Andy's guide to savings

[Andy_B]

This is a rough rule of thumb list I use to run my personal finance. I tend to be conservative in my approach, but I am interested to see how this differs with everyone elses approach

In order of priority:

1) Build up emergency fund - Put 6-9 months worth of expenses into a safe vehicle (ie money market).

2) Pay down all high interest debt (credit cards etc. I hate these so much I have never actually had to do this step because I refuse to ever not pay off the balance each month)

3) Invest in your companies 401K AT LEAST up to the point where you can get the full company match

4) Max out 401k to the legal limit ($14k this year)

5) If you qualify for a Roth IRA, fund it for the legal limit ($4k this year), if not fund a traditional IRA for the legal limit ($4K this year)

6) If you are saving roughly 20% of your gross towards retirement, and have a child, then you can start to feel ok about investing in a 529 plan or a Coverdale plan (which ever one better suits your situation). I use a 529 plan

7) Invest in non tax shelter items (Mutual funds, bonds etc).


I have been following this plan for over a decade now and it has served me very well. Being very conservative, I have also agressively paid off my house. Once I owned the house outright, I then transfered that mortgage payment towards the 529 plan for my daughter.


Comments?

I am particularly interested to see if step 5 should come before step 4 if one qualifies for a Roth....

Andy

[stopper4]

I wound think 5 vs. 4 would depend in some part on the quality of investment options offered by your company's 401k.

[Andy_B]

I wound think 5 vs. 4 would depend in some part on the quality of investment options offered by your company's 401k.

In general a company would never be able to offer the choices that an IRA will but for sake of arguement, lets say the choices are equitable.


4 vs 5 comes down to this for me:
Is it better to invest in a tax deductable, tax deferred vehicle, or a non tax deductable, tax free vehicle?

Andy

[Sachin]

The advantage of a Roth is that the gains are tax free. With the 401(k) or the IRA, the gains are taxable. Over the long term, your gains will outweigh your investments, so with a Roth, the bulk of the money will be tax free.

Sachin

[Hyok]

5) If you qualify for a Roth IRA, fund it for the legal limit ($4k this year), if not fund a traditional IRA for the legal limit ($4K this year)


Is it 4K? Didn't know that. Thought it was 3K still.

[Andy_B]

With the 401(k) or the IRA, the gains are taxable. Over the long term, your gains will outweigh your investments, so with a Roth, the bulk of the money will be tax free.

But this leaves Tax deductability out of the picture.

It obvious that tax free is better than tax defered, but I want to know the ramification of tax free vs tax defered with tax deductability.

The 401k money is taken out before tax. The Roth money is put in after tax.

I don't know how this changes the math.

Andy

[Andy_B]

Is it 4K? Didn't know that. Thought it was 3K still.

Roth/Traditional bumped from 3k to 4k this year
401k bumped from 13k to 14k this year

Andy

[Hyok]

Roth/Traditional bumped from 3k to 4k this year
401k bumped from 13k to 14k this year

Andy

Thanks. Now I have a use for that extra G that was burning a hole in my pocket. :D

[Sachin]

At withdrawal, assuming modest overall returns, gains make up the bulk of the portfolio. Only the invested capital is tax-deductable in an 401(k). Gains are fully taxable, IIRC. Therefore, you pay taxes on the larger portion of the portfolio. With a Roth, you pay taxes on your invested capital, before you put it in. However, you never pay taxes on the gains. So you pay taxes on the smaller portion of the your portfolio, but get the larger portion tax free.

That's the way I see it, anyway.

Sachin

[Andy_B]

Only the invested capital is tax-deductable in an 401(k). Gains are fully taxable, IIRC. Therefore, you pay taxes on the larger portion of the portfolio.

I was about to agree with you but then I reread this and something doesn't sound right.

When I invest 14k in my 401k, 14K comes off of my taxable income.

However, when I retire and start pulling money out, I am pretty sure all the money is taxable at income rates at that time. Both the invested capital and the gains.

Am I understanding this wrong? I am pretty sure a 401k is 100% tax deferred, there is no difference between invested capital and gains once you start pulling money out at retirement time.

At withdrawal, assuming modest overall returns, gains make up the bulk of the portfolio.

Is this true? I just plugged the following into a spread sheet

20 year investment time frame
6% return a year
Invest 14K a year

After 20 years the invested capital was $280,000 and the gain was ~$235,000

Maybe my 6% was too modest?

Andy

[Sachin]

Yeah.. I can see that... maybe I misspoke...

In which case, it would be that 100% of your portfolio -- invested capital and gains are taxable in a 401K. In a Roth, only the invested capital would have been taxed, which should be some percentage smaller than 100%.

Sachin

[Andy_B]

In which case, it would be that 100% of your portfolio -- invested capital and gains are taxable in a 401K. In a Roth, only the invested capital would have been taxed, which should be some percentage smaller than 100%.

Ok I agree with this so lets keep working through this.

I think I now agree that step 5 should come before step 4.

Should step 5 also come before step 3 or could the matching of the company(depending on the match size) easily outweigh the tax advantage of a Roth?

Without doing the math I am inclined to think the order of my original post should be 3,5,4

Andy

[Sachin]

Using this calculator --> http://www.moneychimp.com/calculator/compound_interest_calculator.htm <-- I came up with the following:

0 initial investment
14K annual addition
20 years
6 percent return compounded annually

$545,898 as the total
$280,000 investment
~$265K as the gain.

Now if we do the same over say, 25 years, you get:

$814,189.36 as the total
$350,000 investment
~$464,000 as the gain

Those last 5 years add nearly 75 percent to the gain.

Sachin

[Sachin]

Ok I agree with this so lets keep working through this.

I think I now agree that step 5 should come before step 4.

Should step 5 also come before step 3 or could the matching of the company(depending on the match size) easily outweigh the tax advantage of a Roth?

Without doing the math I am inclined to think the order of my original post should be 3,5,4

Andy
Always, always, always take the match. That's free money that you will not get through salary or anything else. You will literally leave it on the table.

Personally, I would start 7 before 6. You can borrow money for college but you can't borrow money to retire.

Sachin

[Andy_B]

Personally, I would start 7 before 6. You can borrow money for college but you can't borrow money to retire.

Thats why I put the caveat in step 6. I would only do step 6 once you are saving 20% or more of your gross household income towards retirement.

Andy

[Andy_B]

Using this calculator --> http://www.moneychimp.com/calculato..._calculator.htm <-- I came up with the following

My spreadsheet, while overly simplistic must be wrong.

Cell A1: 14000 ;year 1
Cell A2: (A1*1.06) + 14,000 ; year 2
Copy down until Cell A20 which should equal year 20 and I get $514,998

Maybe the difference is that I am putting in the 14K after the growth every year instead of before?

I choose the 20 year time horizon because I am 37 and intend to be retired by that time. I do understand the longer the time horizon and or the better the return, the higher % of gain ones portfolio takes on.

Andy

[Txtriathlete]

This is a rough rule of thumb list I use to run my personal finance. I tend to be conservative in my approach, but I am interested to see how this differs with everyone elses approach

In order of priority:

1) Build up emergency fund - Put 6-9 months worth of expenses into a safe vehicle (ie money market).

2) Pay down all high interest debt (credit cards etc. I hate these so much I have never actually had to do this step because I refuse to ever not pay off the balance each month)

3) Invest in your companies 401K AT LEAST up to the point where you can get the full company match

4) Max out 401k to the legal limit ($14k this year)

5) If you qualify for a Roth IRA, fund it for the legal limit ($4k this year), if not fund a traditional IRA for the legal limit ($4K this year)

6) If you are saving roughly 20% of your gross towards retirement, and have a child, then you can start to feel ok about investing in a 529 plan or a Coverdale plan (which ever one better suits your situation). I use a 529 plan

7) Invest in non tax shelter items (Mutual funds, bonds etc).


I have been following this plan for over a decade now and it has served me very well. Being very conservative, I have also agressively paid off my house. Once I owned the house outright, I then transfered that mortgage payment towards the 529 plan for my daughter.


Comments?

I am particularly interested to see if step 5 should come before step 4 if one qualifies for a Roth....

Andy

1- Done.
2- Never have any balances.
3- I dont have one, am not company employed.
4- Doesnt apply to me.
5- Do not participate in one, provides me not tax benefit due to AGI.
6- No kids.
7- Done (mostly aggressive stocks, market trading)

[Sachin]

I figured it out... You're not compounding Year 20. That's the missing portion.

Sachin

[Andy_B]

5- Do not participate in one, provides me not tax benefit due to AGI.

You did not read step 5 clearly.

If you don't qualify for a Roth, you can invest in a Traditional IRA after tax and have your money grow tax defered. There is no AGI limit for a Traditional IRA

This is what I do because I don't qualify for a Roth.

If you are looking for tax benefits, you should be doing step 5 before 7.

Andy

[Txtriathlete]

You did not read step 5 clearly.

If you don't qualify for a Roth, you can invest in a Traditional IRA after tax and have your money grow tax defered. There is no AGI limit for a Traditional IRA

This is what I do because I don't qualify for a Roth.

If you are looking for tax benefits, you should be doing step 5 before 7.

Andy

I really should look into that, its just that I hate the fact that I cant touch that money! AND its taxed!
I really should consider starting one this year...