Author Topic: Strategy for 26yo with over $50k in investments/cash  (Read 3992 times)

HumbleStash

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Strategy for 26yo with over $50k in investments/cash
« on: June 04, 2016, 01:52:32 PM »
Hello,

I'm new to this forum, but have been following the blog for about two years. I feel like it has definitely helped give me some direction. I'm trying to get a better sense of my options with the amount of money I have at the moment. I'll speak with an investment adviser, but just wanted to see if anyone had opinions based on their experience. I plan to continue reading more books on these topics.

These are my current investments:
VFIAX in taxable account: ~$24000 (automatically reinvesting dividends)
VTSMX in a Roth IRA: ~$6000

Based on my understanding right now, if I was to redo anything that I have done, I would have invested in the total stock market in the taxable account (didn't realize there were some tax disadvantages for the VFIAX). I would have opened up a Roth IRA sooner. I would have also practiced value averaging, instead of just dumping $1000 a month into FVIAX.

I have a lot of cash because I live in an expensive area and want a 6 month of emergency fund. My employment situation may be improving in the next couple months so I can get 401K matching, which I would plan to max out.

Since I have a surplus of cash right now, I'm deciding what to do with it. I have no debt. Should I keep investing in the VFIAX? Should I move the VFIAX into VTSAX (or is that not worth the taxes)? Should I leave VFIAX alone, and instead start investing in a taxable VTSMX? Another option is to buy VGTSX and get some international diversification. I haven't looked too closely at bond funds yet, but plan on not touching these investments for a while.

Any insight is appreciated. I know there is no one right way to do this, since it depends on individual goals, risk tolerance, job/family situation, etc. I guess my main curiosity is how to handle the VFIAX taxable investment now that I know it's not ideal. Thanks!
« Last Edit: June 04, 2016, 02:12:55 PM by HumbleStash »

JJsfr

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #1 on: June 08, 2016, 09:48:25 AM »
I think there are a few things here you might be hung up on.

First, have you developed an investment policy statement? This will help you figure out where you need to be investing your money. If you do determine that 80+% of your holdings need to be in a large caps (as vtsmx has large cap holdings).

Second, you're talking about tax efficiency. VTSMX and VFIAX are pretty close to the same thing, and pretty close in tax efficiency. It'd be different if you were holding bonds in a taxable account. Here's another thread on VTSAX and VFIAX.

Lastly, you say you need a large cash reserve for your e-fund. If you do need it as an e-fund, don't invest it. If your job situation changes in the next few months and you can invest it, look at your IPS.

If you don't need the cash for a while and aren't making a whole lot right now, many will recommend a tIRA for your investments. MDM has a case study spreadsheet around here somewhere with an investment order that can help you out.

Check back in with other questions.

DrF

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #2 on: June 10, 2016, 12:22:51 PM »
If you like value averaging, you should check out Jasonkelly.com.

He's written a couple of books on it like this -
https://www.amazon.com/3-Signal-Investing-Technique-Change/dp/0142180955?ie=UTF8&*Version*=1&*entries*=0

Most people find it impractical while in the mass accumulation phase of saving. It's mostly for people who are already retired and can adjust their portfolios according to the market.

webguy

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #3 on: June 10, 2016, 01:05:03 PM »
As we're talking about pretty small sums of money right now I wouldn't worry too much about tax efficiency as it would make very little difference for you. There isn't much difference in how those two funds are taxed. I would however diversify to international stocks so that you're not too heavy in the U.S. market, as currently you're 100% U.S. Stocks which is pretty risky.

MustacheAndaHalf

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #4 on: June 10, 2016, 03:34:42 PM »
Here's my rough estimate of taxes in the median 25% tax bracket:
"VFIAX in taxable account: ~$24000"

At a 2% dividend, and a qualified dividend tax rate of 15%, that .15 of 2%, or 0.30% in taxes owed.  That's $72.  And it's about the same $72 for total stock market.  Not sure what you mean by tax efficiency between two passive, broad market index funds.  Total stock market has more of the market, but both are tax efficient.

MoonShadow

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #5 on: June 10, 2016, 03:40:38 PM »
Once your Roth has been open for 5 tax years, any of your contributions can be withdrawn without any taxes.  Also there are many exceptions to the 10% early withdrawal penalty that lend the Roth to be a fine investment vehicle for an emergency fund.  It's what I do, in fact.

So, in this case, you can have your cake and eat it too, in a manner of speaking.  The only catch is the first 5 year rule.  I don't remember what the harm in withdrawing your contributions in the first 5 years are, however.

HumbleStash

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #6 on: June 11, 2016, 07:24:05 PM »
Hey, thanks everyone for the replies! Super helpful.

JJsfr - Good point with the IPS. I need to research this more. As for target allocation, ultimately I may want to go towards something like 56% Domestic Stock, 24% International, 20% Bond. Within domestic, that might be 80% large cap and 20% small and mid. Right now since I'm not dealing with large sums of money and just trying to get going, I'd like to keep the number of asset class / index funds to a minimum (perhaps 4). That's part of why I'm slightly bummed I first purchased VFINX over VTSMX, because I would have gotten small cap exposure without purchasing another fund. That thread you linked to is great. It may make sense to counterbalance VFIAX with NAESX, though it would be a while before I would hit admiral shares with a balanced asset allocation.

As for tax efficiency, sounds like it's not a bid deal. I had read this could be a consideration because the S&P periodically adds and deletes stocks, incurring distributions.

You mention tIRA - I'm already maxing my Roth at $5500, so this wouldn't work for me? I'll look more into it.

DrFunk - Thanks for the book recommendation, I'll check it out. What appeals to me about the value averaging approach to gradual investing is that you invest at both market lows and highs, but buy more at the low point - resulting in higher returns than dollar cost averaging.

webguy - Thank you for the input on tax efficiency. That makes sense to me. I also agree with your comment on international diversification. I'm eyeing the VTSMX but I guess it's not eligible for foreign tax credit since it's a "fund of funds".

MustacheAndaHalf - Revealing numbers on tax efficiency. Doesn't seem like much of a difference.

MoonShadow - Interesting, I had not considered the Roth IRA as a potential emergency fund. Definitely some attraction there over holding a ton of cash.
____
So from these replies I'm getting the message that VFIAX is not that tax inefficient, so don't take the capital gains hit to switch over to the total market. I need to develop my IPS, and get international diversification. Also, the Roth IRA can potentially act as an emergency fund.

I welcome any other thoughts! I'll probably have more questions as my journey continues.

MustacheAndaHalf

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #7 on: June 11, 2016, 08:57:40 PM »
"As for tax efficiency, sounds like it's not a bid deal. I had read this could be a consideration because the S&P periodically adds and deletes stocks, incurring distributions."

And it's a lie that I predict was from a salesperson.  Take a look on Morningstar at the "turnover rate" of the S&P 500 and Total Stock Market funds, both of which I see have 3.00% turnover:
http://financials.morningstar.com/etfund/operations.html?t=VOO
http://financials.morningstar.com/etfund/operations.html?t=VTI

The 3% turnover of these funds is extremely low.  Active funds can't touch the low turnover of passive funds.  A fund with high turnover buys and sells frequently, which realizes taxable gains/losses.  Really active funds might have 110% turnover, because they sell every stock within the year.

Anyone familiar with the S&P 500 will say it's tax efficient.  You may have gotten ignorant information, but more likely some salesperson got tired of losing clients to S&P 500 funds and started lying about it's benefits.

seattlecyclone

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #8 on: June 11, 2016, 09:25:42 PM »
Once your Roth has been open for 5 tax years, any of your contributions can be withdrawn without any taxes.  Also there are many exceptions to the 10% early withdrawal penalty that lend the Roth to be a fine investment vehicle for an emergency fund.  It's what I do, in fact.

So, in this case, you can have your cake and eat it too, in a manner of speaking.  The only catch is the first 5 year rule.  I don't remember what the harm in withdrawing your contributions in the first 5 years are, however.


There is no tax for withdrawing Roth contributions within the first five years. There's a lot of confusion out there about the five year rule (actually there are two five-year rules but the other one is for conversions so it's not important right here). The rule says you can't make a "qualified distribution" within five years of opening your first Roth IRA account. However in the case of withdrawing your contributions, it doesn't matter whether the distribution is "qualified" or not! The tax due is zero either way.

As to your question about what you should do going forward, do you have access to a 401(k) right now, just without matching? Consider contributing to this before adding any more money to your taxable account. Get that tax-deferred money compounding as early as possible!

Also there's nothing inherently wrong with holding VFIAX in a taxable account. It's a very low cost index fund tracking the S&P 500. As such, it has about 80% overlap with VTSAX anyway. I prefer to invest in the full market instead of the biggest 500 companies, but there's little practical difference in historical returns between the two funds. They tend to move basically in lockstep, since VFIAX makes up roughly 80% of VTSAX, and the other 20% tends to correlate pretty well with the rest of it.
« Last Edit: June 11, 2016, 09:29:45 PM by seattlecyclone »

HumbleStash

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #9 on: June 12, 2016, 03:29:51 AM »
MustacheAndaHalf - Good to see that 3% turnover. My concerns are removed. Unfortunately that information was from The Intelligent Asset Allocator by Bernstein, p. 146. Maybe things have changed since it came out? In any case, that's too bad because the book is recommended by both MMM and Bogle. I'm going to need to cross reference what I've read now.



seattlecyclone - Excellent point on the 401K still being good without matching. Not sure why I didn't put that together before.. I'll need take advantage of it. Also, I appreciate the insight on Roth and VFIAX. 

seattlecyclone

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #10 on: June 12, 2016, 09:57:26 AM »
That book's point about capital gains distributions being forced by the churn in the index is technically correct, but in reality the Vanguard 500 index fund hasn't distributed gains since the year 2000. I think they do some sort of financial black magic involving ETF shares and who knows what else in order to avoid the need to distribute gains to mutual fund shareholders.

Go ahead and buy VTSAX going forward. Selling your existing VFIAX shares and realizing a gain just to switch to VTSAX likely isn't a worthwhile maneuver. However if you don't have enough wiggle room in your budget to fully max out your 401(k) you might consider "transferring money" to the 401(k) by increasing your 401(k) contributions to the max and selling VFIAX shares as needed to pay your bills.
« Last Edit: June 12, 2016, 10:00:19 AM by seattlecyclone »

JJsfr

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #11 on: June 12, 2016, 08:47:31 PM »
Just throwing this out there, because we keep bringing up the 401k & Trad/ROTH thing. I think if you are in the 15% marginal bracket, ROTH is OK, but if you're 25% or higher, you will probably benefit more from the tIRA. I'll see if I can't find any of the threads that go into detail why, but generally it's because your marginal tax rate will be < 25% in retirement if you retire early. 25% can be a tossup for a retiree of "traditional age" in regards to ROTH or traditional.

MoonShadow

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #12 on: June 12, 2016, 08:55:23 PM »
Once your Roth has been open for 5 tax years, any of your contributions can be withdrawn without any taxes.  Also there are many exceptions to the 10% early withdrawal penalty that lend the Roth to be a fine investment vehicle for an emergency fund.  It's what I do, in fact.

So, in this case, you can have your cake and eat it too, in a manner of speaking.  The only catch is the first 5 year rule.  I don't remember what the harm in withdrawing your contributions in the first 5 years are, however.


There is no tax for withdrawing Roth contributions within the first five years. There's a lot of confusion out there about the five year rule (actually there are two five-year rules but the other one is for conversions so it's not important right here). The rule says you can't make a "qualified distribution" within five years of opening your first Roth IRA account. However in the case of withdrawing your contributions, it doesn't matter whether the distribution is "qualified" or not! The tax due is zero either way.


Oh, but that is where the confusion remains.  While the contributions are not income taxed on the way out, because they have already been taxed, that doesn't mean that the 10% penalty doesn't still apply, because it can't be "qualified" during the first 5 years.  It would still function well as an emergency fund with a 10% penalty, if it was a real emergency, but I have never seen this particular question resolved to my satisfaction.  Some sources imply that withdrawal of one's own contributions are a "qualified" distribution, and thus would incur the 10% penalty, other sources imply that it still doesn't matter. 

seattlecyclone

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #13 on: June 12, 2016, 09:24:57 PM »
No, there's no 10% early withdrawal tax for non-qualified withdrawals of Roth contributions. See Publication 590-B for more information.

Quote
Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.

Note that it says the 10% tax only applies to the taxable part of non-qualified distributions. Withdrawing Roth IRA contributions doesn't increase your taxable income, therefore the 10% tax does not apply.

Also see Form 5329 where you calculate the 10% early withdrawal tax. This tax is calculated in Part I of the form for IRAs.

On Line 1 you report "Early distributions included in income."
On Line 2 you report money from Line 1 that meets an exception to the 10% tax (educational expenses, SEPP withdrawals, etc.).
On Line 3 you subtract Line 2 from Line 1.
On Line 4 you multiply Line 3 by 10%. This is the early withdrawal tax you pay.

For withdrawals of contributions only, you report $0 on Line 1 because these distributions are not included in income. You report $0 on Line 2 because you reported $0 on Line 1. That makes Lines 3-4 also be $0. No early withdrawal tax is due for these withdrawals.

MoonShadow

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Re: Strategy for 26yo with over $50k in investments/cash
« Reply #14 on: June 13, 2016, 11:17:52 AM »
No, there's no 10% early withdrawal tax for non-qualified withdrawals of Roth contributions. See Publication 590-B for more information.

Quote
Unless one of the exceptions listed below applies, you must pay the 10% additional tax on the taxable part of any distributions that are not qualified distributions.

Note that it says the 10% tax only applies to the taxable part of non-qualified distributions. Withdrawing Roth IRA contributions doesn't increase your taxable income, therefore the 10% tax does not apply.

Also see Form 5329 where you calculate the 10% early withdrawal tax. This tax is calculated in Part I of the form for IRAs.

On Line 1 you report "Early distributions included in income."
On Line 2 you report money from Line 1 that meets an exception to the 10% tax (educational expenses, SEPP withdrawals, etc.).
On Line 3 you subtract Line 2 from Line 1.
On Line 4 you multiply Line 3 by 10%. This is the early withdrawal tax you pay.

For withdrawals of contributions only, you report $0 on Line 1 because these distributions are not included in income. You report $0 on Line 2 because you reported $0 on Line 1. That makes Lines 3-4 also be $0. No early withdrawal tax is due for these withdrawals.

Thank you for the reference.  It helps me a great deal.