Stocks — Part VIII: The 401K, 403b, TSP, IRA & Roth Buckets

In Part IV we looked at some sample portfolios built from the three key Index Funds I favor, plus cash.  Those four are what we call investments.

But in our complex world we must next consider where to hold these investments.  That is, in which bucket should which investment go?  There are two types of buckets:

1.  Ordinary Buckets
2   Tax Advantaged Buckets

Now at this point I must apologize to my international readers.  This post is about to become very USA centric.   I am completely ignorant of the tax situation and/or possible tax advantaged buckets of other countries.  My guess is, that at least for western style democracies, there are many similarities and possibly you can extrapolate the information here into something relevant to where you live.  Or you might post a country specific question in the comments below.  The readership of jlcollinsnh has been growing quickly and there are a lot of savvy investors on board who may well be able to help.

Here in the USA the government taxes dividends, interest and capital gains.  But it has also created several Tax Advantaged Buckets to encourage retirement savings.  While well-intentioned, this has created a whole new level of complexity.  Volumes have been written about each of these and the strategies now associated with them.  Clearly, we haven’t the time or space to review it all.  But hopefully I can provide a simple explanation of each along with some considerations to ponder.

The Ordinary Bucket is, in a sense, no bucket at all.  This is where everything would go were there no taxes on investment returns.  We would just own what we own.  Easey peasy.  This is where we’ll want to put investments that are already “tax efficient.”

There are several variations of Tax Advantaged Buckets, and we’ll look at each.  These are the buckets in which we’ll want to place our less tax efficient investments.  In general this means investments that generate dividends and interest.

Let’s look at our four investments from Part IV:

Stocks.  VTSAX (Vanguard Total Stock Market Index Fund) pays around a 2% dividend and most of the gain we seek in in capital appreciation.  Ordinary Bucket.

Real Estate.  VGSLX  (Vanguard REIT Index Fund)  REITs (Real Estate Investment Trusts) invest in real estate and this is also a play for capital gains.  However REITS also tend to pay dividends, VGSLX in the range of 3-4%.  Tax Advantaged Bucket.

Bonds.  VBTLX (Vanguard Total Bond Market Index Fund)  Bonds are all about interest.  Tax Advantaged Bucket.

Cash is also all about interest but, more importantly, it is all about ready access for immediate needs.  Ordinary Bucket.

None of this is carved in stone.

There may be exceptions.  Proper allocation should trump bucket choice.  Your tax bracket, investment horizon and the like will color your personal decisions.  But the above should give you a basic framework for considering the options.

Before we look at the specifics of IRAs and 401Ks, this important note:

None of these eliminates your tax obligations.  They only defer them.

Fix this in your brain.  We are talking about when, not if, the tax due is paid.

You’ll pay tax anytime you withdraw your money and once you reach age 70 1/2 you’ll be faced with RMDs (required minimum distributions).

There are many, many variations of 401K and IRA accounts.  If you are self-employed or work for the government, for example, each has its own variation.  We’ll look at the three basic varieties here.  The rest are branches from these trees.

401K/403b.  These are buckets provided by your employer.  They select an investment company which then offers a selection of investments from which to choose.  Many employers will match your contribution up to a certain amount.  Both your and your employer’s contributions are tax deferred, reducing your tax bill for the year.  All earnings are also tax deferred.  The amount you can contribute is capped.  In general:

  • These are very good things. (but not as good as they once were. See Part VIII-b) I always maxed out my contributions.
  • Any employer match is an exceptionally good thing.  Free money.  Contribute at least enough to capture the full match.
  • Unless Vanguard happens to be the investment company your employer has chosen, you won’t have access to Vanguard Funds.  That’s OK….
  • …Most 401k plans will have a least one Index Fund option.  Look for that.
  • When you leave your employer you can roll your 401k into an IRA preserving its tax advantage.  Some employers will also let you continue to hold your 401k in their plan.  I’ve always rolled mine.
  • Taxes are due when you withdraw your money.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to RMDs.

IRAs are buckets your hold on your own, separate from any employer.

– Deductible IRA.  Contributions you make are deductible from your income for tax purposes.  In general, you’ll want to use these if you are in a high tax bracket and are looking for a deduction to lower your immediate tax obligation.  Just like an 401K.

  • All earnings on your investments are tax deferred.
  • Taxes are due when you withdraw your money.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to RMDs.

- Non Deductible IRA.  Contributions you make are NOT deductible from your income for tax purposes.

  • All earnings on your investments are tax deferred.
  • Taxes are due on any dividends, interest or capital gains earned when you withdraw your money.
  • Taxes are not due on your original contributions.  Since these contributions were made with “after tax” money they have already been taxed.
  • Those last two points mean extra record keeping and complexity in figuring your tax due when the time comes.  A bad thing.
  • Money withdrawn before 59 1/2 is subject to penalty.
  • After 70 1/2 money is subject to RMDs.

- Roth IRA.  Contributions you make are NOT deducible from your income for tax purposes.

  • All earnings on your investments are tax-free.
  • All withdrawals after age 59 1/2 are tax-free.
  • You can withdraw your original contribution anytime, tax and penalty free.
  • There is no RMD.
  • It can be passed to your heirs tax-free and will continue to grow for them tax-free.

All of these have income restrictions for participation.  These change year-to-year, here’s a current table:

In short:

401k/401b = Immediate tax benefits & tax-free growth.  No income limit means the tax deduction for high income earners can be especially attractive.  But taxes are due when the money is withdrawn.

Deductible IRA = Immediate tax benefits & tax-free growth.   But taxes are due when the money is withdrawn.

Non-Deductible IRA = No immediate tax benefit, tax-free growth and added complexity.  Taxes due when the money is withdrawn.

Roth IRA = No immediate tax benefit, tax-free growth and no taxes due on withdrawal.   A better Non-Deductible IRA, if you will.

Now, if you’ve been paying attention, you might be thinking “Holy cow!  This Roth IRA is looking like one very sweet deal.  In fact it is even looking like it violates what jlcollinsnh told us to fix in our minds earlier: ‘None of these eliminates your tax obligations.  They only defer them.‘”  True enough, but as with many things in life there is a catch.

While the money you contribute to your Roth does indeed grow tax-free and remains tax-free on withdrawal, you have to contribute “after-tax” money. That is, money upon which you’ve already paid tax. This can be easy to overlook, but it is a very real consideration.

Look at it this way. Suppose you want to fund your IRA this year with $5000 and you are in the 20% tax bracket. To fund your deductible IRA all you need is $5000 because, since it is deductible, you don’t need any money to pay the taxes due on it. But with a Roth, you’d need $6000: $5000 to fund the IRA and $1000 to pay the 20% tax due on the $5000. That $1000 is now gone forever and so is all the money it could have earned for you over the years. Were you to fund your deductible IRA instead of your Roth, this $1000 could then be invested rather than going to paying taxes.

Personally, I find it very emotionally satisfying to fund a Roth, pay the taxes now and be done with them. But it might not be the best financial strategy.

Further, because I’m the suspicious type, and the tax advantages of a Roth are so attractive, I start thinking about what might go wrong.  Especially since these are such long-term investments and the government can and does change the rules seemingly on a whim.  Two things occur to me:

1.  The government can simply change the rules and declare money in Roths taxable.  But since Roths are becoming so popular and are held by so many people this seems more and more politically unlikely.

2. The government can find an alternative way to tax the money.  Increasingly in the USA there is talk of establishing a national sales tax or added value tax.  While both may have merit, especially as a substitute for the income tax, these would effectively tax any Roth money as it was spent.  This seems more likely to me.

OK, you now are probably thinking: No Roth for me – deductible IRA, that’s the ticket. I’ll take the immediate tax savings and let more of my money compound over time for me.

Well, it is not quite so easy. So which is better? Pay the taxes today and invest in a Roth or take the deduction today with an IRA and worry about taxes later?

In part it depends upon your age, and many readers might well be far along the path of one or the other. But let’s say you are 30 years old and have 40 years until you reach 70 1/2 and face those RMDs (required minimum distributions). A lot can happen in 40 years. Personally I’d be inclined to take the tax benefit today and let that money work for me over the decades. Hopefully, that growth will be greater than the taxes then due.

Let’s finish with the recommendation that, whenever possible, you roll your 401K/403b accounts into your personal IRA. Usually this is only possible when you leave your employer. As we’ve already seen, employer plans are all too frequently laden with excessive fees and your investment choices are limited. In your IRA you have far more control.

Personally, I’ve always been slightly paranoid about having my employers involved in my investments any longer than I had to. The moment I could roll my 401K into my own IRA, I did. Usually, this means once I left the job.

Finally, lets talk a bit about withdrawal strategy.  Except for the Roth, all of these have RMDs (required minimum withdrawals) at age 70 1/2.  Basically this is the Feds saying “OK.  We’ve waited long enough.  Time to pay us our money!”  Fair enough.  But for those of us diligently building FI (financial independence) there is going to be a very large amount of money in these accounts.  Pulling it out in the required amounts on the government time schedule could easily push us into a higher tax bracket.

Assuming when you retire your tax bracket drops, you have a window of opportunity between that moment and age 70 1/2.  Let’s consider an example.

A married couple retires at 60 years old.

  • They have a 10 year window until 70 1/2 to reduce their 401k/IRA holdings.
  • The 15% tax bracket is good up to 69k.
  • Personal exemptions and the standard deduction are good for another 19k.
  • They have up to 88k in income before they get pushed into the 25% bracket.

If their income is below 88k they should seriously consider moving the difference out of their IRA and/or 401k and taking the 15% hit.  15% is a very low rate and worth locking in.  So, if they have 50k in taxable income they might withdraw another 38k.  They could put it in their Roth, their ordinary bucket investments or just spend it.

There is no one solution.  If your 401k/IRA amounts are low you can just leave them alone.  If they are very high pulling them out even at a 25% tax might make sense for you.  The key is to be aware of this looming required minimum withdrawal hit so you can take it on your own terms.

One final note. We’ve touched a bit on tax laws in this post. While the numbers and information is current as of 2014, should you be reading this post a few years after publication, they are sure to have changed. The basic principles should hold up for some time, but be sure to look up the specific numbers that are applicable for the year in which you are reading.

Addendum #1– October 17, 2012:  Health Saving Accounts (HSAs)

Some readers may have access to HSAs.  These can be extraordinary useful retirement tools, in addition to providing funds to cover health care costs.  My pal, The Mad Fientist, has put together a terrific review on hacking your HSA:  http://www.madfientist.com/ultimate-retirement-account/?utm_source=rss&utm_medium=rss&utm_campaign=ultimate-retirement-account

If you are interested, here is my take on HSAs.

Addendum #2– March 10, 2013:

Here’s a great strategy for using IRAs and Roth IRAs at different stages of your life: Traditional IRA vs. Roth IRA _ The Final Battle

Plus there is a really cool picture of two foxes.

Addendum #3:

In the comment section under Part IX of this series reader Prob 8 posted:

“If anyone doubts JLC’s claims regarding the impact of fees and commissions on your portfolio, please check out this video from PBS:http://www.pbs.org/wgbh/pages/frontline/
It’s called The Retirement Gamble. (You’ll have to paste that into the search box to find the video.) There are interviews with Jack Bogle and all you’ll need to know to realize fees and investment advisors are hurting your portfolio more than helping.”

I just finished watching it. Very powerful stuff and I highly recommend readers here check it out.

The math on how damaging even seemingly modest 2% fees really are is nothing short of breathtaking; and even I didn’t fully appreciate just how laden with fees 401k plans have become. Yikes!

Thanks Prob 8!!

Addendum #4: TSP Plans

Buried in the comments below is a conversation with reader Enceladus. It starts July 5th, 2013 if you want to scroll down to read the full exchange. But for my thinking on TSP Plans, here is the low-down:

Hi Enceladus…

TSPs are retirement plans for Federal employees, including military personal.  Think 401k for government employees. But better.

One of the cool things about writing this blog is how much I get to learn. Not having any personal experience with TSPs I did a little digging. Unlike the fee heavy cesspool too many 401k plans have become your TSP offers a nice, but not overwhelming, selection of low cost index funds. As you point out, only .027% last year.

Looking at the chart of ERs going back to 1999 the ER has ranged from a low of .015% in 2007 to a high of .102% in 2003. Seems the variation is due, to quote the site, to:
“The TSP expense ratio represents the amount that participants’ investment returns were reduced by TSP administrative expenses, net of forfeitures”

Still, even at the worst these are very low ERs. And they seem to be coming down in the last five years or so. Good deal.

Also a good deal is that the funds are index funds. The C-fund you mentioned for instance replicates the S&P 500 index. The S-fund is the small cap index. Own both in about a 75/25 balance and you’ve basically got VTSAX. The F-fund is a bond index.

To answer your question: Yep. These are a no-brainer. I’d max out my TSP right after the civilian 401k for the match. Then Roth.

As for your mix of stock v. bonds, at age 26 I’d go light on the bonds if at all. 10% maybe.

Looking at your total assets as a whole (which is the only way to figure asset allocations), I’d try for something like this:

10% in G-fund (bonds)
25% in S-fund (small cap)
65% in FUSVX/C-Fund

These are all low cost index funds and will serve you well over the decades.

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81 Comments

  1. Posted May 30, 2012 at 10:03 pm | Permalink

    Another gem article Jim. As you know, I am a big advocate of the national sales tax. As you’ve pointed out, Roth IRA investment will be taxed if that money is used for the purchase. But, the savings by avoiding double taxation on your earned income itself will be more than 23% to begin with. So, even if you pay taxes on Roth IRA — or for that matter any dollar spent on purchase — savings will offset national sales tax.

    • Posted May 30, 2012 at 11:05 pm | Permalink

      Your article awhile back on the sales tax is what made me think of it!

      Of course for us retired guys without earned income there is no offset with the change.

      Still, it is an idea well worth consideration. Any change in the tax code, however worthwhile, will always have a few that fair less well than before. But that’s no reason not to change.

  2. LtotheBmoney
    Posted May 30, 2012 at 10:27 pm | Permalink

    I am so glad you wrote this, because I am wanting to move my Roth at USAA to Vangaurd. If I can invest more than $5k per year, should I transfer into a fund like the VTSAX as a Roth and open a seperate “regular bucket” index fund and throw as much money into this as possible? You, Dave Ramsey, and MMM rock!

    • Posted May 30, 2012 at 11:11 pm | Permalink

      If I understand you correctly, yes. Here’s what I hear you saying:

      You want to be entirely invested in VTSAX.
      You have more than $5000 to invest each year.
      You plan to open a Roth bucket and put a VTSAX investment in it for $5000.
      You plan to open a second VTSAX fund investment in an Ordinary Bucket for every extra penny you can spare.

      That is exactly what I recommend for young people.

      So, do we rock in that order? :)

      • AB
        Posted June 14, 2012 at 7:24 pm | Permalink

        I want to do the same thing as Bmoney, move my USAA Roth over to Vanguard. I was planning on using the Roth as my bond and REIT funds, and doing the $2,500 to both funds each year, then having the stocks fund in a taxable account. My question is this, I currently have my Roth invested in individual stocks. If I were to move the IRA over to Vanguard, will the stocks still be in it, or would I have to sell them with the USAA brokerage and then move just the cash over?

        • Posted June 16, 2012 at 11:33 am | Permalink

          Hi AB….

          You can move your Roth, and the individual stocks, directly to Vanguard. Then, if you prefer to have the money in the bond and REIT funds, you can simply sell the stocks and move the money into the funds.

          It is very important to be sure you do all this within the Roth bucket so you avoid tax and penalties.

          If you call Vanguard, they can walk you thru the process.

          good luck!

  3. Matt
    Posted May 30, 2012 at 10:45 pm | Permalink

    Very timely article. I have slowly been moving towards investing and was struggling to understand what investments to make in what accounts. With something like the bond fund and the REIT, are you able to set up a Roth that consists of those two funds? Rookie question I know.

    • Posted May 30, 2012 at 11:22 pm | Permalink

      Hey Matt….

      Welcome! No question is rookie. All questions are rookie. Zen for today. ;)

      The answer is: Yes.

      You would contact Vanguard (assuming that’s the company you’re going with), send them the money and provide instructions as to which funds.

      For instance, let say you are just starting a new Roth with the $5000 max you are allowed to contribute for 2012. You might put $2500 each in VBTLX and VGSLX.

      The EXACT way I would do this is to open a money market fund with the 5k. Once that is established you can easily move the money to the other funds right on the Vanguard website.

      You’ll find their phone number at any of the links I provided. They are very helpful and will be happy to walk you thru the process.

      If you are going to rollover an existing IRA definitely call them. They’ll make it a breeze.

      Tell ‘em jlcollinsnh sent ya! They won’t have a clue who that is, but why not! :)

      • Posted May 18, 2014 at 10:16 am | Permalink

        Great article Jim!

        I also have several Vanguard funds and ETFs. In fact, I’ve 3 Portfolios and one of the portfolio (High-Dividend Investment Portfolio: HID1) primarily consists of Vanguard ETFs as elaborated in my blog.

        I would like to add that Vanguard have a minimum requirement of $3000 for any FUND, except for star fund ($1000), while, ETFs have no restrictions like that and can be bought just like any stock and have lower expenses as well.

        Keep up the good work!

        Best wishes,
        PIM

  4. Patrick
    Posted May 31, 2012 at 7:31 am | Permalink

    It’s interesting to note that the only mathematical difference between a Roth and Traditional, deductible IRA is the tax rates, if you ignore the 70 1/2 required withdrawal. I can give a quick proof…

    For a starting amount, x, and an annual rate of return, i, the way to calculate the return after one year is x(1+r). (If you have $100 invested at 5%, at the end of a year, you’ll have 100(1.05) = 105.) To accumulate another year, tack another 1+r to the end, with the idea that r could vary year to year. Let R = (1+r1)(1+r2)…(1+rn), with each r being another year’s specific rate.

    If the tax rate is t, then, for a traditional IRA, your total due in taxes is: x*R*(1-t). In English, take the initial investment, multiply it by all of the annual rates of return, and take out taxes. For a simple example, take $100, invested for 2 years, with rates of return 10% and 3%, in the 15% tax bracket. 100(1.1)(1.03) = 113.3 – 15% = 96.31.

    For a Roth, the equation becomes x*(1-t)*R. Take the initial investment, take out taxes, and multiply it by all of the annual rates of return. Using the same numbers as above, 100 – 15% = 85 * (1.1)(1.03) = 96.31.

    Because multiplcation is commutative, these calculations are equal, provided t is equal. If you expect to be in a higher tax bracket in the future, you would want a Roth, because then you would pay taxes now, in your lower tax bracket. If you expected to be in a lower tax bracket in the future, you would want a traditional, deductible IRA. So you can’t say which is better unless you can determine this…you’ll likely have less income in retirement, so your bracket might drop, but taxes are low now, and income tax increases might be a way for the feds to get a handle on the deficit.

    • Posted May 31, 2012 at 8:28 am | Permalink

      Wow, Patrick….

      thank you!
      what a great, great addition to this post.

      Even if I did need my second cup of coffee to follow the math. ;)

      I took the liberty of highlighting in bold the conclusions in your last paragraph. and what you say also applies to a 401K v. Roth.

      Since, especially for a young person it is very difficult to predict future income and tax rates, I’d still lean toward the Roth. That’s how I’ve steered my 20-year-old. As someone looking looming Required Minimum Withdrawals I can tell you avoiding them with a Roth is a big advantage.

      In addition, as serious a challenge as the deficit is, increases in the income tax are politically unlikely. Except the Bush Tax Cuts which, if only due to gridlock, will in all likelihood be allowed to expire.

      More likely, I believe, will be some sort of National Sales or Value Added Tax. Along with inflation which is a great deficit reducing tool, although hard on the creditors.

      • Patrick
        Posted May 31, 2012 at 9:29 am | Permalink

        The math is definitely fun! :) I agree that a young person should lean more toward the Roth since their income is likely low enough to put them in a low tax bracket, and then in the middle of their careers, switch over to a traditional/401(k). For an average-Joe traditional retirement, I imagine people won’t have trouble making their minimum withdrawals, because they’ll likely come close to exhausting the whole thing.

        For the early retirement folks, who save tons of money, it might still be worthwhile to max out the deductible savings early…if you do it like MMM, you’d have 150k/year of income before retirement, and about 35k/year after. It might still make sense to get that up-front deduction for maxing a 401(k) since there’s such a wide difference between the tax brackets. (After exemptions and the child tax credit, I don’t imagine he pays much taxes at all any more.) The big drawback is the required minimum withdrawals, but I wonder if they’d put you back up in that same high tax bracket you were in to begin with…

        There is one other plus of the Roth…the maximum contribution limit. In paying the taxes up front, they are not part of the contribution limit. So, given a limit of 5k, you can put as much as x(1-t)=5k into your Roth, but only x=5k into your traditional, and in the traditional, you’d have to pay taxes later. A contribution of 5k in a traditional IRA is roughly equivelant to one of 5,882 pre-tax into a Roth, but still comes under the 5k limit…I hope that makes sense… :)

        It’s an interesting conundrum, but at least it provides some useful talking points.

        • Posted May 31, 2012 at 9:54 am | Permalink

          more great points and again I’ve taken the liberty of highlighting a couple.

          The strategy in your first paragraph makes perfect sense. Roth v deductable IRA/401k contributions should idealy change with your income.

          and I love the point you make in the last. that’s been rattling around in my head but I couldn’t quite get it out. thanks!

  5. Danielle
    Posted May 31, 2012 at 1:03 pm | Permalink

    Hi Jim, MMM reader here. First off, I’m enjoying your blog a lot – these stock posts have been immensely helpful. As for investing strategies for ER folks, it seems like a good game plan would to be to max some contributions to a traditional IRA or 401k to reduce tax burden in the short term and use that investment for “old man/lady money” (how ever much you calculated that you’d personally need), then have a Roth to tap into pre-59.5 retirement needs (withdrawing deposits without killing too much investing momentum) if necessary. Does that make sense to you?

    I plan on opening a Roth and also a regular investing portfolio at Vanguard to get in the game, however at the moment I only have funds to choose one (and I already have a 401k started). Given that I’m 26 and would like to retire in 10-15 years, which one would be better (or easier to get my feet wet with)?

    • Posted May 31, 2012 at 6:02 pm | Permalink

      Thanks Danielle….

      …good to hear it’s helping and glad to have you here.

      I like your plan and, if you haven’t already, check out the link KC provided above. It’ll take you to an excellent MMM post on this exact subject.

      Since you are 26 and, I’m guessing, in a low tax bracket this is the order I’d suggest:

      401k up to full company match, if any.
      Roth
      Regular

      If you happen to be in a very high tax bracket:

      401k Max
      Deductible IRA
      Regular

      • Austin
        Posted June 11, 2012 at 2:53 pm | Permalink

        Hi Jim,

        New but avid reader. Had the same question as Danielle above, and am 25 myself. Only one follow up: Following the plan of:

        1) 401K up to full company match, if any (already doing this)
        2) Roth
        3) Regular

        is it accurate to say that the Roth should be backed by VBTLX and VGSLX, and only after putting $5K-worth into that IRA backed by bonds and REITS, move remaining money to VTSAX? Reason i ask is because that seems to follow your tax-advantage/non-tax advantaged bucket rubric, but is somewhat in violate of “VTSAX = primary building block” gospel. Please advise, thanks!

        • Posted June 11, 2012 at 3:30 pm | Permalink

          Thanks Austin,

          and welcome. Great question!

          If you are going to hold VBTLX (bonds) and/or VGSLX (REITS), yer ideally both belong in a tax advantaged account like an IRA, ROTH or 401k. The reason is they throw off more divedents and interest that would be taxable otherwise than VTSAX (stocks).

          but the more important question is wether you should hold these at all. both belong in a portfolio to smooth the ride and:

          VBTLX is a hedge against deflation.
          VGSLX is a hedge against inflation.

          I hold both for these reasons, but I’m an old guy.

          Over time, VTSAX will very likely outperform both, but expect a wild ride along the way.

          If I were 25, (and oh how I wish it could be so!) I’d put everything in VTSAX and ride out the storms. 30-35 years from now I’d look to add the other two.

          Thinking back at all the investments I’ve tried over the past 36 years since I was your age, some blew up and some outperformed. But if I had ignored them all and simply bought VTSAX and added to it as I could, I’d have over twice the net worth I do today.

          Even if I’d done it with VBTLX and VGSLX in the mix I’d be far ahead.

          Just don’t lose your nerve in the dark times and there will be dark times.

  6. A
    Posted May 31, 2012 at 2:51 pm | Permalink

    Hi jlcollinsnh —

    I’ve been struggling with determining where to put money (ordinary bucket vs tax advantaged bucket) for years, and I’m not much closer to settling the debate with myself this year than I was 5-10 years ago. Though this article illuminates things a bit more for me. Thank you.

    I’ve basically defaulted to satisfying my desire for instant (short term) gratification, i.e. reducing the tax burden I have today. So I max out contributions on the tax advantaged buckets — 401k and traditional IRA — and I plough the rest of my money into the ordinary bucket (mostly index funds, some individual stocks, and cash savings). At 35, single, renter, no kids, no debt, low expense lifestyle, and $70k per year salary, my after tax money gets allocated something like this: $21,500 to the tax advantaged 401k/IRA bucket, $26,000 to the ordinary bucket, and $15,000 in living expenses.

    I don’t know if deferring taxes on the $5000 I’m currently putting into the Traditional IRA and instead paying the taxes now and contributing to a Roth IRA would make much difference in the long run, but my aversion to paying the taxes now is motivating my to stay the course I’m on. But I welcome any compelling argument for me to reconsider, if you have any given my particular situation.

    Thanks!

    • A
      Posted May 31, 2012 at 2:57 pm | Permalink

      …guess it would be more accurate for me to say “my salary gets allocated something like this: $21,500 to the tax advantaged 401k/IRA bucket, $7300 to federal+state taxes, $26,000 to the ordinary bucket, and $15,000 in living expenses.”

    • Posted May 31, 2012 at 5:54 pm | Permalink

      Hi A….

      Well first, major league kudos on the 67% savings rate! That alone should keep you golden.

      Here’s some thoughts:

      While I appreciate your aversion to paying taxes, at 70k you are already in a fairly low rate, even before the 21.5k deduction.

      With your savings rate, if you are planning to work anything like a full career (that is to 60+ years old) your retirement accounts will be HUGE. Pulling all that money out could easily put you in a higher bracket than today’s.

      Personally, I’d be inclined to begin a Roth.

      BTW, be sure to read Patrick’s comments below.

  7. KC
    Posted May 31, 2012 at 4:02 pm | Permalink

    I really appreciate this article. I’m always telling myself to just “decide already!” where the money should go and leave it on auto pilot. I have major issues with analysis paralysis!

    Here’s a post from MMM I thought was an interesting take on retirement accounts…
    http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

    Thanks for any input.

    • Posted May 31, 2012 at 5:41 pm | Permalink

      Thanks for the link KC….

      …I hadn’t seen that one from MMM before. Great addition to this conversation and I like the 401k/Roth strategy for early penalty-free withdrawals. Hadn’t heard that one before.

  8. Josh
    Posted June 1, 2012 at 9:07 am | Permalink

    Great article and glad I found you by way of MMM. I’m fortunate enough to have the option of a Roth401K with vanguard and take full advantage of it, up to the match. Is this becoming more common? I know it was new for us last year and most people don’t know about the option or understand it. I’ve had to explain it to everyone I talk to. This article may help a bit. Thanks.

    • Posted June 1, 2012 at 9:32 am | Permalink

      Welcome Josh…

      ….good to see you here!

      With Vanguard funds and a Roth 401k on offer sounds like your employer has it together!

      The Roth 401k is relatively new and for some reason has been slow to catch on. No surprise you’ve been having to explain it. :)

      The difference between it and a regular 401k is the same as the difference between a Roth and a deductible IRA as described above. And, of course, being a 401k the amount you can contribute is much higher than an IRA.

      In other words, a very good thing.

      Especially for anyone in an already low tax bracket and/or those of you planning an early retirement (your contributions, but not earnings, can be withdrawn tax and penalty free anytime as long as you’ve held the account 5+ years).

      Feel free to correct or add anything here Josh, and thanks for pointing it out!

  9. Carolina on My Mind
    Posted June 1, 2012 at 6:18 pm | Permalink

    Hi, jlc — I’ve been learning from your blog for a few months, and I’m finally inspired to comment because this is exactly the question I’ve been struggling with for a while. I know how I want to allocate my investments, but I could never figure out what should be in my 401(k) and what should be in my after-tax accounts. Now, just like that, I have a strategy. So thank you!

    This whole series has been really, really helpful.

    • Posted June 1, 2012 at 6:21 pm | Permalink

      Hi Carolina…

      thanks so much for letting me know.

      Actually, I added this post to the series almost as an after thought and yet it seems to have resonated with folks. Glad you found value in it!

  10. Christina
    Posted June 4, 2012 at 11:52 am | Permalink

    Great article- as always. I have really enjoyed reading your blog!

    I have a question for you, if you don’t mind indulging me for one moment. I am a novice at investing, but my husband and I do have a 401K and a Roth IRA. Our Roth is in several Fidelity Funds through our insurance company. The company charges $25 a year for the Roth, plus whatever fees Fidelity charge- which I am finding impossible to discern.

    I figured we have two options in regards to our Roth:

    1. Instead of having the Roth in several different Fidelity funds, moving them all to their Index Fund. If Fidelity is a low cost, low fee service I would like this option as it is simpler. Do you know much about Fidelity? (I have tried researching on their website, but find it difficult to get answers)

    2. Moving all of our Roth to a Vanguard Roth, where I know the fees are low.

    What would you suggest? Of course, I know you are simply giving suggestions and I am responsible for my own decisions. I think I know what your advice is, but I feel like I need a second opinion before I make such a critical decision.

    Thank you so much in advance! For a novice investor, it is wonderful to learn from somebody who has been so successful!

    • Posted June 4, 2012 at 12:19 pm | Permalink

      Hi Christina….

      Yep, as I’m sure you’ve already guessed, I say go right to Vanguard behind Door #2!

      Even if you want to stay with Fidelity, there is no reason to buy/own your funds thru an insurance company. Other than giving them the chance to pick you pocket with fees.

      If you haven’t already, for more on Fidelity, check out the comments here:

      http://jlcollinsnh.wordpress.com/2012/05/09/stocks-part-v-keeping-it-simple-considerations-and-tools/

      • Christina
        Posted June 4, 2012 at 6:40 pm | Permalink

        Thank you so much! I thought that is what you would say, but it is nice to hear it and reconfirm what I had been thinking. Thank you!!

  11. vvroom
    Posted June 14, 2012 at 7:15 am | Permalink

    Another great way to lower your tax bracket is to live 330 days out of 12 months outside of USA to qualify for the foreign residence tax-deduction. As of 2011, that reduced my taxable income by $92K. Its adjusts up every year due to inflation.

    If you are expecting a big hike in your tax bracket from withdraws, live overseas. Then in the same tax year, max-out your withdraws to $88K + $92K. You will rake in $180K of income, but still at 88K tax bracket.

    • Posted June 14, 2012 at 8:20 am | Permalink

      Hi Vvroom…..

      Very interesting point you’re making here. Can you elaborate for us? My understanding is that:

      1. The US government taxes any and all of the income earned by it’s citizens no matter where in the world thy live and no matter where in the world they earn it. This, I gather, is a uniquely aggressive tax policy.

      2. To off set this, the first 92k earned outside the US in tax free.

      This is what you are saying:

      using my example above of 88k in income ceiling to stay in under the 15% tax bracket, living overseas at least 330 days would allow for adding an extra 92k to our income with no further tax due.

      This would be a great way to empty 401k and IRA accounts tax free.

      But, doesn’t that 92k taxable income reduction apply only to income earned outside the USA?

      Can you tell us more about your situation?

      thanks!

      • Vvroom
        Posted June 14, 2012 at 7:13 pm | Permalink

        There’s actually two ways to qualify for this huge deductions

        1. Physical Presence Test. Accrue 330 days out of 12 months outside of US states and territories. These days do not have to be consecutive days.

        2. Bonifide Residence Test. Prove you are a permanent residence in your foreign country. I think you can come visit your family at the US more than 35 days in a year if you qualify.

        IRS.GOV has the forms with info.

        No, the income does not have to be foreign earned. All my income is domestic (US based employer). But physically, I was outside US for 330 days of 12 months.

        Bonifide Residence Test has the disadvantage of applying for residency at your new place and paying their tax (if any).

        To make physical presence test work, you can visit several countries using a tourist visa for 330 days. Then come back to the States and reap the rewards.

        • vvroom
          Posted June 15, 2012 at 5:27 am | Permalink

          Upon investigating further, you would not be eligible for the foreign exclusion from IRAs because dividends and capital gains are unearned income. This exclusion applies to foreign earned income only. Read more at:

          http://www.irs.gov/publications/p54/ch04.html#en_US_2011_publink100047499

          • Posted June 16, 2012 at 11:27 am | Permalink

            Thanks, Vvroom…

            great addition to the discussion.

            too bad the rule excludes IRA money. It was looking like a great way to limit taxes on those withdrawals!

  12. AB
    Posted June 14, 2012 at 7:55 pm | Permalink
    • Posted June 16, 2012 at 11:19 am | Permalink

      thanks AB….

      Vanguard has lots of great info on their site like this.

  13. Austin
    Posted June 14, 2012 at 8:36 pm | Permalink

    Hi Jim,

    Thanks so much for the feedback. Always nice to know that with starting early comes simplicity in an approach.

    A follow-up: I absolutely love the comparison of dollars to employees, and am eager to put mine to work! That said, I’ve often been concerned with the prospect of putting a down payment on a home in the next 5-10 years (I’m 25 and rent, no student loan debt….yet). How do we marry the idea of “spend less than you earn, invest the rest, don’t accrue debt” with the potential of purchasing a home and needing liquid funds to do so?

    I’m sure there’s a simple, simple answer (government exception to withdrawing from 401K for first-time homebuyers?) so figured I’d pose the simple-minded question :)

    Thanks again

    • Posted June 16, 2012 at 11:19 am | Permalink

      Hi Austin….

      The great thing about your dollar slaves is once you get them started they work tirelessly 24/7 for you. At 25 and no debt you’re at a wonderful starting place.

      Regarding a home, if you haven’t already, read:

      http://jlcollinsnh.wordpress.com/2012/02/23/rent-v-owning-your-home-opportunity-cost-and-running-some-numbers/

      Most often owning a home is an expensive indulgence. Running the numbers will tell you if it makes financial sense.

      Of course, as with any indulgence, there are lots of reasons to want a home beyond just money.

      The whole point of having F-you money is to expand our lives as best suits up. But accumulating the money comes first.

      As with anything, I wouldn’t buy one, or anything else, unless I could easily afford it. In the case of a house that would mean at least 20% down and no more than 25% of my monthly income to service the mortgage, insurance, taxes, repairs and maintenance. If that sounds like a high bar, well, it is.

      Most people shouldn’t own a house. When you do, lots of people make money, but not you:

      The real estate brokers
      The banks
      The insurance companies
      The utilities
      The appliance companies
      The furniture companies
      The home improvement stores
      The garden stores
      The painters, carpenters, plumbers, roofers, exterminators, electricians,
      and more I’m not thinking of just now.

      Suddenly you are pulling your little dollar slaves off the job and sending them away to live with somebody else.

  14. Posted June 19, 2012 at 2:32 pm | Permalink

    In the comments over here: http://jlcollinsnh.wordpress.com/2012/06/12/i-could-not-have-said-it-better-myself/#comments

    JTH posted the following question:

    “Getting ready to retire (30 days). Corporate job. Pension and 401k. Do I take a lump sum on pension or take an annuity?”

    Since this post is a better fit, I’m taking the liberty of answering here. Hopefully more people with a similar concern will see it.

    So, JTH, Congratulations on your pending retirement!

    OK, let’s take a look.

    This is not a simple “do this not that” kinda question. What is best for you is a very personal decision. But with a few guideposts to consider you can walk yourself thru the process.

    First, take comfort in the fact there is really no “bad” decision you can make here.

    Unless you take the lump sum and put it on red in Vegas and up comes black. That would be very bad.

    So question #1 is how confident do you feel in your own investing abilities? If there is any chance at all that you’ll blow this money: No lump sum for you!

    This would also apply if you have any pending lawsuits or judgements against you.

    If you decide to take the pension/annuity you’ll find The insurance companies that operate these things are very good a figuring the odds. They can calculate within a whisker how long people with your profile, and that of your spouse, will live.

    You will notice that you have several further options if you take the pension/annuity. Payments just to you until you die. Payments until both you and your spouse die. Guaranteed payments for a certain number of years. Built in inflation protection. This list is endless.

    Inflation, in my view, is the biggest risk with pensions/annuities. If you are retiring at, say, 60 and think you might live to be 90, that’s thirty years. Even at modest inflation rates the buying power of that check will be very much lower then than now.

    But each item you select lowers your monthly check. Again, they are calculating the averages very precisely. So there is no one “right” answer.

    But those are only averages (which is what matters to them) and you are unique.

    So question #2 is: how long do you and your spouse expect to live?

    The longer you expect to live the better the pension/annuity option looks. And guessing at this will help you choose the benefits best suited to your personal profile.

    The shorter you expect to live the better a lump sum looks.

    Question #3 is: do you want to leave this money to your estate/heirs? If so: lump sum. Although one of the options you may be offered is a smaller monthly check with some money to be passed on.

    Consider, too, that you already have another annuity coming, and this one is inflation adjusted: Social Security. Many of the same considerations as above can steer you in selecting when to start drawing on it. Again, the actuaries have figured to the whisker what payouts to allow at what age. So there is no one “right” answer. But looking at your own situation you can figure what will likely work best for you.

    The nice thing about SS and pensions is that those checks just keep rolling in with no effort. As we all get older and less sharp, having that guaranteed income we can’t lose is a pretty attractive option.

    That said, I took my own small pension as a lump sum.

  15. klr
    Posted September 15, 2012 at 10:41 pm | Permalink

    Jim,

    I stumbled onto your blog this week and have caught up with all your money posts. I would like to say that your guidance has probably saved me months of research and lots of frustration. Thank you for the great topics, but I am now trying to figure out my plan and my head is spinning.

    I’m 26 and have recently graduated from college, and decided to get my financial life in order. Luckily, I was able to find a great job and have no debt. I am working on saving up my emergency fund (roughly 24% of my income is going into it) and now focusing my efforts on investments.

    I was also lucky that my grandparents seeded an investment fund for all of the grandchildren when each was born. It has been managed by a financial advisor for years, and your posts have confirmed my thoughts that I can do better. It currently has around $35,000 in it in 12 different mutual funds.

    Next June, I will be eligible to enter my employer’s 403(b) plan and also a pension plan. I am able to put 3% of my income into the 403(b) plan and they match with 2.5%. It looks like I will be able to enroll in Vanguard’s total stock market index fund. There is also an optional traditional IRA plan that I can contribute up to the maximum allowed by the IRS. It seems that after learning more about all of this, the 5.5% of my yearly salary into my 403(b) is nowhere the maximum allowed by the IRS, which is a little discouraging.

    I don’t think I’m going to do the optional IRA account and instead do a Roth IRA on my own. What is your suggestion on getting rid of my financial manager and all the mutual funds and buying into VTSAX? I don’t fully understand the tax implications that are involved in that. Correct me if I’m wrong, but $5000 would go into the Roth and the rest into a traditional account. I think I know the answer, but do you think it is fine to have the investments in my 403(b), Roth IRA, and my regular account in VTSAX?

    Sorry for the long post, but any assistance would be greatly appreciated.

    Thanks

    • Posted September 15, 2012 at 11:11 pm | Permalink

      Hi KLR….

      ….great questions and I’ll be giving you a detailed answer* in the next day or so. But before I do can you provide a bit of clarification for me? I don’t entirely understand what you are referring to when you say: “There is also an optional traditional IRA plan that I can contribute up to the maximum allowed by the IRS.”

      Are you talking about something offered thru your company or just a regular IRA?

      *here it is: http://jlcollinsnh.wordpress.com/2012/09/17/putting-the-simple-path-to-wealth-into-action/

      • klr
        Posted September 16, 2012 at 1:10 am | Permalink

        Jim,

        Thanks for the quick response on a Saturday. I’m sorry for the confusion. The IRA is offered through the company and is called the “supplemental retirement program”.

  16. Robert Mann
    Posted March 8, 2013 at 2:02 pm | Permalink

    At the end of your article you mention taking a withdrawal from 401k/IRA and making a deposit into Roth. I didn’t think the withdrawals were considered earned income and therefore weren’t eligible for Roth contribution.

    I love the Roth!

    • jlcollinsnh
      Posted March 8, 2013 at 8:06 pm | Permalink

      Welcome Robert….

      What I’m referring to is a rollover from a regular IRA to a Roth.

      Deposits to an IRA or Roth IRA must indeed be from earned income. But once the money is in your IRA you can roll it into a Roth. Make sense?

      But remember, doing so is a taxable event.

      Hope that helps!

  17. Jason
    Posted March 19, 2013 at 5:42 pm | Permalink

    Thanks for this. I’m just absorbing it all. I’m freshly 40, and only recently started looking into everything having to do with investing and retirement. I look forward to acting on some of these ideas. I’m transitioning out of my current job, so I’ll be looking to roll my 401k into something. Looks like a Roth will be the right option. I hadn’t heard about Vanguard prior to reading your posts, so I’ll probably roll my 401k (from Fidelity) into Vanguard.

    I like your indexing idea. I do wonder, however, if one might be prudent in risking some in low volatility stocks and ETFs. SPLV challenges major indices in total return, and individual stocks can offer higher dividends with less volatility than the overall market. Of course it requires more time and research if you’re seeking dividends…

    Anyway, I love what I’ve read, and I’ll keep reading. Hopefully, some of my enthusiasm will transfer to my wife, so we can get on with living happily ever after. I’ve been debt-free of my own accord without help prior to getting married last year. I very much want to return to that space.

    • jlcollinsnh
      Posted March 20, 2013 at 2:23 pm | Permalink

      Welcome Jason….

      Glad you are finding ideas and value here.

      Roths are are great option, but remember converting a 401k to a Roth is a taxable event.

      As you read further thru the blog you’ll learn in some detail why I favor only index funds. Picking stocks and ETFs is a whole other thing and , in my view, a loser’s game.

      Congratulations on your recent marriage! If your new bride hasn’t already seen the debt-free/F-you money light, hopefully you can show her the path.

      • Jason
        Posted March 21, 2013 at 12:49 pm | Permalink

        Interesting. Thanks for the heads up on that.

        I’ll keep reading. Reading stuff like this keeps it in the forefront of my thoughts, it seems, and that’s a good place for FI to be.

  18. Mitchell
    Posted April 1, 2013 at 11:41 pm | Permalink

    A friend of mine who has built up a nice reserve of F-U money recommended me to your blog, and I’ve been reading non-stop since. Has anyone told you that your voice sounds like Bruce Bochy, manager of the SF Giants?

    I am 25 years old, and self-employed. My job is picking up income-wise, and I am beginning to save some money every month (my mother taught me frugality and saving at a young age which has also helped-I’m debt free!). I just wanted to clarify a few things in terms of your recommendations for the path to wealth and financial independence. Correct me if I’m wrong, but if you were in my shoes you would…

    1. Build a cash savings account equal to six months of life expenditures (money market account)
    2. Once this is met (which I will be completing next month), contribute to an IRA, preferably of the ROTH variety, until you have maxed out the annual contribution (5k/yr). Put VTSMX in this ROTH bucket.
    3. Any additional savings I can muster should go into a general VTSMX investment account.

    Is that how you see it? And if so, what about a self employed ROTH 401K vs a standard Roth vs a general investment account (all via total stock market index investments)? Thanks a lot.

    • jlcollinsnh
      Posted April 2, 2013 at 7:49 am | Permalink

      Welcome Mitchell…

      And congrats on a fine start! Your plan works for me.

      The only fine tuning I’d offer is perhaps a less aggressive emergency fund, depending on how secure you feel about your income stream. Since you say you are almost at the six month level, I’d go ahead and hold that. Next time the market tanks, you’ll have some extra cash to deploy. Then you can start rebuilding the E-fund again.

      Most important: Know in your heart the market will tank, and more than once in your decades long investing life. When it does, people will be panicking and screaming “sell!” How you react in those tough times will determine, more than anything, how wealthy you become. Don’t fall for the idea you can “dance in and out” Stay the course. Know the market always goes back up. Remember March 2009 and April 1, 2013. Add even more money if you can, maybe by cutting some spending to free up extra cash.

      Enjoy the journey!

      • Mitchell
        Posted April 2, 2013 at 11:45 am | Permalink

        Thanks Jim! So just to clarify, you are saying the next time that the market tanks (does that mean a few thousand point drop?) I should funnel a good chunk of my six month E-fund into VTSMX(VTSAX) as long as my income is still stable? And then I can replenish the E-Fund as the market begins to rise?

        Also, I do not understand the difference between a Roth 401K vs a Roth IRA and what would be better for someone in my situation (young and self-employed), can you please expound? I understand that these buckets provide tax savings that standard investments do not, so I should use them as much as possible. But I also do not want to have to wait until I am 60 to use the money in these funds.

        I know nothing of investing but have always been fascinated by it, and your simple strategy really makes sense to me. With the increasing pressures our species has been putting on our planet, I worry about our ability to continue in our current pattern of exponential population growth, reduced natural resources, and a compromised atmosphere. Something has to give, its just a matter of when. But like you say, if climate change begins to have apocalyptic affects and compromise our ability to survive on this planet, money will no longer be of any value anyways, so all of this is out the door and its time to collect seeds and return to our primordial ways. That being said, I’m hopeful that a massive global shift to renewable energies along with other shifts towards more sustainable lifestyles will not only stem the tide, but also provide a major boost to the market and our investments. If we are wrong, it won’t matter anyways. If we are right, I’d rather make the right decisions today.

        • jlcollinsnh
          Posted April 2, 2013 at 5:14 pm | Permalink

          Hey Mitchell…

          1. Yep. You got it. Just remember nobody can tell what’s “low” or where the bottom will come. Just like nobody can say what’s “high” or where the top will be. That said, sometimes the market does go to extremes. The best way to recognize a low is when everybody hates stocks, like they did at the beginning of 2009. Conversely when all your friends are bragging about their latest score (everybody’s brilliant when the bull is running) time to worry. Joseph Kennedy is said to have seen the crash of ’29 coming when his shoe-shine boy started giving him stock tips.

          2. 401k are company plans that may or may not offer a Roth option. Roth IRA is one you do on your own. There are ways to get your money penalty free before 59.5, but the best option is to build assets in regular taxable accounts as well.

          3. I think we’ll muddle thru. If not, I’ll still have the peace and freedom FI provides until the end.

  19. Guest052237
    Posted April 20, 2013 at 10:33 pm | Permalink

    Loving everything I’m learning here! Something I’ve been struggling with the past few weeks…

    I have my 401k at work: 90% S&P index fund, 10% in a treasury index fund. Enough to get full employer match.

    Going to eliminate all student debt for me and my wife (3-5 years conservatively, hopefully be paid off before that).

    After that, I’m wondering what I go about putting in a traditional or Roth IRA vs. taxable account?? Would I just have the same investments from vanguard in both?

    Planning on retiring before 50 so will need money to get us through to tax-sheltered distributions.

    Thanks for your help!

    • jlcollinsnh
      Posted April 26, 2013 at 9:37 am | Permalink

      Welcome Guest,

      and congrats on what sounds like a fine start.

      The answer is Yes, the same fund can serve your needs in both taxable and tax deferred accounts.

      For instance, we hold 50% of our assets in VTSAX but it is spread across four accounts: Roths for both me and my wife, in my wife’s traditional IRA and in our join taxable account.

      • guest052237
        Posted April 26, 2013 at 12:14 pm | Permalink

        Thanks for your help!

        Another question…would it make sense to have a target retirement date fund in the Roth since I won’t touch it until I’m 60 anyway, and go with VTSAX in my taxable account?

        Also, how was your trip? Or are you still on it?

        • jlcollinsnh
          Posted April 26, 2013 at 12:56 pm | Permalink

          Yep, still in Prague but i can already report it’s been a fine time. Thanks for asking.

          TRFs are a great choice for a decades long Roth investment. But the costs are a bit higher and VTSAX will give you lower costs and likely a better ultimate result. But it will be a wilder ride.

          • guest052237
            Posted April 26, 2013 at 1:00 pm | Permalink

            Thanks again for your input!

            Enjoy the rest of your trip, Europe is quite amazing!

  20. David
    Posted June 5, 2013 at 3:03 pm | Permalink

    Hi James,

    Thanks for the great article!

    I am presently making the maximum contribution to my company’s 401(k) plan ($17.5K) to take advantage of their 50% matching policy, but I would also like to make the maximum Roth IRA contribution ($5500) before the end of the year.

    I was hoping you might be able to share your thoughts on a couple of things:

    – Am I correct in understanding that putting the $5500 into a Roth IRA rather than a traditional IRA is greatly advantageous, as the former’s returns are only tax-deferred (and the principle is not even deductible) while the later is a purely post-tax investment?

    This also gives me some tax diversity since the 401(k) is a tax-deferred bucket. Is there any sane reason at all to contribute to a traditional IRA if you are over the income limit for getting a deduction on IRA contributions?

    – I am concerned that this year I may exceed the income limit for making a Roth IRA contribution ($127K), but I won’t know precisely what my AGI will be before the year is over (given that my salary can be variable depending on bonuses, stock-based compensation value, etc). What will happen if I make the full contribution, but my AGI ends up being too large?

    I have read about the back door Roth IRA method, where you open a regular IRA and immediately transfer the funds to a Roth, and was wondering if there’s any disadvantage to doing things that way, just in case (I don’t have a traditional IRA at the moment).

    Cheers!
    David

    • jlcollinsnh
      Posted June 5, 2013 at 4:09 pm | Permalink

      Thanks David…

      glad you liked it!

      I think a closer reading of it will answer your first couple of questions, unless I’m not understanding them.

      If you exceed the income limit for a Roth, any excess contributions will have to be withdrawn along with any gains or income they generated. You will also owe tax and penalties on those gains and income. This is really no big deal, but it can be a bit of a PITA (pain in the ass) so it might be worth waiting until you are sure.

      “back door” Roths have the potential to be even bigger PITAs. Clever idea, but complex and with snags for the unwary. Here’s a good overview:

      http://www.bogleheads.org/wiki/Backdoor_Roth_IRA

  21. enceladus
    Posted July 5, 2013 at 2:22 pm | Permalink

    Hi Jim,

    I haven’t been able to find anything from you about Thrift Savings Plans on the blog… I was wondering if you could weigh in with your thoughts on TSPs and where to contribute in it.

    I’m a reservist in the military and I have the option of contributing to a no-match TSP. A big perk to the TSP plan is the .027% expense ratio, which is roughly 50% lower than that of VTSAX. I’m 26 and have many working years ahead of me. To me the C-Fund looks just like an index fund, but the targeted F-Funds also seems to be an intriguing option, as they adjust for acceptable risk over time.

    Currently I put 6% of my civilian salary (matched @ 50% by employer) into FUSVX, and max out my Roth IRA through Vanguard. After reading your recent 401(k) column, a TSP seems to have the benefits of an employer-sponsored plan and more (choice of traditional or Roth, tax-free Roth contributions when deployed(!), ability to roll money in/out from other plans), without most of the drawbacks.

    This seems to be a no-brainer to me (right?), but I can’t decide between the C- and F-Funds.

    Thanks!

    • jlcollinsnh
      Posted July 5, 2013 at 6:23 pm | Permalink

      Hi Enceladus…

      Welcome back.

      Your thinking seems spot on to me.

      As you already know TSPs are retirement plans for Federal employees, including military personal. Which is why you get to participate. Think 401k for government employees. But better.

      One of the cool things about writing this blog is how much I get to learn. Not having any personal experience with TSPs I did a little digging. Unlike the fee heavy cesspool too many 401k plans have become: http://jlcollinsnh.com/2013/06/28/stocks-part-viii-b-should-you-avoid-your-companys-401k/

      your TSP offers a nice, but not overwhelming, selection of low cost index funds. As you point out, only .027% last year.

      Looking at the chart of ERs going back to 1999 the ER has ranged from a low of .015% in 2007 to a high of .102% in 2003. Seems the variation is due, to quote the site, to:
      “The TSP expense ratio represents the amount that participants’ investment returns were reduced by TSP administrative expenses, net of forfeitures”

      Still, even at the worst these are very low ERs. And they seem to be coming down in the last five years or so. Good deal.

      Also a good deal is that the funds are index funds. The C-fund you mentioned for instance replicates the S&P 500 index. The S-find is the small cap index. Own both in about a 75/25 balance and you’ve basically got VTSAX. The F-fund is a bond index.

      To answer your question: Yep. These are a no-brainer. I’d max out my TSP right after the civilian 401k for the match. Then Roth.

      As for your mix of stock v. bonds, at age 26 I’d go light on the bonds if at all. 10% maybe.

      Looking at your total assets as a whole (which is the only way to figure asset allocations), I’d try for something like this:

      10% in G-fund (bonds)
      25% in S-fund (small cap)
      65% in FUSVX/C-Fund

      These are all low cost index funds and will serve you well over the decades. You’re off to a fine start!

  22. Posted September 12, 2013 at 12:11 pm | Permalink

    I finally decided to stop researching and act. This past Monday I moved my Schwab Roth IRA and Traditional IRA over to Vanguard and instructed them to put both funds in VTSAX. I’ve read your blog, among many, and even Jack Bogle’s book.

    The two different IRA’s in my possession are the result of a Roth 401k plan I had with a previous employer. My contributions went into a Roth account, and their match went into a traditional account.

    My question is, should I leave both of these IRA’s separate, or eventually think about rolling the traditional IRA over to the Roth? I know there would be a tax hit, but I’m only 27 and figure that by the time I retire most of the value of both accounts will be interest, so it would be nice to not pay tax on the gains. Or if I leave both separated, should I just contribute to the Roth, or both? I know the limit is around $5500/yr, but does that apply to just one or the cummulative contributions to both?

    Thank You, and here’s a link describing my current goal of paying off my student loans: http://jlyblog.wordpress.com/2013/09/10/goal-1/

    • jlcollinsnh
      Posted September 20, 2013 at 11:29 am | Permalink

      Hi Josh….

      The answer to your question requires some consideration of your tax situation: How much you make, what tax bracket you are in and how much money is in the IRA that you would be moving to the Roth. That last because moving it will be a taxable event that could push you into a higher bracket.

      Roths are beautiful things, especially with the time yours will have to compound tax-free since you are only 27. Personally, I would move the regular IRA into the Roth.

      But I would try to do this consistant with remaining in the 15% tax bracket. This might well mean moving it a portion at a time over several years.

      In fact, this is exactly what I am personally doing with the goal of having as much as possible in the Roth before the government mandated withdrawals from my regular IRAs that begin when I turn 70.5.

  23. colin
    Posted September 26, 2013 at 7:42 pm | Permalink

    Jim

    I have a 401k through my employer via The Standard. They offer Vanguard options, but I don’t see your recommendation listed. The options are: Vanguard 500 Index Sig, Vanguard Extd Mkt Idx Sig, Vanguard Mid Cap Indx Sig, Vanguard Sm Cap Index Sig, Vanguard Wellington Adm, and Vanguard Windsor II Adm. Do you have any suggestions on these? Should I pursue a single fund or a mix?

    Thanks for the great articles

    • jlcollinsnh
      Posted September 26, 2013 at 8:03 pm | Permalink

      Hi Colin…

      If you want to most closely match VTSAX:

      80%: Vanguard 500 Index Sig
      20%: Vanguard Extd Mkt Idx Sig

      To keep things as simple as possible, 100% Vanguard 500 Index Sig would be fine too.

      The good news is your plan offers Vanguard index funds!

  24. Tony
    Posted October 8, 2013 at 3:46 pm | Permalink

    You mentioned investing in the C, S, and G funds regarding TSP but what are your thoughts on the Lifecycle funds the TSP offers as well. I am currently 28 and have 60% going to the L 2050 Fund and 40% going to the L 2040 Fund.

  25. aretina Rittenhouse
    Posted November 17, 2013 at 4:25 pm | Permalink

    I am also invested in TSP-age 36 and looking into retiring at 51 if not earlier (military + federal service =30 yrs service eligible for deferred retirement pension at 51).

    I’ve been following MMM and now this blog for a couple months and have been reviewing all my finances to see where I can better grow my money.

    I already moved my entire TSP balance (approx $64k) into C funds only. I also plan on opening a VTSAX in January.

    My expenses are roughly half my income and decreasing. I am debt and mortgage-free.

    In 2012 I opened a Roth IRA through my bank thinking it would balance my TSP should I be in a higher tax bracket in the future-(before I was obsessed with early retirement)- which was variable and earning less than 1 % most quarters. So this year I threw it all into a 5 year cd at 1.5% and planned on maxing out annually during that time.

    But given I have a low income to begin with ( $41000/yr gross) is there really any point in maxing out a Roth each year? Since I can’t touch it anyway until 59.5 yrs and I am hoping to be retired by then.

    The one upside I thought about the Roth IRA is after early retirement I will lose my health coverage (not that I need it- hubby and I both veterans) but will still want coverage for my kids and with the Roth I can make withdrawals for insurance premiums.

    Or should I take that $5500 per year and increase my TSP withholding instead. I contribute enough to get the employer match but TSP fees are only .027% (which I only checked after reading your “Should you Avoid your 401K).

    Or invest it all in VTSAX? Thanks!

    • jlcollinsnh
      Posted November 18, 2013 at 8:36 pm | Permalink

      Welcome Aretina…

      Congratulations on being debt free and your 50% savings rate.

      TSP funds, as discussed above are great and have exceptionally low fees. The C-fund replicates the S&P 500 index and as such is a great place for your long term retirement money. I suggest you contribute to the maximum allowed.

      Roths are also great investment “buckets” and you should fund yours to the max each year. After five years you can withdrawal your contributions without tax or penalty, although the earnings must remain until 59.5. Because this is also long-term investment money, VTSAX is perfect for your Roth.

      I would not have put your CD in the Roth. At 1.5% interest there is too little income to worry about protecting from taxes, especially in your tax bracket. Plus such rates make CDs a poor long-term investment these days. I would take the interest rate penalty and move this money to VTSAX.

      Cash should be held for short-term needs and a five year CD is not well suited for that. If you feel the need for cash better to hold it in a regular savings account, or shorter term CDs. On line banks like Ally offer better rates that traditional banks.

      Hope this helps!

  26. dude
    Posted January 9, 2014 at 4:20 pm | Permalink

    Love your Stock Series, Jim. One thing I wanted to add with respect to the TSP’s advantages over many 401k’s is the G Fund itself. While it shouldn’t be the cornerstone of anyone’s portfolio, it is a unique fund only available to fed employees. The securities issued to that fund by the Treasury earn intermediate-term rates on short-term securities. Thus, on average, they have returned 1.78% more than regular 90-day T-bills. A nice feature for a 100% safe investment.

    • jlcollinsnh
      Posted January 9, 2014 at 4:52 pm | Permalink

      Thanks dude…

      ..and welcome.

      Good to know about G-fund!

  27. David
    Posted February 5, 2014 at 2:12 pm | Permalink

    Very basic question since I am new, but I am struggling to understand the point of a non deductible IRA is? My situation is I just started to max out my 401k and roth IRA every year. If I have additional income to invest, my best option would be to invest in the VTSAX in an ordinary bucket correct? This would mean I am investing already taxed income, do I pay tax on gains only when withdrawing or annually?
    What would be a situation someone would opt for a non deductible IRA?

    • jlcollinsnh
      Posted February 5, 2014 at 4:02 pm | Permalink

      Hi David…

      ..and welcome.

      Actually yours is an excellent question.

      There are a couple of things to understand.

      First, there are limits each year as to the total amount you can invest in IRAs during the year. If you are younger than 50, each year your contributions are limited to $5500 across all IRAs. For those 50 and over the limit is $6500. These are the current limits and they could go up in coming years as they have in the past.
      http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits

      Second, there are income limits as to who can invest in deductible IRAs tied to whether you or your spouse have a retirement plan at work:
      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

      Third, there are income limits as to who can contribute to a Roth IRA:
      http://www.irs.gov/Retirement-Plans/Amount-of-Roth-IRA-Contributions-That-You-Can-Make-For-2013

      This chart does a nice job of distinguishing between Deductible and Roth IRAs:
      http://www.irs.gov/Retirement-Plans/Traditional-and-Roth-IRAs

      So, a non-deductable IRA would come into play for those unable to invest in a Deductible and Roth. Like a Roth, contributions are not deductible and they are not taxed when withdrawn. (Although there could be a penalty before 59.5). They are not taxed because the contribution has been made with after tax money — it has laready been taxed.

      However, with a Roth the earnings are also tax free on withdrawal. The earnings on a non-deductable are taxed when withdrawn.

      So someone would only opt for a non-deductable when not eligible for a Roth or deductable. But it still allows the investment to grow tax free until withdrawal.

      If you are maxing out your 401k and your deductible and/or Roth, your next move would be in the ordinary bucket.

      When you invest in the ordinary bucket each year your fund will report on dividends and capital gains distributions. Both are taxable in the current year. Index funds like VTSAX tend not to have capital gains distributions which is one of the reasons they are considered tax efficient.

      When you sell shares it is also a taxable event, but this of course you control. If at a gain, you will owe the capital gains tax. If at a loss you can use that loss to offset other capital gains during the year. Once those are offset you can use up to $3000 of your loss to reduce your taxable income. If your loses still exceed that, you can carry them forward to use in future years.

      Hope this all makes sense and helps!

  28. Jonathan
    Posted March 6, 2014 at 6:25 pm | Permalink

    Hey Jim,

    Just wanted to tell you I’m so glad I came across your blog!!
    I’ve always found the stock market to be so interesting and wanted to become a broker but in the end I’m majoring in accounting. Turned out to be one of the best things I’ve done because I’m already working for a firm making about 25k a year (after taxes).
    Anyway, I’m 19 and just opened a roth and invested my first few paychecks – 3k (enough for VTSMX). I’m extremely lucky at the opportunity I’ve been given.
    I still live at home and only have my phone payment; saving about 90%. I’m currently working to get my AA, while it’s not easy being a FT student and maintaining a FT job, I know it’ll be worth it in the end.
    Can’t say how grateful I am at the plethora of information I’ve devoured on your site, One step closer to having my FU Money.

    Thanks – Jonathan

    • jlcollinsnh
      Posted April 8, 2014 at 2:07 pm | Permalink

      Hey Jonathan…

      Congratulations on what sounds like a splendid start. Would that I were as wise when I was 19!

      As you might well already know, once your VTSMX account hits 10k Vanguard will automatically roll it into the lower cost VTSAX for you.

      Finally, thanks for the kind words. You made my day!

  29. James
    Posted July 1, 2014 at 2:34 pm | Permalink

    Hi Jim,

    I have two daughters, ages 7 & 4, and I am fortunate to have filled the buckets listed in this post. How do you feel about 529s? Where do they fit into the bucket equation?

    Thanks,

    James

    • jlcollinsnh
      Posted July 1, 2014 at 4:09 pm | Permalink

      Welcome James…

      With my daughter just graduated from college, I haven’t thought about 529s in some time. Personally, I decided against using them as the restrictions seemed to out weight the benefits, at least with simplicity as one of my goals. Here are a few things to consider:

      1. You need to be careful which state plan you choose, and you are not limited to your own state. You are looking for a state that offers low fees and low-cost index funds among the investment choices.

      2. Your contributions are not tax-deductable, but the earnings do grow tax deferred.

      3. If you don’t use the money for the specified educational expenses when the time comes, those earnings are subject to a 10% penalty.

      4. Since the benefit is the tax-defered growth you need time for this to work. 10 years at least. So you are right to be thinking about these now.

      5. Because of the 10% penalty, you have to be pretty sure your kids are college bound. Although, if one goes and the other doesn’t, you can transfer the money to the one that does.

      6. There are some exceptions to the penalty, but they involve ugly things like death and disability. Scholarships covering the costs also waive the penalties, but I imagine that is a pain to confirm and deal with.

      7. If you are a high income earner and your kids are destined for expensive private schools, 529 plans allow you to put away pretty large sums. I believe the limit is 300k in most states. At least it used to be. Maybe more now…

      For more, here’s a pretty good Q&A from the IRS: http://www.irs.gov/uac/529-Plans:-Questions-and-Answers

      Good luck and enjoy your daughters while they’re young. You’ll be attending their graduations just after the next time you blink. :)

      • James
        Posted August 3, 2014 at 5:42 pm | Permalink

        Thank you John. I’ve re-read this response several times over the past month. Great advice. You are doing a great work here.

        • jlcollinsnh
          Posted August 3, 2014 at 10:41 pm | Permalink

          Thanks, James…

          If I ever see “John” I’ll let him know. ;)

          • James
            Posted August 3, 2014 at 10:43 pm | Permalink

            Haha, sorry about that Jim!! :)

  30. Dennis
    Posted August 28, 2014 at 10:39 pm | Permalink

    This stock series has been immensely helpful to me! I’m 28 and looking to begin investing my hard earned money. As far as retirement planning goes, I’ve only been contributing to a 457 plan to match my employers contribution and there is a pension (annuities based on amount of service and age) that I am working towards. I’m currently in the 25% tax bracket and was trying to figure out whether to open a traditional or roth IRA with Vanguard. The Roth seems like a good option, but I’m wondering whether or not it would be more wise to open a traditional.

    I am becoming more encouraged by your posts to let my money work for me! I’m just not sure which bucket (tax advantaged or even an ordinary bucket)

    • jlcollinsnh
      Posted August 28, 2014 at 10:49 pm | Permalink

      Thanks Dennis…

      I’m glad to hear it.

      Personally I would seize every tax break I could get now to keep as much of my money earning and compounding for me over the decades as possible. Especially in the 25% bracket.

      Good luck!

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