Author Topic: Should we invest in our IRA's?  (Read 4517 times)

PencilMustache

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Should we invest in our IRA's?
« on: February 18, 2014, 08:33:31 AM »
Hello all,

Currently my wife makes about 105k per year and contributes 5% to her matched 401k, which leaves us with around 80k after taxes. Using a take-home-pay calculator, we predict that with an income from me somewhere around 50k (and 5% to 401k) we will have a total take home pay of around 110k. 20k of this we will have to use for living expenses, which leaves 90k per year for investing.

We are fairly young (in our early 20's) and were planning on a retirement date of around 2026 and were hoping to draw somewhere around 40k per year (in case of children expenses).

Our question was: should we both contribute to our ira's? At a max total contribution of 11k per year, it is a significant percentage of our investment money that we won't be able to have any access to until we are much older, and is thus unable to help with any fluctuations in the market.

Thanks in advance for your advice and I am happy to provide any further information if this was too unclear.

sherr

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Re: Should we invest in our IRA's?
« Reply #1 on: February 18, 2014, 09:03:08 AM »
Yes. But...

What is really beneficial for you as high-income earners is putting money in traditional 401k or traditional IRA accounts. Every dollar you invest in a traditional IRA / 401k has an immediate 25% gain due to not having to pay taxes on it. However, because you earn so much you are not actually eligible to deduct you traditional IRA contributions from your taxes, so that benefit goes away. http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/2014--IRA-Contribution-and-Deduction-Limits---Effect-of-Modified-AGI-on-Deductible-Contributions-If-You-ARE-Covered-by-a-Retirement-Plan-at-Work

What would be best for you then is for you both to contribute the maximum you can to your 401ks, currently $17,500 / year each. Then, after that's done, if you still have extra money to invest then yes, contributing to a Roth IRA is stlil better than just putting things in a regular taxable account (but not quite as good as a traditional IRA unless you're planning on spending *a lot* of money per year in retirement).

At a max total contribution of 11k per year, it is a significant percentage of our investment money that we won't be able to have any access to until we are much older,

This is not really entirely true. There are several ways to get your money out early from your IRAs / 401ks without paying the penalty. One is to take Substantially Equal Periodic Payments from it until you reach retirement age. The other is to enact what is known as a "Roth pipeline", see here for an explanation: http://www.mrmoneymustache.com/forum/ask-a-mustachian/help-me-understand-the-roth-conversion-pipeline-idea-and-its-benefits/

Even if that's not true and you do have to pay the 10% penalty, if you're withdrawing money because you retired early then it's still probable that your average-income-tax-rate + 10% penalty will be less than your current tax bracket of 25%, therefore making it still profitable to use tax-advantaged accounts.

and is thus unable to help with any fluctuations in the market.

Well I'm not really sure what you meant by that, but I think you're wrong. If you mean that you want to withdraw money from the stock market when it's high and add money to it when it's low, then there are two problems with that:
1) it's virtually impossible to tell when the stock market is high or low. If you could do that you could be a billionaire investor. "The market can remain irrational longer than you can remain solvent."
2) you can do that even if your money is in a 401k / IRA. Simply transfer money out of your stock mutual fund and into a bond mutual fund, or REIT, or gold fund, or whatever (in the 401k's case: assuming that your company has provided those options). The only thing that having money in a 401k / IRA prevents you from doing willy-nilly is taking money out and putting it into your checking account.

But regardless, by leaving your money in "for the long haul" you *would* be riding out the fluctuations of the stock market, and therefore getting the average annual return from the stock market. The problem people have with fluctuations is that they sell all their stock right after a crash, which is the absolute worst thing you can do. To many people, the more inaccessible their money is the better. You may want to read up on "dollar-cost averaging" for a more full discussion on the topic.
« Last Edit: February 18, 2014, 09:05:03 AM by sherr »

PencilMustache

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Re: Should we invest in our IRA's?
« Reply #2 on: February 18, 2014, 10:28:47 AM »
Quote
Even if that's not true and you do have to pay the 10% penalty, if you're withdrawing money because you retired early then it's still probable that your average-income-tax-rate + 10% penalty will be less than your current tax bracket of 25%, therefore making it still profitable to use tax-advantaged accounts.

This might be a very silly question, but after I retire, does the money I take out of my investment accounts to live on get taxed with capital gains tax, income tax, or both?

PencilMustache

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Re: Should we invest in our IRA's?
« Reply #3 on: February 18, 2014, 11:27:54 AM »
This might be a very silly question, but after I retire, does the money I take out of my investment accounts to live on get taxed with capital gains tax, income tax, or both?

Someone correct me if I'm wrong, but I think I may have answered my own question. According to 2014 tax rates, if we withdrew 20k from our investments every year after retirement, then we would technically be in the 15% tax bracket if this were normal income. Since we are in the bottom two tax brackets, we would pay 0% capital gains tax (according to this page: http://taxes.about.com/od/Federal-Income-Taxes/fl/Federal-Income-Tax-Rates-for-the-Year-2014.htm).

This would mean that if we withdrew money early from our 401k or Traditional IRA, we would end up losing only 10% to taxes and penalties combined, which is a lot less than the 25% we would lose currently by putting it into taxable accounts.

Am I correct in this, or totally off?

Cromacster

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Re: Should we invest in our IRA's?
« Reply #4 on: February 18, 2014, 12:00:07 PM »
Eh your off...mostly.  401(k) and IRA withdrawals are taxed as income.

In early retirement you don't withdraw money from a 410(k) or an IRA and pay the penalty.

You roll over the 401(k) to an IRA, then as you need it you rollover money from you IRA to your Roth IRA, and pay income taxes.  Wait 5 years and the money is yours.

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

Vjklander

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Re: Should we invest in our IRA's?
« Reply #5 on: February 18, 2014, 12:55:11 PM »
I think you missed the part where his combined income is above the IRA limits. His best bet is to max out the 401Ks, then max out His-n-Hers Roth IRAs, then invest in a regular brokerage account. The Roth IRAs work well for him as he can pull out the capital down the road if he needs to. The penalty would only come into play if he pulled out the earnings from the Roth IRA and would only apply to the earnings.
I set up brokerage accounts for all of my family and a lot of friends. Nothing but good blue-chip stocks paying a decent dividend. This creates an income stream that should eventually carry into retirement.  My Mother-in-law's account yields over 5k per month. Even with her fairly generous gifts and donations, I have never had to sell a single share of stock and the balance is greater than ever. Her retirement income and dividends cover everything.

Cromacster

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Re: Should we invest in our IRA's?
« Reply #6 on: February 18, 2014, 02:19:28 PM »
I think you missed the part where his combined income is above the IRA limits. His best bet is to max out the 401Ks, then max out His-n-Hers Roth IRAs, then invest in a regular brokerage account. The Roth IRAs work well for him as he can pull out the capital down the road if he needs to. The penalty would only come into play if he pulled out the earnings from the Roth IRA and would only apply to the earnings.
I set up brokerage accounts for all of my family and a lot of friends. Nothing but good blue-chip stocks paying a decent dividend. This creates an income stream that should eventually carry into retirement.  My Mother-in-law's account yields over 5k per month. Even with her fairly generous gifts and donations, I have never had to sell a single share of stock and the balance is greater than ever. Her retirement income and dividends cover everything.

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

Again, read the madfientist link it explains it all better than I can.

GlassStash

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Re: Should we invest in our IRA's?
« Reply #7 on: February 18, 2014, 09:21:20 PM »
There is no reason not to max tax advantaged accounts for fear of not being able to access the funds before age 59.5. While there may be situations where paying the 10% penalty and very little capital gains are better than paying the 25% rate, paying a penalty is a complete waste of money. As Cromacster linked, the Madfientist article outlines how to access 401k/Trad'l IRA money in early retirement. Neither of the two methods, the Roth conversion ladder or 72(t), incur a penalty.

Vjklander

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Re: Should we invest in our IRA's?
« Reply #8 on: February 19, 2014, 04:35:39 AM »

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

True, but he has 40 years to get to that point. My advice was for now. The premise is he will have 10s of thousands of dollars per year to do something with. The Roth IRAs will take a nibble out of that, but the tax free distributions in retirement would not be subject to his marginal tax rate at that time.
Vjk

sherr

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Re: Should we invest in our IRA's?
« Reply #9 on: February 19, 2014, 05:26:34 AM »
This might be a very silly question, but after I retire, does the money I take out of my investment accounts to live on get taxed with capital gains tax, income tax, or both?

Someone correct me if I'm wrong, but I think I may have answered my own question. According to 2014 tax rates, if we withdrew 20k from our investments every year after retirement, then we would technically be in the 15% tax bracket if this were normal income. Since we are in the bottom two tax brackets, we would pay 0% capital gains tax (according to this page: http://taxes.about.com/od/Federal-Income-Taxes/fl/Federal-Income-Tax-Rates-for-the-Year-2014.htm).

This would mean that if we withdrew money early from our 401k or Traditional IRA, we would end up losing only 10% to taxes and penalties combined, which is a lot less than the 25% we would lose currently by putting it into taxable accounts.

Am I correct in this, or totally off?

You're right but for the wrong reason. You never pay capital gains tax for any money in a 401k or IRA, regardless of what your income is. You are correct that if you were in the 15% tax bracket (or below) you wouldn't have to pay capital gains tax on investments sold in regular taxable accounts.

And you *do* have to pay income tax on withdrawals from a traditional 401k or traditional IRA, regardless on when you withdraw (before retirement age or not). So if you were to withdraw 20k a year at current tax rates without using any of the penalty-avoiding tricks then:

The first $12,200 is not taxed at all thanks to the married-filing-jointly standard deductible.
The other $7,800 is taxed at 10%.
(Those two add to an average income tax rate of 4%)
You have to pay a 10% early withdrawal penalty on the entire $20k.

So your tax rate would be 14%, significantly less than the 25% you're paying now. And as people have pointed out, there are ways to avoid the 10% penalty, so then you'd just be paying 4%.

Cromacster

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Re: Should we invest in our IRA's?
« Reply #10 on: February 19, 2014, 06:35:30 AM »

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

True, but he has 40 years to get to that point. My advice was for now. The premise is he will have 10s of thousands of dollars per year to do something with. The Roth IRAs will take a nibble out of that, but the tax free distributions in retirement would not be subject to his marginal tax rate at that time.
Vjk

I thought we were talking about early retirement.  Why would you not get to that point for 40 years?

Either way, he should be maxing out his 401(k) first, then maxing out his Roth.  Any left overs go into taxable accounts.

GlassStash

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Re: Should we invest in our IRA's?
« Reply #11 on: February 19, 2014, 09:23:14 AM »

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

True, but he has 40 years to get to that point. My advice was for now. The premise is he will have 10s of thousands of dollars per year to do something with. The Roth IRAs will take a nibble out of that, but the tax free distributions in retirement would not be subject to his marginal tax rate at that time.
Vjk

I thought we were talking about early retirement.  Why would you not get to that point for 40 years?

Either way, he should be maxing out his 401(k) first, then maxing out his Roth.  Any left overs go into taxable accounts.

If the OP has enough money to max both 401(k) accounts and both Roth IRA accounts, the order is a moot point. If not, I think the prudent order would be:

1) 401(k) to Employer match %
2) 401(k) to get into 15% marginal tax rate
3) Roth IRA
4) Max 401(K)
5) Taxable Accounts

This method ensures the benefits of locking in the 15% tax rate for a portion of the money, and adds tax diversification. Again, this is a preference....but I think it is the best medium between tax deferred and tax advantaged savings.

Cromacster

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Re: Should we invest in our IRA's?
« Reply #12 on: February 19, 2014, 11:03:58 AM »

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

True, but he has 40 years to get to that point. My advice was for now. The premise is he will have 10s of thousands of dollars per year to do something with. The Roth IRAs will take a nibble out of that, but the tax free distributions in retirement would not be subject to his marginal tax rate at that time.
Vjk

I thought we were talking about early retirement.  Why would you not get to that point for 40 years?

Either way, he should be maxing out his 401(k) first, then maxing out his Roth.  Any left overs go into taxable accounts.

If the OP has enough money to max both 401(k) accounts and both Roth IRA accounts, the order is a moot point. If not, I think the prudent order would be:

1) 401(k) to Employer match %
2) 401(k) to get into 15% marginal tax rate
3) Roth IRA
4) Max 401(K)
5) Taxable Accounts

This method ensures the benefits of locking in the 15% tax rate for a portion of the money, and adds tax diversification. Again, this is a preference....but I think it is the best medium between tax deferred and tax advantaged savings.

I agree, but with an estimated income of 155,000 pretax, using standard deductions they can barely make the 15% bracket, and that's if they max 401(k) and max HSA (if available)

In that scenario  they would now qualify for the Traditonal IRA deduction, and if they max that out, they would just be within a few grand of being in the 15% tax bracket.  So if they own a house or have deductions greater than the standard, they might be able to squeak in there.  IF all that is accomplished then go for the Roth

GlassStash

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Re: Should we invest in our IRA's?
« Reply #13 on: February 19, 2014, 11:07:55 AM »

You would still rollover your 401(k) to an IRA when you quit/retire.  Then as you roll that money into the Roth IRA you pay normal income taxes on that money.  In 5 years time you can access it penalty free.

True, but he has 40 years to get to that point. My advice was for now. The premise is he will have 10s of thousands of dollars per year to do something with. The Roth IRAs will take a nibble out of that, but the tax free distributions in retirement would not be subject to his marginal tax rate at that time.
Vjk

I thought we were talking about early retirement.  Why would you not get to that point for 40 years?

Either way, he should be maxing out his 401(k) first, then maxing out his Roth.  Any left overs go into taxable accounts.

If the OP has enough money to max both 401(k) accounts and both Roth IRA accounts, the order is a moot point. If not, I think the prudent order would be:

1) 401(k) to Employer match %
2) 401(k) to get into 15% marginal tax rate
3) Roth IRA
4) Max 401(K)
5) Taxable Accounts

This method ensures the benefits of locking in the 15% tax rate for a portion of the money, and adds tax diversification. Again, this is a preference....but I think it is the best medium between tax deferred and tax advantaged savings.

I agree, but with an estimated income of 155,000 pretax, using standard deductions they can barely make the 15% bracket, and that's if they max 401(k) and max HSA (if available)

In that scenario  they would now qualify for the Traditonal IRA deduction, and if they max that out, they would just be within a few grand of being in the 15% tax bracket.  So if they own a house or have deductions greater than the standard, they might be able to squeak in there.  IF all that is accomplished then go for the Roth

You are correct. If the OP can't get to 15%, then he should undoubtedly stash every dollar he can in tax deferred accounts.