Personal finance - strategies: Minimize tax or maximize investments

[avil_saver36]

Greetings.

I am a newbee. I stated paying attention to my personal finances just over a few months ago. I don't know what triggered it; probably in your mid 30s (I am 36), everyone feels at some level to gauge their situation and get a sense of what they will have in retirement.

Like everyone else, I have similar goals. With the order of priority:

1. Fund our children's education (just the bachelors). We have one 6 year old daughter as of now. We may have a second child (high probability event since our financial situation is getting better).
2. Have at least USD 500K's worth in retirement (in today's dollars) but preferably USD 1 million. My wife has a pension fund so the sum of future cashflows of her pension should be considered instead.
3. Leave inheritance to each of my child. For me, that's 1 townhouse with considerable equity (at least 50%) in it valued at $350K in today's dollars. This townhouse should be a stable income generating instrument.

There is already some conflict. 3 years ago, my household income was barely at $95K. My wife was not working. Now, our household income is $160K. My wife works part time and has her own tutoring business, and we estimate her income will continue to rise significantly. I am also on an upward career trajectory, and I estimate at least 1 significant jump in the coming year or 2. With the increasing income, I am starting to feel the taxes and obviously, people in my situation will divert a significant portion of the income in the 401Ks (my wife can contribute more in her pension fund).

Putting too much in retirement will satisfy objective 2, but will probably hurt objective 3. For objective 1, people probably use 529s, but I haven't started a 529 fund yet. We already have investments in 6 figures overseas (in our native country) and possible inheritances (rich grandparents, far far likely to fund the education of their dear grandkids), so I never really paid attention to the 529 plan.

As of now, my company gives me a 4.5% match. I only match it, and nothing more. At this moment, I have $90K in my 401K. My wife started working just over an year ago, so her pension fund is very small. She also only works part time (4 hours) and gets the rest of her income through her business.

We don't have student loans or credit card debt. However I am paying my mortgage off ($2094 - 20 year loan at 3.9% on our townhouse that we bought at $370K in 2013), 2 cars (these total almost $1192 - both cars new and bought with absolutely NOTHING down, but interest rates are only 1.9% thanks to Honda) and a home equity line of credit ($33.4K total loan). The HELOC loan was originally a 401K loan and almost all of it is in our home equity. It was taken to hit a 15% equity when we purchased our house originally and increase it to 20% when we refinanced it in Dec 2014. When I left my job, I used my house equity to pay off 401K - talk of circular loans. This is a very friendly loan though with an interest of only 0.99% for the first 12 months and 3.5% afterwards (although it's a variable interest loan, I don't think it will rise above it).

I want to pay $300 towards my HELOC loan. Combined, my debt service comes to $3600 or so every month.

We have $24K cash in our savings account. We are desperately trying to increase it to have enough money to buy our second house. We will then rent out our current townhouse and get closer to objective 3. At the present rate of savings, I estimate that we will have $120K there in 3 years.

I pay $1500 for the 2 car loans and HELOC. Even when my cars are paid off (1 will be in Dec 2016 and the second in Dec 2018), I want to take that money and throw it in the HELOC. With that plan, all 3 loans can be retired in about 4 years from now.

I am not making any extra payments on my current townhouse.

I hope my financial picture makes some sense now. I estimate we will be in about 22% tax bracket this year (could be in 25% too). If our incomes keep increasing, this bracket will go up. What should we do with the extra money?

- Divert to 401K and continue to live on our "current disposable income" OR
- Get more in home, but take a higher tax hit in the process. However use the extra money to increase cash savings, pay off the current townhouse faster and get debt free sooner.

I wish I hadn't bought 2 shiny new cars, but what's done is done. I have to pay them off. Our townhouse is more reasonable. But long term, I want to convert it to a rental property, so realistically, I still view ourselves as future homeowners.

Any advice/discussion on what people do in our income bracket and similar life goals would be awesome. Please move the post to appropriate forum if this was the wrong choice. And please also excuse the "general vagueness" of this post.

[autoxer]

I am also 36 and have a similar income and I max out every retirement account that I have access to, in order to reduce my tax liability. It isn't exactly going to hurt objective 3, because whatever is left in the 401k accounts can be left as an inheritance. Don't be so worried about putting too much in.

Will your current house make a particularly good rental house for cash flow?

I started a 529 for my daughter, just putting a small amount in each month. My state gives a small tax break for using it and it will save on federal tax if the money is used towards education, but I don't think it makes sense to use one unless you have taken advantage of all of the other tax breaks first (i.e. maxing out the 401k).

I see you are carrying quite a bit of debt, is your attitude towards debt changing?

[feh]

OP - you just need to do some reading; educate yourself.

Bogleheads.org is an excellent resource. If your questions are regarding personal finance, click on the link in my signature. For investing, start here: http://www.bogleheads.org/wiki/Bogle...g_start-up_kit

PS - most folks will advise you to prioritize retirement funding over paying for your kids' education

[avil_saver36]

I am also 36 and have a similar income and I max out every retirement account that I have access to, in order to reduce my tax liability. It isn't exactly going to hurt objective 3, because whatever is left in the 401k accounts can be left as an inheritance. Don't be so worried about putting too much in.

Will your current house make a particularly good rental house for cash flow?

I started a 529 for my daughter, just putting a small amount in each month. My state gives a small tax break for using it and it will save on federal tax if the money is used towards education, but I don't think it makes sense to use one unless you have taken advantage of all of the other tax breaks first (i.e. maxing out the 401k).

I see you are carrying quite a bit of debt, is your attitude towards debt changing?

Thanks for giving me a significant comparison point!

The reason we have too much debt is that a significant portion of our wealth got tied in investments overseas some 3-4 years ago. At that time, we were going to wind up our life in the US and move permanently out. However, things changed suddenly and it made much more sense to stay put after all. We settled for good "here", but most of our money was "there".

In 2013, we decided to buy a house. We bought a reasonably cheap townhouse in an excellent school district - I live in Maryland, and it is one of the most expensive states especially if you are near the DC metro area. I am happy with my house purchase decision. However, we didn't have enough cash and I had to borrow against my 401K. Then later as interest rates fell, I refinanced, got a 20 year loan, but the appraisal of our house came a little low and I had to pony up extra cash (again from the 401K) to meet 20% and get the most favorable terms on the loan.

I compounded my situation by buying 2 new cars. Before we relocated, I had a very good Sonata that I sold off. Our second car was an old beater, which I still could have kept using till this day in the hindsight - that was sold off too. Those 2 cars got replaced by 2 shiny new cars - 1 of them a minivan. I did't have any cash - just excellent credit - so I put 0 down on both and just took 1.9% 5 year loans from Honda. In hindsight, I could have had far more options if I had more money and not have to stick with Honda. Not that they are bad cars - both give me excellent mileage and no problems - but I am paying $1192 per month on both.

So right now, my budget is stretched. We still manage to save my wife's entire salary, her business income, and also my annual bonus, but we have to spend everything else. We feel poorer as a result of our debt burden.

My attitude towards debt has changed significantly. The car loans are really bad and are setting me back. I want to run these cars in the ground and buy only used cars for the rest of my life. Lesson learned.

My current townhouse - being in an excellent schooling district - is easily rentable. It will probably sell at $375K right now in an "as is" condition. It will fetch $2K in rent without breaking a sweat - more if I work at it and go with an agent. The rental yield is high. Many people in this community have rented and most renters are families who want access to the schools. So I view this townhouse as a good investment down the line.

I guess I will "freeze" the taxable income around $160-170K and any future increases will be just diverted off to the 401K. I also think this needs to take interest rates into account. At low interest rates, it probably makes sense to lock up more money in the 401K, but if they rise, it might be a good idea to get more cash in hand. Thoughts?

[avil_saver36]

OP - you just need to do some reading; educate yourself.

Bogleheads.org is an excellent resource. If your questions are regarding personal finance, click on the link in my signature. For investing, start here:

PS - most folks will advise you to prioritize retirement funding over paying for your kids' education

Thanks for both the links. I am not really a savvy investor and have just gone with index funds so far. I guess that needs to change at some point once I start having a nontrivial nest egg.

At this point, I am immediately more focussed at buying another house and getting debt free (both auto loans and the HELOC).

Both of your links are very promising and I will surely spend some time with them. Thanks again!

[feh]

Thanks for both the links. I am not really a savvy investor and have just gone with index funds so far. I guess that needs to change at some point once I start having a nontrivial nest egg.

Nothing un-savvy about that. The link I sent you will suggest you keep using index funds.

[autoxer]

In 2013, we decided to buy a house. .... However, we didn't have enough cash and I had to borrow against my 401K. Then later as interest rates fell, I refinanced, got a 20 year loan, but the appraisal of our house came a little low and I had to pony up extra cash (again from the 401K) to meet 20% and get the most favorable terms on the loan.

You didn't have to borrow from your 401k, that was a decision that you made. You also didn't have to refinance, not that it was a bad decision, but it was a decision and not something forced on you. If you take ownership of your decisions, you will feel more empowered and it will be easier to avoid debt the next time something happens.

I guess I will "freeze" the taxable income around $160-170K and any future increases will be just diverted off to the 401K. I also think this needs to take interest rates into account. At low interest rates, it probably makes sense to lock up more money in the 401K, but if they rise, it might be a good idea to get more cash in hand. Thoughts?

I don't see why interest rates would affect how much you want to contribute to a 401k. Can you elaborate on that?

[Jluke]

Instead of a 529 for college savings, consider a ROTH IRA; esp since there's a good chance of grandparents paying for college. Do some research and you may see the advantages to this.

[avil_saver36]

You didn't have to borrow from your 401k, that was a decision that you made. You also didn't have to refinance, not that it was a bad decision, but it was a decision and not something forced on you. If you take ownership of your decisions, you will feel more empowered and it will be easier to avoid debt the next time something happens.


I don't see why interest rates would affect how much you want to contribute to a 401k. Can you elaborate on that?

The general thought is this: If the interest rates are low, then I do not need a lot of cash upfront to buy a second house. I might go with only 20% down and still keep making monthly payments on it. This works because the cost to borrow money for my real estate investments is less. I will save in the long run because I will reduce my "peak income tax rate" and spread it over the lifetime of a reasonable tax rate.

If the interest rate OTOH was more like 7%, then the interest I pay on my mortgage is too much and it makes it much less palatable to me. In that case, it might be a better idea to bring more after tax cash home, and just use as much cash as possible to buy the house. If the interest rate is high, I will try to minimize the time it takes to pay the house off.

This is basically the major dilemma. Unfortunately, none of my forefathers owned a business and we don't own a business (yet). We get ordinary income, and it gets taxed the worst in this country. Also, I realize that very high incomes are not going to last lifelong - maybe for the next 15 years at best. The question is how to get the best utility out of this income. On one hand, you can divert a significant portion of it in retirements and reduce the tax hit. On the other hand, you can bring more cash on the table and nab good real estate investments. Basically, we need a balancing act and everything depends upon the numbers. I would like to know if someone has done the research, crunched out numbers, have "various scenarios" set up in Excel etc. Even if there are paid tools out to crunch these based upon the tax code and the interest rates, I would probably buy them (Intuit seems the most logical company, but I haven't come across a tool like this from them).

I don't know if I articulated my problem accurately. If I didn't, my apologies.

P.S. I do agree that buying the house and refinancing were choices, but they were no brainers. In essence, I just didn't have enough cash because my money was stuck

[avil_saver36]

Instead of a 529 for college savings, consider a ROTH IRA; esp since there's a good chance of grandparents paying for college. Do some research and you may see the advantages to this.

I did look into the Roth IRAs. I clarify again and admit I am a newbee, so my questions might be silly. What's the advantage of putting money into a Roth IRA? The contributions are after tax, and the only advantage seems to be that the investment gains are not taxed. I prefer real estate over stocks, and the only place where I dabble with stocks is in my 401k.

Let me know if I am missing something. Doesn't a 529 give you state taxes off at least? In Maryland, that can actually be a big deal because the state taxes are kind of high here.

[Jluke]

I did look into the Roth IRAs. I clarify again and admit I am a newbee, so my questions might be silly. What's the advantage of putting money into a Roth IRA? The contributions are after tax, and the only advantage seems to be that the investment gains are not taxed. I prefer real estate over stocks, and the only place where I dabble with stocks is in my 401k.

Let me know if I am missing something. Doesn't a 529 give you state taxes off at least? In Maryland, that can actually be a big deal because the state taxes are kind of high here.

ROTH: all money that you deposit into the account can be withdrawn prior to age 59 (certain rules apply); you can't withdraw earnings on that money (interest, gains, dividends).

If your kid(s) college is paid for by someone else; more retirement money for you. if not, you can also use this towards college.

529 is only for education... if you don't use towards education then you pay a penalty.

It can come down to a matter of personal preference on where to save your money.

All in all, you're in good shape and planning now will pay off down the road.

[tripods68]

$3600 in debt service is JUST CRAZY! With your income $160K you should not be in this bad situation. You seems to have a lot of plans but not "focus".

Biggest thing I would do first: Sell the two cars and buy used 'beat up cars instead. You may owe difference but still a better choice financially.

We were in bad debt situation few years (living out 'the life') until we realized we needed to make to a change. We have good income but felt drowning with debt. We decided to start paying off our DEBT using the debt snowball (from smallest to largest). We made monthly budget and "gazelle intense" to get out of DEBT. It was not easy by any means--couples must be in agreement to make this work and 100% committed-adhering to a STRICT budget. In the end we were able to be debt free (except our mortgage).

The good news if you simply dedicate half of your income this year and next year you can be debt free in no time. Don't go on vacation for few years until the mess is clean. I would worry less about taxes but focus in paying down the DEBT.

You can maximize all your retirement contributions up to the limit once you are debt free and save up and upgrade to a better used cars. I would hold off in buying another investment property while paying down the debt. Set aside 3-6 months towards EF and use the rest to payoff your debt.

[avil_saver36]

$3600 in debt service is JUST CRAZY! With your income $160K you should not be in this bad situation. You seems to have a lot of plans but not "focus".

Biggest thing I would do first: Sell the two cars and buy used 'beat up cars instead. You may owe difference but still a better choice financially.

We were in bad debt situation few years (living out 'the life') until we realized we needed to make to a change. We have good income but felt drowning with debt. We decided to start paying off our DEBT using the debt snowball (from smallest to largest). We made monthly budget and "gazelle intense" to get out of DEBT. It was not easy by any means--couples must be in agreement to make this work and 100% committed-adhering to a STRICT budget. In the end we were able to be debt free (except our mortgage).

The good news if you simply dedicate half of your income this year and next year you can be debt free in no time. Don't go on vacation for few years until the mess is clean. I would worry less about taxes but focus in paying down the DEBT.

You can maximize all your retirement contributions up to the limit once you are debt free and save up and upgrade to a better used cars. I would hold off in buying another investment property while paying down the debt. Set aside 3-6 months towards EF and use the rest to payoff your debt.

Wow! I thought $3600 was really not THAT bad since it also includes my mortgage, but I guess not! I however do know several people whose mortgage alone is in the 3000s. Not that I am justifying my debt situation which is less than optimal.

Should I sell the cars? One of the cars is in the 4th year of being paid. With next month's payment, only 16 more payments to go. It's a very good car, well maintained. We drive our cars carefully and take good care of them. Part of the reason going with a new car was that we just didn't trust another owner taking good care of their cars. Anyway, the first car will be paid off in Dec 2016. It accumulates about 10000 miles per year.

The second car is a minivan and will be paid off in Dec. 2018. Again, not that I am justifying me buying a new minivan - would certainly have done things differently - just my question is that after being in it for 20 payments already, would it make sense to sell it?

Both cars are well maintained. I can at least break even on the minivan (and probably will do better) and get at least a few thousands out of the first car.

We have a savings fund that's got some $25K in it. That fund is growing at the rate of $20-25K per year. Theoretically, we can apply that fund to wipe away our debts but we wanted to buy a second house, and I was rather hoping to use it as a downpayment for it! I still want to be in this "special window for homeowners", where the interest rates are down and prices are holding up - not too down, not too up, which is to my liking.

I estimate at the current rate of payments, all my non-mortgage loans will be paid off in the next 48 months. I am just in the first year of my 20 year refinanced mortgage, and since the interest is low, I don't mind paying it off for its entire term.

Did I get something wrong here? Is it better to wipe out ALL my debts including the primary mortgage before I even think about a second house? Advices appreciated

[tripods68]

We had similar view about debt..."its just $3600" but this debt causing all kind of anxiety, marriage issue, and prevent us from achieving our goal. If you flip the question around, would you rather keep $3600 extra a month?


How fast do you want to get rid of your car debt? Again, that depends how angry about your financial situation to be slave in debt. Most people are fine having debt, and then wonder why they are always broke? Being debt free is a LIFE CHANGING moment. It is a mindset that adjust your behavior towards wealth building and financial freedom.

[autoxer]

Ahh, I see you are more comfortable with the idea of investing in real estate vs. investing in stock markets.

I don't have a crystal ball, but I do believe that interest rates will rise in the future. This shouldn't change your comfort level with different investment classes and it won't preclude the ability find good real estate investments. The interest rate on the loan is just one of many costs associated with a rental property, so I wouldn't single that out as a reason to move into a different asset class. If interest rates do rise a couple points, you aren't all of a sudden going to be comfortable with stock markets, you might just look for different things in a real estate investment.

To be upfront, I am more comfortable investing in stock markets and don't have much interest in real estate. I don't necessarily think that investing in real estate is bad, just not something that I'm comfortable with.

P.S. I do agree that buying the house and refinancing were choices, but they were no brainers. In essence, I just didn't have enough cash because my money was stuck

I don't view my 401k money as being stuck, just set aside for the future. If I was faced with the option of taking a 401k loan, then the no brainer solution for me would be to wait and save up more. I just started saving up for a down payment on my next house and although I could liquidate my brokerage account and make the move right now, I would rather leave that money invested and save more from my cash flow until I have enough money in my savings account to put 20% down on my next house.

Should I sell the cars? One of the cars is in the 4th year of being paid. With next month's payment, only 16 more payments to go. It's a very good car, well maintained. We drive our cars carefully and take good care of them. Part of the reason going with a new car was that we just didn't trust another owner taking good care of their cars. Anyway, the first car will be paid off in Dec 2016. It accumulates about 10000 miles per year.

I like my new car, even though I know it wasn't a wise financial decision. If you can reduce future depreciation and/or get something more fuel efficient and be happy with the decision then consider selling them, otherwise just pay them off and keep driving them.

Did I get something wrong here? Is it better to wipe out ALL my debts including the primary mortgage before I even think about a second house? Advices appreciated

You don't necessarily have to eliminate all debts before taking on another mortgage, if you are comfortable with the cash flow, but it would certainly give you more flexibility. Freeing up cash flow allows you to plan more for the future, instead of paying for past decisions. Just keep in mind that using debt strategically to leverage appreciating assets is good and depreciating assets are bad, whether they are financed or not.