Question - Taxable Accounts vs Retirement Investing

[mustache110]

Hey guys,

Found this site a few months ago and have slowly been grooming my stache to get my spending in check. My wife and I are currently slashing our bills one by one and generating a savings surplus to invest for early retirement. However, I am unsure as to how to divide investments between retirement accounts (for old man money) vs taxable mutual funds (for the gap years between retirement and my old man money). I have searched around the site and the forum and can't find a clear answer to this, so wanted to ask it here since many of you have this stuff nailed down (and, despite me having an MBA, I suck hard at math!).

Here is my current position:

1. Age: I'm 31, and the wife is 34 (with a 2 year old)
2. Annual Income: mid 80's, though this will go up when my wife goes back to work this year.
3. Pre-Mustachian monthly spending was previously around 4k, but we have yet recalculated this since we have been ultra-focused on bill cutting (and, oh yeah, raising the little one!). It will obviously be much lower, but have to sit down with the wife after the holidays are over to get the numbers. So, whatever the surplus is will go towards investing.
4.  Mortgage: 93k remaining with 3% interest rate. Year 3 of 15 year term.
5. IRA - 72k
6. Roth IRA/401K - 42k
7. Savings - 48k...was previously on the Dave Ramsey Plan of healthy emergency funds, but going to invest a substantial chunk of this when I make the decision.
8. No Rental Properties

I am currently only investing 6% in my 401k to get the match, so not sure if I should focus on maxing that out first before I focus on taxable accounts at all? Or, do I need some sort of blended rate to cover the gap years before I can touch retirement accounts? So, what do you guys think or do you need more information? Thanks for the help!

[DrF]

Are you a 1 income family? Do both of you contribute to your employer retirement accounts?

What types of IRAs do you have? If you pay more than 15% tax (fed rate) then you should contribute to traditional IRAs. Both of you can have an IRA even if only 1 of you is working.

Are the investment options in your 401k(s) good? What are the expense ratios (ERs) of the funds you are invested in?

My recommended buckets are: add to 401k(s) to get the match > max out traditional IRAs > max out remaining 401k(s) > max any other pre-tax options you have > any left over goes into a taxable account.

[GGNoob]

If you plan on retiring early, all you really need is access to 5 years worth of expenses. This could be saved in a taxable savings/investment account or could be Roth IRA contributions that you can withdraw anytime penalty free. The rest of your money should be in retirement accounts for the tax benefits. Then for the remaining years you would access your retirement money through a Roth IRA conversion ladder or the IRS rule 72(t). I don't have any great links to share on those, but somebody here might. The Roth IRA ladder basically means that every year (in early retirement) you convert 1 years worth of expenses from a Traditional IRA/401k to a Roth IRA. Then 5 years later, you can withdraw that money tax and penalty free. I don't know exactly what the rule 72(t) is so I won't even try.

Thankfully I don't have to worry about any of that because I have access to a 457 Plan that I can withdraw from anytime once I leave my job.

[Monark]

Based on the information you provided, I would do the following: 1) increase your 401(k) savings up to 10-15%. 2) continue to max out your IRA/Roth IRA each year. 3) put a chunk of your savings into the mortgage and try paying that off in 10 years rather than 15. 4) consider a 529 plan for Junior--state of Utah has a great one. 5) unless you're really handy, forget about a rental property.  If you really want real estate exposure, then put some money into a REIT fund.  6) open a joint taxable acct for you and your wife at Vanguard and start making regular auto-deposits into one of the Target Retirement funds. 7) if you still have more to invest, max of the 401k then put remainder into the Target Retirement fund. 

A note on your emergency funds: this is really specific to the individual situation.  For example, someone in sales is much more likely to get laid off than say a nurse or a doctor.  If you have a high-risk job, I think 6 months of emergency money is reasonable time to find a new job.  If you have a very low-risk job (e.g. doctor), I wouldn't keep more than an extra month's worth of expenses in your savings acct.  As MMM says, you gotta make sure you're putting your little green foot soldiers to work. 

[mustache110]

Are you a 1 income family? Do both of you contribute to your employer retirement accounts?

What types of IRAs do you have? If you pay more than 15% tax (fed rate) then you should contribute to traditional IRAs. Both of you can have an IRA even if only 1 of you is working.

Are the investment options in your 401k(s) good? What are the expense ratios (ERs) of the funds you are invested in?

My recommended buckets are: add to 401k(s) to get the match > max out traditional IRAs > max out remaining 401k(s) > max any other pre-tax options you have > any left over goes into a taxable account.

Thanks for the advice!

Currently, we are a one income couple, but will be two when my wife finds a job (will start looking after the year). For now, we have maxed out our Roth for the year. I'm of the opinion that tax rates will be higher when I'm older (obviously no one knows for sure), so that's why I've been focused on the Roth vs Pre-Tax. Plus, I get some small additional "utility value" from exactly how much I have at one time without considering taxes. Looks like you are advocating maxing out retirement funds, though.

The investment options are good, though I've chosen a target date fund so that I don't have to think about it. The expense fees are .61%, so not sure how that compares to the average.

[mustache110]

If you plan on retiring early, all you really need is access to 5 years worth of expenses. This could be saved in a taxable savings/investment account or could be Roth IRA contributions that you can withdraw anytime penalty free. The rest of your money should be in retirement accounts for the tax benefits. Then for the remaining years you would access your retirement money through a Roth IRA conversion ladder or the IRS rule 72(t). I don't have any great links to share on those, but somebody here might. The Roth IRA ladder basically means that every year (in early retirement) you convert 1 years worth of expenses from a Traditional IRA/401k to a Roth IRA. Then 5 years later, you can withdraw that money tax and penalty free. I don't know exactly what the rule 72(t) is so I won't even try.

Thankfully I don't have to worry about any of that because I have access to a 457 Plan that I can withdraw from anytime once I leave my job.

OHHHHH I think I really get the value of that rule now. That was a huge lightbulb I think. Gracias.

So, for example, if I invest 17,500 today into a traditional IRA, then I could let it grow until such time that I want to retire (let's say I want to retire at 45). At age 40, I would convert that over to a Roth IRA (and pay taxes), which I would then be able to withdraw at 45 tax free since at that point it would be viewed as a Roth "contribution"?

That being the case, are you just permitted to withdraw whatever you put into a Roth 401(k) per the same guidelines, or does it only apply to IRA's?

[DrF]

Ouch, .61% is pretty steep in this day and age. It may be the best you have available to you through your 401k though. You did say target retirement fund. Can you list the ~5 lowest cost funds you have available in your 401k?

You can probably save a bunch by mixing your own.

Get your spouse an IRA pronto! Max it out for 2014, then max it out for 2015.

Please read this article about pre-tax investing.

http://www.madfientist.com/retire-even-earlier/

[mustache110]

Based on the information you provided, I would do the following: 1) increase your 401(k) savings up to 10-15%. 2) continue to max out your IRA/Roth IRA each year. 3) put a chunk of your savings into the mortgage and try paying that off in 10 years rather than 15. 4) consider a 529 plan for Junior--state of Utah has a great one. 5) unless you're really handy, forget about a rental property.  If you really want real estate exposure, then put some money into a REIT fund.  6) open a joint taxable acct for you and your wife at Vanguard and start making regular auto-deposits into one of the Target Retirement funds. 7) if you still have more to invest, max of the 401k then put remainder into the Target Retirement fund. 

A note on your emergency funds: this is really specific to the individual situation.  For example, someone in sales is much more likely to get laid off than say a nurse or a doctor.  If you have a high-risk job, I think 6 months of emergency money is reasonable time to find a new job.  If you have a very low-risk job (e.g. doctor), I wouldn't keep more than an extra month's worth of expenses in your savings acct.  As MMM says, you gotta make sure you're putting your little green foot soldiers to work.

Yes, absolutely I'm not in for rentals. Though I'm quite handy, I've heard plenty of headaches about those that I would do REITs if anything. For the emergency fund, I'm in a relatively stable job/field (knock on wood), but I do want to invest it a little more aggressively since it's a big chunk of change just sitting there. With this new lifestyle, I worry a lot less about things like a job loss anyways (come to think of it, it's probably way more than 1 year's worth of Mustachian level expenses, anyway).

So your strategy is to start a split between taxable and tax-advantaged. Interesting that it seems to be the opposite of the other two...are there multiple schools of thought on this, then?

Thanks for all the help everyone.

[mustache110]

Ouch, .61% is pretty steep in this day and age. It may be the best you have available to you through your 401k though. You did say target retirement fund. Can you list the ~5 lowest cost funds you have available in your 401k?

You can probably save a bunch by mixing your own.

Get your spouse an IRA pronto! Max it out for 2014, then max it out for 2015.

Please read this article about pre-tax investing.

http://www.madfientist.com/retire-even-earlier/

Yeah, honestly have never even checked the investment fees as it's been a set and forget piece (I hate to think of spending time rebalancing, although I may just have to). For each step I take, seems there's three more to learn. :)

Here are the five lowest fees available:
   LARGE CAP INDEX  - .03%
 BOND INDEX  - .06%
MID CAP INDEX - .07
 SMALL CAP INDEX - 0.07
VANG PRIME MM INST (VMRXX) - .1

[GGNoob]

If you plan on retiring early, all you really need is access to 5 years worth of expenses. This could be saved in a taxable savings/investment account or could be Roth IRA contributions that you can withdraw anytime penalty free. The rest of your money should be in retirement accounts for the tax benefits. Then for the remaining years you would access your retirement money through a Roth IRA conversion ladder or the IRS rule 72(t). I don't have any great links to share on those, but somebody here might. The Roth IRA ladder basically means that every year (in early retirement) you convert 1 years worth of expenses from a Traditional IRA/401k to a Roth IRA. Then 5 years later, you can withdraw that money tax and penalty free. I don't know exactly what the rule 72(t) is so I won't even try.

Thankfully I don't have to worry about any of that because I have access to a 457 Plan that I can withdraw from anytime once I leave my job.

OHHHHH I think I really get the value of that rule now. That was a huge lightbulb I think. Gracias.

So, for example, if I invest 17,500 today into a traditional IRA, then I could let it grow until such time that I want to retire (let's say I want to retire at 45). At age 40, I would convert that over to a Roth IRA (and pay taxes), which I would then be able to withdraw at 45 tax free since at that point it would be viewed as a Roth "contribution"?

That being the case, are you just permitted to withdraw whatever you put into a Roth 401(k) per the same guidelines, or does it only apply to IRA's?

You're welcome! It really is as simple as that...convert an amount each year from Traditional to Roth and withdraw it 5 years later tax and penalty free.

I think you have to wait until 59.5 years old for a 401k, regardless of Roth or Traditional. But I'm not entirely sure on that.

[GGNoob]

Ouch, .61% is pretty steep in this day and age. It may be the best you have available to you through your 401k though. You did say target retirement fund. Can you list the ~5 lowest cost funds you have available in your 401k?

You can probably save a bunch by mixing your own.

Get your spouse an IRA pronto! Max it out for 2014, then max it out for 2015.

Please read this article about pre-tax investing.

http://www.madfientist.com/retire-even-earlier/

Yeah, honestly have never even checked the investment fees as it's been a set and forget piece (I hate to think of spending time rebalancing, although I may just have to). For each step I take, seems there's three more to learn. :)

Here are the five lowest fees available:
   LARGE CAP INDEX  - .03%
 BOND INDEX  - .06%
MID CAP INDEX - .07
 SMALL CAP INDEX - 0.07
VANG PRIME MM INST (VMRXX) - .1

Looks like your 401k has some really cheap index funds. I bet there is a cheap international fund as well. So you'd want to create your own asset allocation by mixing those...

Large Cap Index
Mid Cap Index
Small Cap Index
International Index (assuming you have one)
Bond Index

Then I agree with DrFunk that you should really get your wife an IRA and max both yours and hers each year. My goal is eventually to max all tax-advantaged accounts. After reading the website he mentioned and this website (http://rootofgood.com/make-six-figure-income-pay-no-tax/), I did some of my own calculations. If my wife and I max out all of our tax-advantaged accounts with tax-deferred investments (traditional accounts), we can get our tax rate down to like 3% federal with a household gross income of over $125k. Not bad.

[DrF]

DO NOT pay off your mortgage early. It is a waste of your green soldiers while you have mortgage interest at 3%.

I would immediately transfer all assets in your 401k to the following:

80% Large cap
10% mid cap
10% small cap

if you REALLY want some bonds then do 70% large cap and add 10% bonds (or even less, 5%).

Set your continuing contributions to the same. Rebalance 1x per year, or every other year back to 80/10/10.

The target fund would have to earn > 0.5% every year forever to make it worthwhile (hint, it won't).

[mustache110]

Thanks guys. This is even more info than what I was expecting. And no, I'm not going to be paying off the mortgage early, at least not for now.

I set some time on the calendar in two weeks and will be taking the lead on my investments. I'm going to do some further research and read the articles a few more times, but I'm guessing I'll be coming to a percentage matching what you prescribed.

One last one though...as you get closer to retirement, will you guys be getting more conservative over time to reduce principal risk, or no since we will need it for longer than the Average Joe?

[DrF]

I will switch mine to a more dividend centric portfolio. It won't matter what the stocks are doing, just as long as my dividend checks keep coming.

[GGNoob]

DO NOT pay off your mortgage early. It is a waste of your green soldiers while you have mortgage interest at 3%.

I would immediately transfer all assets in your 401k to the following:

80% Large cap
10% mid cap
10% small cap

if you REALLY want some bonds then do 70% large cap and add 10% bonds (or even less, 5%).

Set your continuing contributions to the same. Rebalance 1x per year, or every other year back to 80/10/10.

The target fund would have to earn > 0.5% every year forever to make it worthwhile (hint, it won't).

Assuming you have a cheap international index fund, I'd include that to something like this:

56% Large-Cap Index
7% Mid-Cap Index
7% Small-Cap Index
30% International Index

Unless of course your international allocation is in your IRA accounts.

If you aren't going to be able to handle seeing large drops in your retirement balance during crashes, then you may want to add bonds. Then you could shift your account to more bonds as you get closer to retirement. The above allocation can be the allocation for your stocks. Bogleheads (bogleheads.org) would recommend a minimum of 20% bonds. Personally, I plan to be 100% stocks for life.