Retirement planning 401(k), IRA, pension, student loans

Question

Currently I am making 58k/year with a chance for a 10% bonus. (I am pretty sure I will receive this bonus). I'm trying to decide how I want to set myself up for retirement. I'm 23 years old turning 24 in a few months, so I believe I already have a jump start on my retirement planning.

• My company offers a $1200 match on 401(k) in a fund that I designated as target date 2060 (may retire before 2060 but want a higher risk right now). I'm contributing 3% right now, but may jump to 4%, and this there is also a 1% auto increase option I've taken up to 10% (may increase to 1.5-2% up to 12%)

• My company offers a pension; the most I can get out of it if I stay here until retirement is ~1/3 to 40-45% of my income, depending on IRS standards for Social Security when I retire. We can assume 1/3 to be conservative.

• I'm planning on opening a Roth IRA account with Vanguard for the low-fee funds. I wanted to invest into all stock ETFs (S&P 500, world track, all stock, etc.), but I'm afraid I won't have the time to mess with this because of how OCD I am (I would be checking the market every day, worrying about reinvesting funds, spending all my time absorbed in this) so I'm on the fence for a Vanguard Target Date 2060 Roth IRA. The expense ratio is 0.16% for both my 401(k) and the Roth IRA. I'm still on the fence about managing my own investments and allowing Vanguard to do it as well, I wish they offered their target dates at a higher stock/bond ratio than 90/10. One of my concerns is that I am already pretty busy as it is and I don't see that changing as my career kicks off. I'm definitely expecting my income to rise over the years as well. Currently in the 25% tax bracket. I believe at this time I could comfortably contribute $250/mo toward a Roth IRA.

• Another thing to add is my ~54k ($53,667) in student loans. Weighted average of about 5.3% APR. Some rates are as high as 6.8% and some as low as 3.6%. My 10-year plan has me on ~$600/mo student loan payments. My plan for this was to drop my student loan to the 25 year plan (trust me: I'm aware of compound interest, so just follow my thought process) and enjoying the flexibility of having low payments a month, but still contributing $600-800/mo toward my FEDERAL student loans (Since they are all federal there is no penalty for paying early or toward principle). My payment would be $323/mo and I would be able contribute $600-800 total/mo. I would allocate the extra payments toward paying down principal on my highest APR loans and waterfall down. This way if any emergencies arose I could drop these payments down to $323/mo and use the extra money toward that.

What are your thoughts on the Roth IRA? Should I consider another option? I want to get the most bang for my buck in retirement but I'm also pretty busy. I figured I could give up some ~10 basis points and flexibility since I have the pension through my company.

And my student loans: I figure I can pay them off in 6-8 years. I'm planning on being married in a few years and assume I'll be able to pay at least $1000/mo in 2-3 years.

Answer 1

You asked specifically about the ROTH IRA option and stated you want to get the most bang for your buck in retirement. While others have pointed out the benefits of a tax deduction due to using a Traditional IRA instead, I haven't seen anyone point out some of the other differences between ROTH and Traditional, such as:

• ROTHs have no required minimum distribution. Around when you hit 70 yrs of age, you are required to withdraw a certain amount from a traditional plan, and this will count as normal income. Depending on the size of your balance, this minimum distribution may be enough to push you over into taxation on your social security or pension that you otherwise wouldn't have. Whereas with a ROTH, when you do choose to withdraw money, it is NOT income and thus won't make any social security taxable.
• ROTHs have the added ability to withdraw your contributions, tax and penalty free, 5 years after you contributed the funds. You can't withdraw their earnings though. This means that you can take your contributions out if you have a serious emergency and need cash. You can't do this on a traditional, though there you might be allowed to take a loan under certain conditions. But these are usually tricky and have serious consequences in and of themselves.
• I personally believe that just as you might want to diversify into different asset types, it may some day make sense to have diversified into traditional and ROTH account types. (It sounds like your 401k is traditional, so a ROTH IRA would help diversify some funds) I'm thinking about the case where Congress decides to suddenly change the terms of any traditional retirement accounts. Then again, this diversification could expose you to a similar decision to do something with ROTHs.

I agree with your thoughts on using an IRA once you maximize the company match into a 401k plan. My reasoning is:

• The access to more investment options, such as ETFs which are typically not available in 401ks. (More on this below.) You can even pursue dividend growth investing with direct stock purchases -- which seems to be all the rage, though I'm not trying to diss that strategy. Going even further, with the right provider, you can invest or trade in just about anything from foreign stocks, to preferred shares, to bonds, to property, to FX, etc.
• I believe alot of 401k programs have fairly high, and mostly hidden, participation fees. I've had 401ks that charged a quarterly % of assets just for the privilege of participating. I've had other 401ks that only had custom "funds", for which you couldn't compare expenses in the plan against publicly available information -- which I interpreted as a way to hide higher costs. The only time I was truely happy with a 401k program was once when my provider was ING, the plan included brokerage options for US equities, and the company paid all fees for management of the 401k. But that kind of structure appears to be quite rare IME. And you have no say in which provider and structure you get, that's an employer decision. On the other hand, with an IRA you're in charge and can easily switch to a provider that has policies that suit your investment style. Not that I'd recommend this, but you can even find providers with such low transaction costs that it would be possible to day trade your IRA funds.

I personally prefer ETFs over mutual funds for the ability to get in and out with limit, stop, or OCO orders, at open or anytime mid-day if needed. However, the price for that flexibility is that you risk discounts to NAV for ETFs that you wouldn't have with the equivalent mutual fund. Said another way, you may find yourself selling your ETF for less than the holdings are actually worth. Personally, I value the ability to exit positions at the time of my choosing more highly than the impact of tracking error on NAV.

Also, as a final comment to your plan, if it were me I'd personally pay off the student loans with any money I had after contributing enough to my employer 401k to maximize matching. The net effect of paying down the loans is a guaranteed avg 5.3% annually (given what you've said) whereas any investments in 401k or IRA are at risk and have no such guarantee. In fact, with there being reasonable arguments that this has been an excessively long bull market, you might figure your chances of a 5.3% or better return are pretty low for new money put into an IRA or 401k today. That said, I'm long on stocks still, but then I don't have debt besides my mortgage at the moment. If I weren't so conservative, I'd be looking to maximize my leverage in the continued low rate environment.

Answer 2

None of your options seem mutually exclusive. Ordinarily nothing stops you from participating in your 401(k), opening an IRA, qualifying for your company's pension, and paying off your debts except your ability to pay for all this stuff. Moreover, you can open an IRA anywhere (scottrade, vanguard, etrade, etc.) and freely invest in vanguard mutual funds as well as those of other companies...you aren't normally locked in to the funds of your IRA provider.

Consider a traditional IRA. To me your marginal tax rate of 25% doesn't seem that great. If I were in your shoes I would be more likely to contribute to a traditional IRA instead of a Roth. This will save you taxes today and you can put the extra 25% of $5,500 toward your loans. Yes, you will be taxed on that money when you retire, but I think it's likely your rate will be lower than 25%. Moreover, when you are retired you will already own a house and have paid off all your debt, hopefully. You kind of need money now. Between your current tax rate and your need for money now, I'd say a traditional makes good sense. Buy whatever funds you want. If you want a single, cheap, whole-market fund just buy VTSAX. You will need a minimum of $10K to get in, so until then you can buy the ETF version, VTI. Personally I would contribute enough to your 401(k) to get the match and anything else to an IRA (usually they have more and better investment options). If you max that out, go back to the 401(k).

Your investment mix isn't that important. Recent research into target date funds puts them in a poor light. Since there isn't a good benchmark for a target date fund, the managers tend to buy whatever they feel like and it may not be what you would prefer if you were choosing. However, the fund you mention has a pretty low expense ratio and the difference between that and your own allocation to an equity index fund or a blend of equity and bond funds is small in expectation. Plus, you can change your allocation whenever you want. You are not locked in. The investment options you mention are reasonable enough that the difference between portfolios is not critical. More important is optimizing your taxes and paying off your debt in the right order.

Your interest rates matter more than term does. Paying off debt with more debt will help you if the new debt has a lower interest rate and it won't if it has a higher interest rate. Normally speaking, longer term debt has a higher interest rate. For that reason shorter term debt, if you can afford it, is generally better. Be cold and calculating with your debt. Always pay off highest interest rate debt first and never pay off cheap debt with expensive debt. If the 25 year debt option is lower than all your other interest rates and will allow you to pay off higher interest rate debt faster, it's a good idea. Otherwise it most likely is not. Do not make debt decisions for psychological reasons (e.g., simplicity). Instead, always chose the option that maximizes your ultimate wealth.

Answer 3

I'd suggest you avoid the Roth for now and use pretax accounts to get the greatest return. I'd deposit to the 401(k), enough to get as much match as permitted, then use a traditional IRA. You should understand how tax brackets work, and aim to use pre-tax to the extent it helps you avoid the 25% rate. If any incremental deposit would be 15% money, use Roth for that. Most discussions of the pre-tax / post tax decision talk about 2 rates. That at the time of deposit and time of withdrawal. There are decades in between that shouldn't be ignored. If you have any life change, a marriage, child, home purchase, etc, there's a chance your marginal bracket drops back down to 15%. That's the time to convert to Roth, just enough to "top off" the 15% bracket.

Last, I wouldn't count on that pension, there's too much time until you retire to count on that income. Few people stay at one job long enough to collect on the promise of a pension that takes 30+ years to earn, and even if you did, there's the real chance the company cancels the plan long before you retire.