Author Topic: What would you do?  (Read 5328 times)

theorem23

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What would you do?
« on: May 03, 2014, 02:20:29 PM »
Hi All,

I'm a 30 year old systems analyst making a mid-70K salary with about 75K stashed in retirement accounts and about 90K of equity in my 165K home. I'm married with one child. My wife is a home maker. I have no debt outside of the mortgage.

We recently had a windfall of about 40K and I am trying to decide whether I should put it into the market or into the mortgage. With the market at an all time high I am worried about an imminent correction eating away my lump sum. Is it smarter to put it into the mortgage right now? Or should I do something else with it entirely?

I've talked with several different people at this point and have gotten a lot conflicting answers. I'm still weighing the responses, but thought I'd see what the folks on this board had to say as well.

Thoughts?

nereo

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Re: What would you do?
« Reply #1 on: May 03, 2014, 02:48:45 PM »
first, what's your interest rate and how much do you owe?  If it's under 4% chances are you will do better putting it into the market and leaving it there for many years.

Second, realize that saying things like " With the market at an all time high..." is trying to time the market.  It could continue to go up, it could go down, or it could go horizontal for a while.  If you decide to put it into the market, one (good) strategy would be to DCA by putting a set amount of money automatically every week for many weeks; say $800/week for a year. Or $400/week for two years.

Finally, I'd consider putting it into the market ONLY if you plan on leaving it there 5+ years.

Rebecca Stapler

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Re: What would you do?
« Reply #2 on: May 03, 2014, 02:58:47 PM »
Do you also have a comfortable emergency fund and a savings account for your next big purchase (eg, if you'll need a car in the next few years)? If not, I would focus first on putting it in there.

Does your wife have a retirement account? I would also consider starting an IRA for her if she doesn't.

theorem23

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Re: What would you do?
« Reply #3 on: May 03, 2014, 03:18:15 PM »
Nereo,

The interest rate on the mortgage is 4.45%.

I know (in theory) I shouldn't be trying to time the market, and in general I don't. Do you feel that the present level of the stock market shouldn't influence my decision?

Rebecca,

We do have an emergency fund with about $15,000 in it. My wife does have a Roth IRA and a 401K from a previous job.

milesdividendmd

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Re: What would you do?
« Reply #4 on: May 03, 2014, 03:22:16 PM »
In most cases I think you would be better off investing the money.

With mortgage debt, an important consideration is that your interest is tax deductible. So if you want to figure out your expected return on prepaying your mortgage take your current interest rate minus your top marginal tax rate and think of it like a bond that pays you that rate.

For example if your interest rate on your mortgage is 4%, and your marginal tax rate is 25%, then you can think of prepaying your mortgage as buying a bond with a 3% coupon (4 X 0.75)

So if you think you can beat that in the market, which you should be able to in the long term, it's smarter to just invest the money. This is especially true if your mortgage will be paid off prior to your anticipated date of financial independence.

Hope that helps,

Alexi

Rebecca Stapler

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Re: What would you do?
« Reply #5 on: May 03, 2014, 03:27:58 PM »
If you don't have plans for the money in the next 5 years, I would put it in the market for retirement. If the windfall was a gift and you don't owe taxes on it, I wouldn't put it in a retirement account. But if it were taxed, I would look at maximizing retirement accounts.

If you're concerned about the market, let it dribble into the accounts every other week or so and you'll benefit from dollar-cost averaging. If it were me, though, I wouldn't let my concerns about the market influence me because if it's in retirement accounts, you're not going to touch it for decades and it'll have time to bounce back if it needs to. I would just max out retirement contributions in one fell swoop this year, then deposit the rest of it next year in a lump sum.

theorem23

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Re: What would you do?
« Reply #6 on: May 03, 2014, 04:50:49 PM »
Thanks for all the feedback everyone. I think I am going to go ahead and put it in the Market.

Rebecca, you mentioned that if the money isn't taxed you wouldn't put it into a retirement account. I would have thought a retirement account would be preferable because of the tax-sheltered growth. Can you elaborate?

nereo

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Re: What would you do?
« Reply #7 on: May 03, 2014, 06:08:57 PM »
Thanks for all the feedback everyone. I think I am going to go ahead and put it in the Market.

Rebecca, you mentioned that if the money isn't taxed you wouldn't put it into a retirement account. I would have thought a retirement account would be preferable because of the tax-sheltered growth. Can you elaborate?
here's where you get into the fungibility of money.  If you aren't already maximizing all the tax-advantaged accounts that you can, I would definitely do this (assuming you are putting it into the market).  It doesn't matter that that particular $40k comes to you tax-free.  What you are doing is lowering your overall tax burden.

However, I'll just say that at 4.45% the choice between putting the money into the market and into your home are less clear.  There have been 20 year periods when the market has returned <4.5% in real-adjusted returns.  One could certainly make the case for taking the "safe" 4.45% return over the uncertain market.

As for whether the present level of the market should influence your decision, I'd say "no".  That's the definition of market timing, and it's a game almost everyone looses.  DCA the windfall would be my strategy (depositing them weekly over 6 months to 2 years).  A case could be made that the economy is improving and gains will continue (see April's job's report).  A case could be made that the economy will stagnate or go down (see end of Quantative easing, election politics, etc).

theorem23

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Re: What would you do?
« Reply #8 on: May 03, 2014, 06:16:12 PM »
Nereo,

What if my time horizon is 30 years (which it is)? I know you could probably find 30 years stretches where the market returned less than 4.45%, but is it likely enough to worry about?

Rebecca Stapler

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Re: What would you do?
« Reply #9 on: May 03, 2014, 07:29:21 PM »
Thanks for all the feedback everyone. I think I am going to go ahead and put it in the Market.

Rebecca, you mentioned that if the money isn't taxed you wouldn't put it into a retirement account. I would have thought a retirement account would be preferable because of the tax-sheltered growth. Can you elaborate?

I'm just assuming that you've maxed out your Roth IRA, but if you haven't, put it in there (yours and your wife's). Plus, you can only put $11,000 into Roths, so that won't take care of all the money.

Otherwise, what's the point of a tax shelter (like a traditional IRA or a 401k) on money that wasn't taxed? I wouldn't take up space in a non-Roth retirement account with tax-free money if you can put some taxed income in there instead. If, at the end of the year, you find that your 401k or traditional IRAs are not maxed, fill in the gap with the $40k that's been invested in the meantime (particularly the yields, which will be taxed!).

milesdividendmd

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Re: What would you do?
« Reply #10 on: May 03, 2014, 08:06:20 PM »
I wouldn't think of prepaying your mortgage as a "risk-free 4.5%."The reason is that this ignores the tax benefits of paying your interest. If you were in the 25% tax bracket and there is no state tax, you can think of it as a 3.375% bond. If there is a state income tax where you live this rate will be even lower.

And don't forget this is not a real (after inflation) return. The real yield can be found by taking the 3.375 % and subtracting the inflation rate in between now and the end of your mortgage (which is unknowable.) so if you guess inflation will be a 2%, this is a real yield of 1.375%. The current yield on a 30 year TIPS (which is a good approximation of what The real return on a risk-free investment is, is 1.1%. So by prepaying your mortgage you're only getting an extra 0.275% yield.

Investing in the whole market, you should get in much better risk  premium than 0.275%! (As long as you can handle the risk.)

In terms of where you should put the money, I would go in this order.

1. Front load workplace retirement accounts.(in other words use the $40,000 to pay your bills and put 100% of your paychecks into your retirement accounts until they are  filled)

2. Frontload a health care savings account if it is available to you through your work. Pay for all of your health care expenses out-of-pocket.

3. Put $11,000 for you and your husband into a Roth IRA.(Or if your income is too high into a backdoor Roth IRA)

4. If you have kids Max out your 529 contribution up to the state tax break in your state.

5.  Put the rest of the money into a taxable investment account.

Although dollar cost averaging provides the psychological benefit of not being worried that the market goes down right after you invest, and the long-term I think you're better off just putting the money into the market as soon as possible and letting it ride.

Alexi

aj_yooper

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Re: What would you do?
« Reply #11 on: May 03, 2014, 08:47:15 PM »
You are in the 15% marginal tax bracket and have $40K to allocate.  Over the next 4 years I would place that money in Roth IRAs ($11 total per year) for you and your spouse.  Within the Roth, I would follow your pre-defined asset allocation policy.  If you don't have a policy statement, you need to read up. 

nereo

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Re: What would you do?
« Reply #12 on: May 04, 2014, 06:02:18 AM »
Nereo,

What if my time horizon is 30 years (which it is)? I know you could probably find 30 years stretches where the market returned less than 4.45%, but is it likely enough to worry about?

In the end it's what you are most comfortable with.  Personally, any time period longer than about 5 years I'd choose to put it in the market. historically, 30 year time frames have always returned more than 4.45%(real adjusted returns) - in fact 4.7% is the lowest.  The mean has been just above 7%.

Quote
Otherwise, what's the point of a tax shelter (like a traditional IRA or a 401k) on money that wasn't taxed? I wouldn't take up space in a non-Roth retirement account with tax-free money if you can put some taxed income in there instead. If, at the end of the year, you find that your 401k or traditional IRAs are not maxed, fill in the gap with the $40k that's been invested in the meantime (particularly the yields, which will be taxed!).
The reason is that money is fungible - it doesn't matter that his salary is taxable and his gift isn't; it's all one pot of money to spend and invest.  The OP makes $70k of taxable income and recieved $40k of (presumably) untaxed money.   So he has $110k to spend an invest - it doesn't matter where it comes from.

Here's an example.  Let's assume he files jointly and puts all his $40k in taxable accounts - $70k of taxable income yields $59k (assuming standard deductions and 1 dependent). That means he has $99k to spend an invest.  He's paid $11k in taxes.

But now let's assume he uses this $40k to max out all his tax-advantaged accounts.  He puts $11k into t-IRAs for him and his spouse, he contributes $17,500 to his 401(k) (for this example his employer contributes nothing) and he puts another $3600 into a HSA.  Then his tax bill is on  $70k - ($11k + 17,500 + 3600) = $33,175 of earned income.  After taxes he will have $32,125 of his salary + the $40k windfall + his $36,128 that he put into tax-advantaged accounts.  He has just over $108k to spend and save. He's paid just under $2k in taxes.  With a few more deductions (mortgage interest, for example) it's likely he will be untaxed on all $70k salary in my rough example.

EDIT: The above is just an example to illustrate how the fungibility of money means that it doesn't matter that the $40k is tax free - he should still maximize all tax-advantaged accounts first before putting them into taxable accounts.
« Last Edit: May 04, 2014, 06:17:26 AM by nereo »

theorem23

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Re: What would you do?
« Reply #13 on: May 04, 2014, 09:40:31 AM »
Thanks for all of the great advice everyone! I really learned a lot!
« Last Edit: May 04, 2014, 12:19:44 PM by theorem23 »

Tyler

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Re: What would you do?
« Reply #14 on: May 04, 2014, 11:00:09 AM »
I wouldn't think of prepaying your mortgage as a "risk-free 4.5%."The reason is that this ignores the tax benefits of paying your interest.

Lots of good advice here. But I'd like to note that with only $75k outstanding on the mortgage, there's a very good chance that the mortgage interest deduction is irrelevant because the standard deduction + exemptions for a couple filing jointly is likely the better tax deal than itemizing.  Mortgage interest deduction benefits are not as automatic as some people may think.

nereo

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Re: What would you do?
« Reply #15 on: May 04, 2014, 11:26:59 AM »
I wouldn't think of prepaying your mortgage as a "risk-free 4.5%."The reason is that this ignores the tax benefits of paying your interest.

Lots of good advice here. But I'd like to note that with only $75k outstanding on the mortgage, there's a very good chance that the mortgage interest deduction is irrelevant because the standard deduction + exemptions for a couple filing jointly is likely the better tax deal than itemizing.  Mortgage interest deduction benefits are not as automatic as some people may think.
+1.  Especially for a couple filing jointly with $70k income and one dependent.  $12,400 standard deduction plus $3600 EITC won't leave much for the mortgage deduction on $75k remaining (likely ~$3k interest in 2014).  If the OP is contributing to 2x t-IRAs the mortgage deduction will do basically nothing on $70k salary.

milesdividendmd

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Re: What would you do?
« Reply #16 on: May 04, 2014, 01:29:19 PM »
Tyler,

Excellent point!

Alexi