26k $25,166.25 is in mutual funds / ETFs

The $18k is designed to grow continuously until retirement, at which point withdrawals will be made regularly, and taxed at the income at retirement, which includes total income from pensions, social security, and all three of these accounts.

Generally, yes. Remember that withdrawals from your Roth IRA generally don't count as income, nor does the principal part of withdrawals from your taxable account. Therefore if you have money in these types of accounts, you should often expect your retirement income to be less than your expenses.

Quote
If it's less than $100k, I pay less in taxes than if I had not invested this in the 401(k) and instead added it to the $26k. If it's more than $100k, I pay more in taxes than if I had not invested this in the 401(k) and instead added it to the $26k. This money is very hard to access quickly pre-retirement, and requires years of backdoor shenanigans to convert it to the Roth account.

Retirement fund money is very easy to access prior to retirement, so long as it's not in your 401(k) with your current employer. You just need to ask for a withdrawal and you'll have it. The catch is that you'll likely have to pay 10% extra in taxes on that money if it's in a traditional IRA/401(k) and you haven't done the "shenanigans" first.