Big pay raise - what to do with it?

[Onwards]

I recently took on a full-time position that'll bump my income up from around 30k to 45k, and I want to make sure that I use the increase wisely, rather than allow my standard of living to "expand" into my means. Right now my costs are $1500/month, and it may fluctuate up to $2000/month if my living arrangement changes. I'm estimating that I'll take home $3000/month with my new salary (assuming 20% taken out in taxes; is this realistic? I live in Oregon). So that leaves me with an extra $1000/month to pay myself first. Here is what I'm thinking of doing with it--any suggestions as to how I should approach them would be very much appreciated!

*Build up an emergency fund of $6000. I want to do this first. Should I put this in a money market account?

*Pay off the car. Principal balance: $6500. Monthly payments remaining (as of this month): 26 payments of $268. Is it worth doing this to save money on interest? Or so I can bump down my insurance coverage and save on that? (Interest rate is 6.5%)

*Max out an HSA. My plan has a high deductible ($2500) and my employer reimburses me for my premiums ($150/month). The maximum annual HSA contribution is currently $2900. I want to build this up as much as I can so that I'm prepared for any medical emergencies, and so that it can double as a retirement fund if I'm robust.

*Open Roth IRA. I'm thinking of putting a low amount in here (how much would you recommend?) and investing it aggressively so that I can use the loophole to pull out $10k to help with a first home down payment in 5 years.

Any feedback? Advice? Ideas? More background info--I'm 25, can reliably plan on sticking with this job for at least 5 years, have no credit card debt or student loans, and no savings to speak of (my emergency fund got wiped out by a family emergency).

Thanks in advance for your help!

[noppenbd]

My advice:

1) Open the Roth IRA with $5000 (the max for 2008). Use this as your emergency fund initially since you can withdraw your contributions at any time without penalty. Invest conservatively in a balanced fund like Vanguard Wellesley (VWINX). Even if you plan to eventually use this for your house down payment, with a 5 year horizon you cannot invest that aggressively. So maybe when #2 is complete you could go to a slightly more aggressive, like VBINX (60/40 stocks/bonds) or VWELX (66/33).
1a) Look into employer 401k/403b. Contributing 15% to retirement is a good amount at your age. This would be $6750 a year for you.
2) Build up emergency fund to $6K (3-4 months expenses in your case). Use a high-yield online savings account or money market. You should be able to get close to 4% right now. In case of a medical emergency you would use e-fund instead of HSA.
3) Contribute max to HSA if possible.
4) Pay off car if cash flow allows. Most likely this will not get done early if you follow the above. That's ok, the interest charges are not that excessive and it will be paid off in 2 years anyway.

[Onwards]

Thanks for the advice--I hadn't thought about using the Roth IRA as a temporary emergency fund. My employer doesn't have any kind of retirement plan (it's at least a year away). So with your advice, this is the kind of timeline I'd be looking at for the next year:

---

5 months - Save Roth IRA $, invest conservatively.

6 months - Save e-fund, place in high-yield account; move Roth $ to a slightly more aggressive fund.

1 month - Set aside $1k for HSA.

---

Approximately how much will I need to put into the Roth IRA over the next few years to be able to pull out 10k in five years (assuming I put it in VBINX or VWELX)? I.e. what kind of ROI can I look for? (I've never invested a dime in my life, other than a CD).

[noppenbd]

Originally Posted by Onwards

Approximately how much will I need to put into the Roth IRA over the next few years to be able to pull out 10k in five years (assuming I put it in VBINX or VWELX)? I.e. what kind of ROI can I look for? (I've never invested a dime in my life, other than a CD).

You should definitely max out the Roth this year, since you do not have another vehicle for retirement savings, and because you are expecting to pull $10K out in 5 years.

Next year, since HSA and EF will be funded, you should max out Roth ($5K) and invest at least an additional $3250 in either

a) employer's retirement plan (if available) or
b) spousal Roth IRA (if married) or
c) a taxable brokerage account.

This will amount to $8250 a year total, which amounts to 15% of gross pay ($6750) plus $2500 for house down payment. Do this for 4 years and you will have saved 15% of income plus an extra 10K for the DP. If you put $5K in Roth for 5 years you will have made $25K in contributions. I would advise you to keep $10K of this in a fairly conservative fund or funds since you plan to withdraw in 5 years. Once you get over $10K you can consider investing more aggressively, as long as you are comfortable with risk. You need to think about how comfortable you are with large swings in the value of your investments. Stocks do not go in a straight line and some years your investments will go down. I would look into some of the online risk tolerance tests.

The funds I recommended have returned 8-10% a year in the past, but you cannot plan on this for the future. All you can do is manage your risk. So my advice is to not try to get too exact with the $10K target, but rather try to save up $10K in extra contributions on top of your 15%. Any return you get on that extra 10K will be extra money for retirement, which will be a good thing.

By the way, congrats on the new job!

[zetta]

After funding the ROTH, efund, and HSA each year, why not start putting money aside toward your downpayment? That way you won't need to touch the ROTH, and it can just keep growing and working for you.

So each year after your efund is in place, put $5k to ROTH, $1K to HSA, and $6k to downpayment fund. When your car is paid off, put the money that was freed up into your downpayment fund. Within 3-4 years you'll have $20k, which would give you 20% down on a $100k home. Not sure how much homes cost in your area, but it's smart to put down 20% to avoid PMI fees.

[Onwards]

Originally Posted by noppenbd

Once you get over $10K you can consider investing more aggressively, as long as you are comfortable with risk. You need to think about how comfortable you are with large swings in the value of your investments. Stocks do not go in a straight line and some years your investments will go down. I would look into some of the online risk tolerance tests.

The funds I recommended have returned 8-10% a year in the past, but you cannot plan on this for the future. All you can do is manage your risk. So my advice is to not try to get too exact with the $10K target, but rather try to save up $10K in extra contributions on top of your 15%. Any return you get on that extra 10K will be extra money for retirement, which will be a good thing.

By the way, congrats on the new job!

Thanks for the additional advice, and the congratulations!

I wanted to invest aggressively with the money in the Roth because if I figured *if* I pull in a big ROI, I won't get taxed for it, which is one of the main benefits of investing through a Roth. But that was my line of thinking before I knew how much income I would get with the raise.

Another way to look at this is to approach it as a 5-year plan. Every year I'll have 12k to invest, for a total of 60k when I'm 30. Any unexpected costs will decrease this amount, and any promotions/raises will increase it. How do I divvy up that 60k so that I meet my goals (which are still a little hazy) and manage risk so that it's more likely to grow?

The hazy goals:

-Have a DP in 5 years. Don't know how much yet because I don't know which neighborhood I'll end up in, but I would guess that I'll be looking at homes in the 175-275k range. I might be interested in flipping, but it all depends on how real estate goes, and what my life is like (e.g. if I have kids at that time, I'll have to invest in a changing table rather than a table saw).

-Get a nest egg going for retirement. I don't know whether to do this through the HSA, the Roth, or both. I also don't know how much I should aim for. Any feedback on this?

-Invest a small part of my income aggressively. I'm willing to take the risk; I'd like to try and take advantage of my youth to ride out swings in the market. I'll DEFINITELY need to do more research on this, though!

[Onwards]

Originally Posted by zetta

After funding the ROTH, efund, and HSA each year, why not start putting money aside toward your downpayment? That way you won't need to touch the ROTH, and it can just keep growing and working for you.

You know, I think I got hung up on the investment earnings not being taxed part, and I tried to fit that into my goals. Now I see that it's not necessarily making sense. This is why it's good to ask for advice.

Originally Posted by zetta

So each year after your efund is in place, put $5k to ROTH, $1K to HSA, and $6k to downpayment fund. When your car is paid off, put the money that was freed up into your downpayment fund. Within 3-4 years you'll have $20k, which would give you 20% down on a $100k home. Not sure how much homes cost in your area, but it's smart to put down 20% to avoid PMI fees.

Hmmm, that's another way to approach it. Thanks for the ideas. I think I'm going to need to write down a few scenarios and compare them side by side before I scratch out an investment plan.

[Onwards]

OK, so I did some "defogging" on my goals and now I can begin planning with the end in mind...

In 5 years, I'd like to:

-have put 10k into the EF (6k is minimum; I'm presuming I'll need to replenish it at some point)

-have 25k for retirement
*5k per year in Roth?
*how should I invest this? (discussed above)

-have 25-35k for DP
*extra from finishing with car payments
*what kind of account should I put it in?

Maybe this is more of a saving plan than an investment plan, but I do want to know how I can handle this money so that it beats inflation and maybe grows a little over these next 5 years.

[noppenbd]

Originally Posted by Onwards

How do I divvy up that 60k so that I meet my goals (which are still a little hazy) and manage risk so that it's more likely to grow?

-Get a nest egg going for retirement. I don't know whether to do this through the HSA, the Roth, or both. I also don't know how much I should aim for. Any feedback on this?

I think Zetta's advice is good on divvying up the money. It will be a little "cleaner" by keeping the DP separate from the retirement.

On the topic of how much to aim for, 15% of gross is a good rule of thumb. Another rule of thumb is that you need 25X yearly expenses saved up to retire. In fact there are whole websites devoted to this. Since you are young and your expenses are likely to change greatly in the future, I would aim for 15% at this point, plus extra for the downpayment.

Since you can't save the whole 15% in a Roth due to income limits you may need an additional taxable brokerage account just for retirement savings, at least until you get a 401k. So you would have 3 accounts total:

1) Roth IRA ($5K per year)
2) Taxable brokerage for retirement ($1750 per year increasing with salary to maintain 15% of gross)
3) Taxable brokerage for DP ($6K per year plus car pymt once paid off)

[disneysteve]

I'm of the belief that retirement accounts are for retirement. They aren't for EFs. They aren't for home downpayments. They aren't for any other purpose. They are for retirement - period.

One other thing to keep in mind is that beginning in 2009, the Roth contribution limit will be indexed to inflation, rising in $500 increments, so 2008 is the last year it will be $5,000. Next year it will likely be at least $5,500 and rise annually from there.

[noppenbd]

Originally Posted by Onwards

-have 25k for retirement
*5k per year in Roth?
*how should I invest this? (discussed above)

-have 25-35k for DP
*extra from finishing with car payments
*what kind of account should I put it in?

Unfortunately these are not easy answers and there are as many opinions as there are people on this board. I would suggest reading William Bernstein's "The Four Pillars of Investing". He advocates low-cost index fund investing for retirement. Personally I use Vanguard index funds, with about 80% stocks and 20% bonds (I am 32). The stocks are split up 20% large US, 20% small US, 10% REIT, 10% emerging international, and 20% value international. However, you need to choose your own allocation based on your own risk tolerance, experience, and age.

For the DP monies, if you are comfortable with the risk that you could theoretically lose money, you could put it in taxable brokerage account, and invest in a balanced fund. A balanced fund is one that tries to straddle the line between income preservation and growth, so you will get some growth, but at less risk than an all-stock portfolio. Examples are the Vanguard Wellesley or Balanced Index. However, even with these moderate funds you still are taking some risk (albeit a managed amount). You have to decide if you feel comfortable with this.

If you are not, you should look for the highest yield savings or MM you can find.

[maat55]

Generally speaking, payoff debts and then invest more. Many people will just spend it and use it to obtain more debt, bad plan.

[Tree0164]

Congrats on the pay raise! You are smart to go with a plan on the extra money.

I would keep the Roth and Down payment money separate. Roths are not for emergenies.

I would also work on funding the Roth and EF at the same time. For the extra $1000 put $500 each month in each account. You can adjust in 2009 to fully fund.

Once you have the E-fund completed, then make sure the car is paid off. Then take your car payment into another account so you do not have to take out another car loan in the future.

Start saving for the down payment. Ideally you want 20% down-keep it in an ING account.

[Onwards]

Originally Posted by maat55

Generally speaking, payoff debts and then invest more. Many people will just spend it and use it to obtain more debt, bad plan.

That makes sense, and my first instinct is to pay off my balance on the car, but I've already made more than half the payments so--based on my own thinking and on everyone's advice--it seems better to continue making the payments and go for filling up the EF first.

[Onwards]

Originally Posted by Tree0164

Congrats on the pay raise! You are smart to go with a plan on the extra money.

I would keep the Roth and Down payment money separate. Roths are not for emergenies.

I would also work on funding the Roth and EF at the same time. For the extra $1000 put $500 each month in each account. You can adjust in 2009 to fully fund.

Once you have the E-fund completed, then make sure the car is paid off. Then take your car payment into another account so you do not have to take out another car loan in the future.

Start saving for the down payment. Ideally you want 20% down-keep it in an ING account.

Thanks for the congrats!

Why would you recommend an ING account in particular, versus other accounts?

[Onwards]

Originally Posted by noppenbd

Unfortunately these are not easy answers and there are as many opinions as there are people on this board. I would suggest reading William Bernstein's "The Four Pillars of Investing". He advocates low-cost index fund investing for retirement. Personally I use Vanguard index funds, with about 80% stocks and 20% bonds (I am 32). The stocks are split up 20% large US, 20% small US, 10% REIT, 10% emerging international, and 20% value international. However, you need to choose your own allocation based on your own risk tolerance, experience, and age.

For the DP monies, if you are comfortable with the risk that you could theoretically lose money, you could put it in taxable brokerage account, and invest in a balanced fund. A balanced fund is one that tries to straddle the line between income preservation and growth, so you will get some growth, but at less risk than an all-stock portfolio. Examples are the Vanguard Wellesley or Balanced Index. However, even with these moderate funds you still are taking some risk (albeit a managed amount). You have to decide if you feel comfortable with this.

If you are not, you should look for the highest yield savings or MM you can find.

Thanks for the book recommendation. I'll check it out.

I see what you're saying about the DP fund. I'll have to think about it. Thanks for laying out the options for me, I appreciate it!

[maat55]

Originally Posted by Onwards

That makes sense, and my first instinct is to pay off my balance on the car, but I've already made more than half the payments so--based on my own thinking and on everyone's advice--it seems better to continue making the payments and go for filling up the EF first.

In this economy, filling the EF funds is wise. Advoiding future debt would be good also.