401k + Roth IRA combination

[ia87]

I'm wondering if the below makes sense, or if it is better to go all into a 401k.

A little background info. I am a 27 year old software engineer making a pinch over six figures. I am frugal in all but two areas: cars and food. I have been silly for the past four years and not put any income toward retirement. Basically, I have just let my savings accumulate in a checking account and once in a while transferred some into my savings account.

Now for the plan. I want to put in a reasonable amount into my 401k, but not necessarily max it. I want to max a Roth IRA. My reason for not maxing out the 401k is that I the combined contributions to a 401k and Roth IRA reduce my monthly disposable income to a level below what I am comfortable with. I have substantial student loan debt (nearly 60K on a graduated plan) plus a five year loan out on a entry-level luxury vehicle ($497/month). I also pay $1000/month in rent. I have $20,000 in an emergency fund and $15,000 that I basically do nothing with at this time, but wouldn't consider part of my emergency fund (that is in its own online savings account).

Here is my rationale. My idea is to contribute enough to the 401k to keep all of my income taxed at a lower bracket. This comes out to roughly $12,000. I would then contribute $5,500 to a Roth IRA. I plan to take out the contributions in 5 years to help me put a down payment on a house. As I understand it, this can be done without any penalty with a Roth IRA.

I have three questions:

1) Is my plan reasonable?
2) If no to (1), what combination of retirement accounts and contributions to these accounts makes sense given my age, debt, spending habits, and profession? (If not enough information is available, let me know what else to provide.)
3) What should I be doing with the rest of my disposable income? Just let it sit in a high-yield savings account as an ever-growing emergency fund? Invest it outside of an IRA/401k? Put *everything* in a 401k or IRA?

I have researched for a while on my own, but I fear making going forward with my plan due to lack of life experience (read: I haven't yet had a family, serious medical emergencies, mortgage payments, etc). Those of you here who have this experience may see the folly of my plan and give sage advice, which I would greatly appreciate. Thanks so much.

[rennigade]

I make a little more than half of what you do and I max my 401k and roth ira and still have money left over...and I live in an expensive metro area. Thats all I have to say about that. If I can do you you certainly can.

[autoxer]

You are going in the right direction, but I also think you should shoot higher. If you don't max out the 401k and Roth IRA, then you are giving up tax deductions, so that you can dispose of more disposable income. Even if you get all of your income below the 28% bracket, you are still paying 25% income tax. Even in that bracket, you should take any tax deduction that is offered to you.

As your income has gone up, you have adjusted your spending accordingly. It may seem like a huge sacrifice to adjust it back down, but it really isn't. No matter what your income is, you have to live within your means.

The fact that you called your luxury vehicle 'entry level' indicates to me that you probably expect to upgrade in the future. I love cars just as much as the next guy, but I have finally come to terms with the fact that basic transportation is a need and anything beyond that is a want. Car payments don't have to be a fact of life.

Beyond that, do any of your loans have a high interest rate?

[ia87]

You are going in the right direction, but I also think you should shoot higher. If you don't max out the 401k and Roth IRA, then you are giving up tax deductions, so that you can dispose of more disposable income. Even if you get all of your income below the 28% bracket, you are still paying 25% income tax. Even in that bracket, you should take any tax deduction that is offered to you.

As your income has gone up, you have adjusted your spending accordingly. It may seem like a huge sacrifice to adjust it back down, but it really isn't. No matter what your income is, you have to live within your means.

The fact that you called your luxury vehicle 'entry level' indicates to me that you probably expect to upgrade in the future. I love cars just as much as the next guy, but I have finally come to terms with the fact that basic transportation is a need and anything beyond that is a want. Car payments don't have to be a fact of life.

Beyond that, do any of your loans have a high interest rate?

Thanks for the response, autoxer. I'll definitely consider maxing my 401k. Does my traditional 401k + Roth IRA combination appear as a decent approach? Perhaps there is a different combination that makes better sense?

As for calling my car entry-level luxury, I name it so only because that is its actual designation. KBB and other sites refer to it as an entry-level luxury vehicle. I have no plans to change cars for at least seven years (it has 5 years of warranty on it - 4 factory, 1 CPO, and I intend to keep it for a while after that). I am a car enthusiast, actually. I go to the track once in a while, though not regularly and I don't take it too seriously. That said, cars bring me a lot of enjoyment in life and that improves my mood while working. This may change as my priorities in life change. Anyway, the car value is in the very low 30s--nothing too ridiculous like a 528i, which runs much higher. At my salary I believe this is alright. I have no plans to sell the car, but also no plans to step up to a higher end vehicle come time to sell this one.

A while ago I had several 7.9% student loans. I have since paid those off. All loans are now 6.8%. Herein lies the dilemma. The 10 year return rate for portfolio comprising stable, well-known index funds are not too different from the 10 year interest rate on my loans. Would I be better paying off as much of the loans as possible as quickly as possible while keeping my emergency fund and contributing fully to a 401k + roth ira, or should I take some of my disposable income and place it into, say, a vanguard index fund? I'm not sure which would be a better use of my money. I'm leaning toward paying off the loans as fast as possible because I want to have more disposable income available 5+ years from now to handle medical issues that may pop up. Then again, 5 years from now I will still be young and medical issues will be unlikely. Thoughts?

[autoxer]

A while ago I had several 7.9% student loans. I have since paid those off. All loans are now 6.8%. Herein lies the dilemma. The 10 year return rate for portfolio comprising stable, well-known index funds are not too different from the 10 year interest rate on my loans. Would I be better paying off as much of the loans as possible as quickly as possible while keeping my emergency fund and contributing fully to a 401k + roth ira, or should I take some of my disposable income and place it into, say, a vanguard index fund? I'm not sure which would be a better use of my money. I'm leaning toward paying off the loans as fast as possible because I want to have more disposable income available 5+ years from now to handle medical issues that may pop up. Then again, 5 years from now I will still be young and medical issues will be unlikely. Thoughts?

Although using a taxable brokerage account is the next logical step after maxing your 401k and Roth IRA, with that interest rate I would be more inclined to attack those loans. It'll be a lot easier to handle a house payment without all that other debt.

Start tracking your net worth once a month and it will keep you motivated to stay on track.

Regarding your thoughts about buying a house. It is true that you can withdraw roth ira contributions for a house down payment, but I wouldn't really recommend that, because the money is so valuable growing tax free in the Roth. If you know you will need ~50k in 5 years, then just pretend like you have a mortgage now and set that money aside in your savings account every pay day. Treat it like a bill, transferring $833 every month, instead of just saving what is left.

Side note, I did a few track days in my old WRX, until I had a little shunt that scared me straight. I spun off the track at ~70mph, but somehow avoided the wall. I vowed not to go back to the track unless it was in a car that was disposable, not my financed daily driver.

[Goldy]

I agree with autoxer. I would max the 401k and Roth then turn to the loans.

[ia87]

Thanks. I'm going to try that approach, then. $20k in an emergency fund and a few grand as cash reserves is sufficient from what I've researched. Do you guys agree? If so, I'll put the rest of my disposable income into the loans asap.

[ia87]

I'm also wondering why it is necessary to fully max out the 401k, especially consider my company provides no match. Wouldn't it make sense to contribute a lesser amount (say, 12k rather than 17.5) and use the difference to help quickly pay off the student loans? I'm wondering what the correct balance would be. There's probably an equation to help me in this regard.

[autoxer]

I'm also wondering why it is necessary to fully max out the 401k, especially consider my company provides no match. Wouldn't it make sense to contribute a lesser amount (say, 12k rather than 17.5) and use the difference to help quickly pay off the student loans? I'm wondering what the correct balance would be. There's probably an equation to help me in this regard.

The correct balance will be whatever you are comfortable with. The equation would make lots of assumptions about future tax rates, market appreciation, and how long the assets stay vested, so it really comes down to your comfort level with investment risk. If you aren't comfortable with stock fluctuations and your 401k is in a money market, then you will do much better paying down that loan. If you are more comfortable with the volatility and will stay the course in a turbulent market, then you can probably do better with investing vs. paying down the debt. Doing a mix of both is an excellent choice.

Instead of trying to compromise between maxing the 401k and paying extra towards the debts, take a look at some of your consumption habits and see if any of those can be compromised. That's what I am doing to try to increase my savings rate. I thought I was frugal until I started analyzing my spending.