Over in the Ask jlcollinsnh page, reader Joe posted a very interesting profile along with a series of questions. Since I think his situation and our conversation about it might have broad interest, it has become our first case study in a long time (here’s #1) and this post.
First is his note, which I have edited a bit, but only to include some facts he later provided:
Jim –
I wanted to layout my personal situation for myself and my girlfriend and get some feedback from you re: any things you think we’re missing out on or areas of opportunity.
(Joe is 27 and his girlfriend is 24. The income and expenses are his alone. She is a full-time student.)
Monthly Income
* Salaried at $12,500/mo with quarterly bonuses based on profit. Given past profit numbers this should equate to about $3,300-4,200/mo. Total comp: $15,800-16,700/mo.
I get 100% covered health insurance, dental, etc. I have disability insurance through work.
Monthly Expenses
* Housing (own) = $1,315/mo (House mortgage + property taxes + pmi)
* Bills & Utilities = $423/mo (Gas, Water, Electric, Internet, Cable TV, Cell Phone for myself and GF)
* Transport = $287/mo (Car Insurance, Gas, Maintenance, Parking, EZPass, Transit Pass, Bike Maintenance)
* Food & Dining = $321/mo (Groceries, Restaurants, Bars)
* Shopping = $330/mo (House goods, clothes, electronics, gifts)
* Pet care = $59/mo (Dog food, annual vet visit, toys)
Annual Expenses
* Travel = ~$3.2k/year, $260/mo (g/f family is INT’L so we need to travel at least once per year)
Monthly Investment Contributions
* Roth 401k = $728/mo
* 401k = $728/mo
^^ Note: Company matches to the tune of about $200/mo
* Principal Payment = $300/mo (Pay an extra $300 towards house)
* Vanguard taxable = $4k/mo (55% VTSAX, 15% VGTSX, 15% VGSIX, 15% VBMFX)
TOTAL INCOME: $16,250/mo
TOTAL EXPENSES: $2,995/mo
TOTAL INVESTMENTS: $5,756/mo
In terms of what I’ve gotten so far:
Assets
* House, Zillow = $255k
* CASH = $53k
* Car, KBB = $13k
* Roth 401k = ~$18k (Principal Target 2045 Retirement Fund)
* 401k = ~$18k (Principal Target 2045 Retirement Fund)
* Old 401k = ~$28k (Assortment of funds available in Fidelity)
* Vanguard Roth IRA = ~$21k (Target 2045 Retirement Fund VTIVX)
* Vanguard Taxable = ~$20k (55% VTSAX, 15% VGTSX, 15% VGSIX, 15% VBMFX)
Liabilities
* House Mortgage = $173k
QUESTIONS
- Anything good to do with some of that cash to keep it mostly liquid / safe as an emergency fund + life fund (marriage, new car, etc)? It’s just sitting in Capital One 360 + Bank of America.
- I just upped my investments, my plan is to up the contribution amount until I am breaking even every month and not growing my savings. Based on what my predicted income, taxes, spending, and current investment contributions are, I think that means I will likely push my monthly investments up another $3k/mo.
- I can rent out my house for ~$1,700 and move closer to my work for a monthly rent of ~$1,800. I would save about an hour per day by being closer to work, and given the the fact that utilities would be cheaper and I would make money on top of mortgage, it seems like a good idea. Thoughts?
- Should I consider saving some money and buying another house for myself as either an investment property or a house to live in (thus converting my current into an investment property)? Around me it is common to buy a house for between $250-350k that is pretty nice and it can rent out for $1500-2500.
- Are the target retirement funds decent?
- Am I missing out on any big opportunities in my portfolio?
- Does it seem like I’m on a good track?
Joe
My Reply
Welcome Joe and thanks for your detailed profile. Let’s start by answering your last question (#7) first:
It seems you are on an beautiful track!
Well done so far.
You have just about 200k in income and you are living on under 36k per year. That’s an annual savings rate of 82%. That’s brilliant. About the only thing that appears to be missing is accounting for the repairs and maintaince your house is sure to require over time. But think hard and be sure you’re not missing anything else in your expense profile.
If those expense numbers are accurate, and for anybody living on 18% of their income, I’d say spend it on whatever you damn well please.
OK, let’s look at your other six questions, in order:
1. 53k in cash, for somebody with your income and spending level, is needlessly high. It is just shy of 1.5 years of your current living expenses.
If wedding costs and/or a new car are in your near term plans, figure those costs and hold that aside as cash. Otherwise, half your annual spending is more than enough: 18k. And unless your job is insecure, I wouldn’t even hold that much. But with your assets, if you want to, it is a small enough number.
Make that money work harder: Move the excess to VTSAX (Vanguard Total Stock Market Index Fund) in your taxable account.
2. You should push your investment levels far higher. Subtracting your expenses ($2995) from your income ($16,250) you have a monthly surplus of $13,255. Yet you are only investing $5756, leaving $7499 unaccounted for. Since you don’t mention if your income is pre or post tax, some of that might be going to the tax man. But you still have much more to deploy.
3. Your idea of moving certainly makes sense from a cost and commute time savings point of view. However, with your income and savings rate, I’d make the call based more on which option provides you the most appealing lifestyle.
4. Having a rental house can be a very attractive investment. But it can also be a money pit. Do some very serious homework first, rather than just buying another house and converting your current home into a rental.
Remember, too, this is also a part time job. If this appeals to you and you see it as a desirable way to spend your free time, go for it. If not, you have no real need here.
A REIT like VGSLX (Vanguard REIT Index Fund) gives you broad-based real estate exposure while you read a good book sipping cognac by a roaring fire.
If you haven’t already, start by reading this: Why Your House is a Terrible Investment.
5. I am not familiar with Principal Target 2045 Retirement Fund, but taking a quick look it seems OK. The .63% ER (expense ratio) is a little pricey. (Your Vanguard Roth in VTIVX, the Vanguard equivalent, has an ER of .18% for comparison.) My guess is you are in it because that’s what’s offered in your 401k. That’s fine, but when you leave that employer you’ll want to roll it into a Vanguard IRA (unless you are using the Backdoor Roth strategy described below). There will be no reason not to own the better, lower cost VTIVX in your IRA/Roth then.
Here’s my take on TRFs overall.
6. Not big opportunities, but your portfolio could use some fine tuning. Let’s look at that next…
We’ll just move a few little things around…
Open a non-deductable IRA…
and immediately convert it to a Roth IRA. This is a very cool technique called a Backdoor Roth IRA. High income earners utilize this to get access to a Roth.
There are some complications to this (as described in the link), the main one being that such a conversion will also effect all IRAs held other than Roths. But you don’t have any others. Your personal situation is such that you’ll avoid this common complication altogether.
Here’s what you do:
Read that linked article carefully. Then….
Open an IRA with Vanguard (you don’t have to specify deductible or non-deductable) and put the max contribution ($5000) into VMMXX: Vanguard Prime Money Market Fund. You want the money market fund so you have as little variation in value as possible in the short time you hold it as value variations add complexity.
Immediately instruct Vanguard to transfer it into a Roth IRA. You can use your existing Roth. You now have a perfectly legal Roth contribution in spite of your high income. And you can do this every year. Just be sure you don’t open any other IRAs or roll any 401k money into an IRA.
You won’t get any immediate tax deduction, but earnings will grow tax sheltered; important in your tax bracket.
BTW, for those readers who have lower incomes that allow for traditional deductable IRAs, my pal the Mad Fientist has worked out some very clever strategies:
http://www.madfientist.com/retire-even-earlier/ Check out the section on Roth IRA Conversion Ladder
http://www.madfientist.com/traditional_ira_vs_roth_ira/
Old 401k
Ordinarily, I’d suggest you promptly roll this out of Fidelity (where the funds are likely to have high ERs) and into an IRA at Vanguard holding VTSAX. But that would vastly complicate the Backdoor Roth strategy above. So do this only if you decide against the Backdoor.
If you do decide to use that strategy, keep the old 401k but with an eye towards consolidating the multiple funds you have into Fidelity’s Total Stock Market Index fund, if available. Responding to the competition from Vanguard they have made these very low cost and it will serve you well.
If they don’t offer the Total Market Index fund, look for the S&P 500 Index Fund. That will serve nicely. So would a Target Retirement Fund if you prefer one of those.
Vanguard Roth IRA in VTIVX
I guess is this is an older Roth built when your income was low enough to allow Roth contributions? If not, I see a problem. As a single guy, your income disqualifies you from contributing to a Roth. (Other than the Backdoor discussed above.) The phase out limits range from 112k to 127k. Past 127k you can no longer contribute at all. If you built up this Roth when your income was within the limits, no worries. If not, you’ll have to back out of it.
As for VTIVX, this is a fine fund. But Roth money is very long term and you already hold a very similar fund in your 401k. I’d use VTSAX instead. It will be a more volatile ride, but if you leave it alone after 40-50 years it will very likely have delivered a much stronger return.
Vanguard Taxable
You have 20k spread across four funds and you are adding 4k per month. That’s great, but you don’t need so many funds. I’d simplify and focus all this into VTSAX for the reasons I outline here, and this is why I don’t feel the need for international funds.
Mortgage
While I don’t have a great problem with you paying an extra $300 per month, I also don’t see the need. If your interest rate is 4.5-5% or less, better to invest this money in VTSAX. If your interest rate is higher, look into refinancing. With your income and lack of debt, they should fall all over themselves offering you their best terms and rates. I’d go for a 15 year fixed. It will be a higher payment than a 30 year but you’ll be done with it sooner.
I’d also borrow a full 80% on your 255k value = 204k. This is higher than your current 173k balance and not the advice I’d give to most. But this debt is so small compared to your income and your tax bracket is so high, you can easily afford it and will benefit from the tax deduction. Put the excess you receive right into your VTSAX fund.
Oh, and if you keep this mortgage you now have more than enough equity to have them dump the PMI. That’s wasted money for you and I’d get it gone ASAP.
OK, now…
First, keep on with your terrific savings rate and increase your investing pace. Soon enough you’ll find your investments are producing the 36k you are spending. When that happens, live on that and invest your full income. Your investments will then really explode, as will the income they can provide. At that point, feel free to expand your lifestyle to that increasing level. For more on how much spending your investments can support, here’s my piece on the 4% rule.
Second, notice we are simplifiying and streamlining your investments. At this point in your life you are in the very active wealth building phase and VTSAX is the best tool for that. Both in your taxable and tax advantaged accounts. Because it’s what is offered in your 401k, you’ll also be holding the Principal Target 2045 Retirement Fund. That’s fine and you can roll it to Vanguard when you move on from this job, depending on your use of the Backdoor Roth.
Third, we are introducing that last as way to access the benefits of a Roth.
Fourth, your house is very modest against your income and that will serve you very well. Unless you can advantageously refinance, don’t worry about the mortgage. But dump the PMI.
You are off to a fine start and with your income, spending level and savings rate should easily hit finacial independance in short order.
Good luck and keep us posted on your progress!
Addendum:
For more on the idea of buying another more suitable house and turning your existing home into a rental: How a smaller house saves us $16,500 a year.
