Author Topic: What should I use? 401k? Roth? IRA? IBA?  (Read 4832 times)

cam513143

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What should I use? 401k? Roth? IRA? IBA?
« on: October 01, 2015, 03:23:42 PM »
Hi everyone, couple of questions.  I'm decent with my money, try to save as much as I can, and don't spend a lot on frivolous things, but also trying to be more structured about saving/investing than I used to be.  About me:

  • Just graduated college, no student loans (lots of scholarships and grants)
  • 23 years old
  • about $18,000 net worth (been tracking since 18)
  • first full time job 55k salary, employer offers 401k but does not match
  • average 2000 monthly expenses, (about 1500 is mandatory, rent, kids, etc.) but keep in mind this includes my school bill
  • I've already got a bit of money in a few different accounts:  Scottrade Roth IRA, Vanguard IRA, Vanguard IBA
  • work a second job in the summer
Basically, I'm trying to figure out what to invest in...the main draw to the 401k is that it's pre-tax.  I know the IRA is too, but the difference is that the taxes come back when I file (if I'm understanding everything correctly), rather than out of my check pre tax from the beginning.  A little more on my situation:
  • I'm targeting a 30-35% savings rate (40% is my stretch goal)
  • thinking about buying property in the next 2-3 years (but my savings for down payment is included in the savings rate, right?)
  • 6 year old son lives with me halftime, I pay most of his expenses
  • plan on retiring early, latest would be mid 40s
  • travelling is definitely my biggest discretionary expense
  • no real loyalty to big cars, big houses, fancy food, etc. (good in this department!)

So I need to know what kinds of accounts would be my best option for savings?  Thanks for all the help ahead of time!

MDM

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #1 on: October 01, 2015, 04:44:07 PM »
Does the following set of guidelines seem helpful?

In the lists below, thinking "first your 457 (if you have one), then your 401k and/or 403b" wherever "401k" appears is likely correct.   
Differences of a few tenths of a percent are not important when applicable for only a few years (in other words, these are guidelines not rules).   
   
WHAT   
0. Establish an emergency fund to your satisfaction   
1. Contribute to 401k up to any company match   
2. Pay off any debts with interest rates ~5% or more above the 10-year Treasury note yield.   
3. Max HSA    
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level   
5. Max 401k (if 401k fees are lower than available in an IRA, or if you need the 401k deduction to be eligible for a tIRA, swap #4 and #5)   
6. Fund mega backdoor Roth if applicable   
7. Pay off any debts with interest rates ~3% or more above the 10-year Treasury note yield.   
8. Invest in a taxable account with any extra.   
   
WHY   
0. Give yourself at least enough buffer to avoid worries about bouncing checks   
1. Company match rates are likely the highest percent return you can get on your money   
2. When the guaranteed return is this high, take it.   
3. HSA funds are totally tax free when used for medical expenses, making the HSA better than either traditional or Roth IRAs.   
4. Rule of thumb: traditional if current marginal rate is 25% or higher; Roth if 10% or lower; flip a coin in between (or see   
   http://forum.mrmoneymustache.com/investor-alley/deciding-between-roth-and-traditional-ira-based-on-marginal-tax-rate/
   if you want even more details on that topic.)
5. See #4 for choice of traditional or Roth for 401k   
6. Applicability depends on the rules for the specific 401k   
7. Again, take the risk-free return if high enough   
8. Because earnings, even if taxed, are beneficial   

cincystache

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #2 on: October 01, 2015, 06:43:24 PM »
+1 for MDM's response

Great job graduating college debt free, landing a good paying job, spending less than you earn, and providing for your kid. You are doing a great job and have a bright future.

I'd max out pre-tax retirement accounts and put it in low-cost stock index funds.

Good luck!

MoonShadow

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #3 on: October 01, 2015, 07:36:23 PM »
I was going to add my two cents, but I see that MDM has already done a great job.

cam513143

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #4 on: October 02, 2015, 06:38:40 AM »
Thank you!  This is great, so this is my plan from what's been written (in order of priority):
  • Increase my emergency fund.  I definitely want it higher, but already have a small stash.
  • Contribute to 401k (maybe 10%?).  No company match anyway.
  • Max out Traditional IRA.
  • Max out Roth IRA.
  • Save money for house down payment (what kind of account would be best for this?)
  • Save in a regular taxable account, maybe brokerage or Lending Club, or something else.
  • I have no debt to pay off/down, and pay off credit cards in full every month (only use them for the cash back/points), I'm actually on my family's health insurance until 26, so don't have an HSA to contribute to
  • I looked up the mega backdoor Roth IRA...kind of understand it...but I'm not sure it would be useful as I don't think I'd be approaching the upper limits anyway.

So, just to be clear, should the 401k still be my focus even though there's no employer match?

One last question, when do you need to start factoring in the concept of early retirement?  For example, if I focus solely on IRAs and 401k, wouldn't that be poor planning since the funds would be penalized for early withdrawal?  I am toying with the idea of putting some of my IRA funds towards first-time homebuyer expenses for a larger downpayment when the time comes.

Riff

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #5 on: October 02, 2015, 07:45:15 AM »
Going back to MDM's list, on step 2 you contribute up to your employer's match: $0.  On to step 3 then, max out your IRA.  Remember that you can contribute $5500 total per year to your IRA, whether it's traditional or Roth, but not both (only $5500, not $11k).

The reason for maxing out your IRA before putting into your 401k in your situation is that you have complete control over your IRA.  You have the most flexibility with the least amount of fees.  Want to put it all into VTSAX at Vanguard?  Done. Easy.  With the 401k, you're at the mercy of your employer's plan and offerings (and fees). 

Cromacster

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #6 on: October 02, 2015, 07:46:17 AM »
Thank you!  This is great, so this is my plan from what's been written (in order of priority):
  • Increase my emergency fund.  I definitely want it higher, but already have a small stash.
  • Contribute to 401k (maybe 10%?).  No company match anyway.
  • Max out Traditional IRA.
  • Max out Roth IRA.
  • Save money for house down payment (what kind of account would be best for this?)
  • Save in a regular taxable account, maybe brokerage or Lending Club, or something else.
  • I have no debt to pay off/down, and pay off credit cards in full every month (only use them for the cash back/points), I'm actually on my family's health insurance until 26, so don't have an HSA to contribute to
  • I looked up the mega backdoor Roth IRA...kind of understand it...but I'm not sure it would be useful as I don't think I'd be approaching the upper limits anyway.

So, just to be clear, should the 401k still be my focus even though there's no employer match?

One last question, when do you need to start factoring in the concept of early retirement?  For example, if I focus solely on IRAs and 401k, wouldn't that be poor planning since the funds would be penalized for early withdrawal?  I am toying with the idea of putting some of my IRA funds towards first-time homebuyer expenses for a larger downpayment when the time comes.

Just to note that the total you can do between a Roth and Traditional is 5,500.

If your goal is to save for a home or property, my advice would be slightly different than most of the above.

1)E fund, check
2) Max IRA
3) HSA if available
3) Save for downpayment, cash, cd's, low risk.
4)Any leftovers into 401(k),  without a match this loses priority, but any extra should still be going into here.

I would not recommend taking any money out of your IRA's for a down payment.  I think you will hear this sentiment from a lot of folks on these boards.

As to the withdrawing funds early in retirement accounts.  You can access all of your funds when you need them, without penaltly, with some planning.  You will still have to pay taxes on this money.  This is called the Roth pipeline.  Google it, or look to peoples signature lines, as this question comes up alot.

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

http://www.gocurrycracker.com/never-pay-taxes-again/

http://www.madfientist.com/ultimate-retirement-account/

cam513143

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #7 on: October 02, 2015, 09:15:47 AM »
This is wicked helpful!  So I think I'm understanding the idea of a a Roth pipeline, and it's great; it definitely takes away some of my fears on the 'early' retirement side of things.  Also, I was confused on the IRA/Roth IRA contribution limits.  New priority list:
  • Emergency fund
  • Max 401k (I'm still leaning this way because it will reduce my AGI to put me into the 15% head of household tax bracket, and the employer actually offers plenty of options, Vanguard total stock, S&P 500, various growth/income related funds, etc.)
  • Save for house. Tough to define at this stage still, I'm not sure how much I'll need (not sure where/when to buy, Boston area is getting more expensive)  To be honest, still trying to figure out if I want to own a house, pending some ifestyle changes (RV trip anyone?)
  • Max IRA (this will be very easy at only $5.5k/year limit)
  • Taxable accounts

Let me know what you think...and really, I appreciate all the help and advice.  I've posted once or twice, but mainly just lurk around the blogs.  There is SO much information on here.

Cromacster  What do you mean by "E fund, check"?  And sadly, no HSA available since I'm not doing my own health insurance policy (on my parents' "family" plan until the kick off my younger brother...)  When I do though, I'm definitely doing high deductible + HSA (I barely go to the doctor's anyway.
« Last Edit: October 02, 2015, 10:09:17 AM by cam513143 »

Riff

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #8 on: October 02, 2015, 09:25:20 AM »
Fund the IRA before the 401k.  The 401k is less flexible, and more fees.

MDM

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #9 on: October 02, 2015, 09:52:19 AM »
Max 401k (I'm still leaning this way because it will reduce my AGI to put me into the 15% head of household tax bracket, and the employer actually offers plenty of options, Vanguard total stock, S&P 500, various growth/income related funds, etc.)
If you want a traditional IRA and would otherwise be above the MAGI limit, doing the 401k first makes sense.  Otherwise look to Riff's suggestion.

Quote
Save for house. Tough to define at this stage still, I'm not sure how much I'll need (not sure where/when to buy, Boston area is getting more expensive)  To be honest, still trying to figure out if I want to own a house, pending some ifestyle changes (RV trip anyone?)
Definitely a "what do you value more - ER or not renting?" question.  If ER, then filling all your tax-advantaged buckets first, then buying a house only after accumulating enough in taxable savings for a 20% down payment, seems best.

Quote
What do you mean by "E fund, check"?
I think "check" = "yes, I agree"

Quote
And sadly, no HSA available since I'm not doing my own health insurance policy (on my parents' "family" plan until the kick off my younger brother...)  When I do though, I'm definitely doing high deductible + HSA (I barely go to the doctor's anyway.
Do your parents have an HDHP?  If not, should they have one for their own benefit?  If you are a child covered by a family HDHP but are not a dependent for Form 1040 purposes, you may contribute the family maximum to your own HSA.  Great deal for you if available.  Maybe also good for your parents to go the HDHP/HSA route, but of course their needs should come first.  See http://forum.mrmoneymustache.com/taxes/hsa-for-an-adult-child-great-benefit-if-one-qualifies/ for more.

cam513143

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #10 on: October 02, 2015, 10:42:51 AM »
I definitely won't be above the MAGI limit.  I guess I just mean 401k is top priority chronologically, ie. the money will come out of my paycheck first thing.  Then I'll max out my IRA.  But really, IRA is top priority.
I think I value ER first, but I suppose I'll just need to think on that one for a while.
My parents don't use an HDHP right now, and I have a feeling it will be tough to convince them to switch.  Let's just say I didn't get my interest in personal finance from my parents..

Is there any way around the IRA limits?  I plan on meeting the limit for 2015, probably with catch-up contributions if I can't hit it before the end of the year.  Then in 2016, I'll just put 5,500 in as soon as I can.  After that though, it seems like my only tax-deferred growth is used up already.  Anything I'm missing for my plan?

MoonShadow

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #11 on: October 02, 2015, 12:09:06 PM »

  • Max out Traditional IRA.
  • Max out Roth IRA.


No.  You cannot max out both, you will have to choose.  If you are young, then you probably don't make a great deal either.  Max out the Roth IRA.  Not only does the Roth IRA have the advantage that, since you likely don't make a lot, it has a tax advantage over the Traditional IRA; but also your youth gives the Roth the advantage of time compounding.

MoonShadow

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #12 on: October 02, 2015, 12:11:45 PM »

One last question, when do you need to start factoring in the concept of early retirement?  For example, if I focus solely on IRAs and 401k, wouldn't that be poor planning since the funds would be penalized for early withdrawal?  I am toying with the idea of putting some of my IRA funds towards first-time homebuyer expenses for a larger downpayment when the time comes.

You can withdraw your contributions to a Roth at any time without penalty, as well as up to $10K of gains for a first home downpayment.  There are other cases that allow you to avoid the early withdrawal penalties.  Contributing to the annual max of a Roth is almost never a bad idea.

cam513143

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #13 on: October 02, 2015, 12:50:22 PM »
Moonshadow if I plan on using a Roth pipeline in the future though, then it probably makes more sense to use the traditional IRA right?  (Somebody correct me if I'm wrong), but the way I understand it:

$$ into traditional IRA (not taxed) > move untaxed money into Roth IRA (conversion) > +5 years > withdraw conversion money from Roth, tax free

In this way, I don't have to pay taxes on withdrawal of the money, I just have to wait 5 years before taking it out.  Is this correct?

MDM

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #14 on: October 02, 2015, 01:48:56 PM »
$$ into traditional IRA (not taxed) > move untaxed money into Roth IRA (conversion) [and pay taxes on the total amount converted each year] > +5 years > withdraw conversion money from Roth, tax free

In this way, I don't have to pay taxes on withdrawal of the money, I just have to wait 5 years before taking it out.  Is this correct?

With the edits made, yes.

cam513143

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #15 on: October 02, 2015, 01:56:41 PM »
I see now, that makes sense.  I got jumbled with another article I was reading (keeping income + conversions under deduction amount for taxes).

So anyway, max out IRA and then 401k, that's the verdict I'm getting from people here right?  Any other things I should consider?  Thanks again for all the help everyone!

MoonShadow

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #16 on: October 02, 2015, 01:59:08 PM »
Moonshadow if I plan on using a Roth pipeline in the future though, then it probably makes more sense to use the traditional IRA right?  (Somebody correct me if I'm wrong), but the way I understand it:

$$ into traditional IRA (not taxed) > move untaxed money into Roth IRA (conversion) > +5 years > withdraw conversion money from Roth, tax free

In this way, I don't have to pay taxes on withdrawal of the money, I just have to wait 5 years before taking it out.  Is this correct?

The step I quoted gets taxed at the rate of the year it happens within, and also contributes to MAGI, so could actually result in a net higher tax rate than simply taking the tax income hit on the front end with the regular annual contribution limit of the Roth.  The Roth pipeline is a method of getting around that limit for certain individuals, but it will not result in a lower tax bill if you are still working when you do it.  Also, the combined annual limit for both types of IRA accounts prevents you from being able to contribute to both, and do a Roth conversion later and come out ahead; it just results in extra tax forms you have to keep track of.

That said, a traditional 401k > traditional IRA > Roth IRA path might be in your interest if 1) you make too much to contribute to a Roth at all or 2) you just FIREd the year before and have enough room in your bottom tax bracket to move 401k funds into a Roth pipeline.

#1) is a good problem to have under any conditions.

#2) is a fine early retirement plan, but you still need to have at least 5 years expenses of contributions saved into your Roth, because (specific to that rolled over 401k deposit) another 5 year clock starts ticking, so you can't access those newly pipelined funds from the 401k until it has aged in the Roth for 5 years or more.  This trick does not work with a traditional IRA at all.

So, I reaffirm that maxing out the annual limit on a Roth IRA is rarely a bad plan, because contributions can be used for expenses during the first 5 years of early retirement, as an emergency fund prior to that (but only after it's been open for 5 years), to contribute towards a down payment of your first home (if you wish, not often the best idea), to pay for excessive medical expenses (even if you have an HSA, but also not often the best plan), to reduce your need for life insurance if you have a family later, and for many other purposes. 

With this in mind, how many years of full annual contributions, at $5500 per year presently, would it take you to confidently pay for one year of early retirement expenses?  I'd say at least 3 years for every one, or $16,500, per adult; but probably 4 years ($22K).  Those numbers will increase with inflation, but so does the annual contribution limit; so the ratio will remain the same.  Rather conveniently, if you get married, your spouse can also open his/her own Roth, with it's own annual limit, so getting married doesn't alter the number of max contribution years.

Based upon that, I'd say the typical young adult will need 15 to 20 years of max contributions to a Roth in order to be able to depend upon that account alone to get them through the first 5 years of early retirement, so that their pipelined funds can be accessed without penalty.  If you get there and find you don't really need to withdraw your contributions, even better; they can continue to grow inside a well protected (legally) and tax advantaged vehicle till you choose otherwise.  If you have a family crisis at year 12 that demands $30K from your Roth, at least you had it available.

Most of these arguments also apply well to the HSA.  Get one for yourself, if you can; especially if you don't think you will have any need for it anytime soon.  Even if you only contribute to it for a few years, and then switch to another form of health coverage, those stached funds will form a backstop to a medical crisis.  And if you never need those funds either, all the better still; you can use them to pay for your medical expenses or premiums in early retirement.

seattlecyclone

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Re: What should I use? 401k? Roth? IRA? IBA?
« Reply #17 on: October 02, 2015, 03:00:10 PM »
Do not utter the words "can't access" with regard to part of your stash, unless you are literally prohibited from withdrawing it (due to still being employed at the employer sponsoring the account, for example). These words lead to irrational fear of paying early withdrawal penalties.

Yes, if you simply withdraw money from a traditional IRA/401(k) before you're old enough, you'll pay tax at your marginal rate plus 10% on that money. That is a far cry from being unable to access this money. In many cases, this will be better than paying tax while working, putting that money in a Roth account instead, and withdrawing it penalty-free during retirement.

Suppose you're in the 28% tax bracket while working and you plan to be in the 15% bracket while retired. You could either pay 28% now and make Roth contributions so that you have plenty of funds to withdraw penalty-free during retirement, or you could save that money in a traditional retirement account and pay 15% plus a 10% penalty (for a total of 25%) when retired. 28% is more than 25%.

Again, don't be irrationally averse to paying early withdrawal penalties. If it costs less to pay them than the alternative, go ahead and pay them!