August 10, 2021

Bogleheads® Chapter Series – Prioritizing Investments

Choosing where to invest your money first is important. Bogleheads forum member FiveK shows you how.

Hosted by the Starting Out Life Stage and South Florida chapters. Recorded on August 10, 2021.

The slide presentation can be accessed here.

Chat from the recorded meeting can be accessed here.

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Bogleheads® Chapter Series – Prioritizing Investments


Host: Welcome to the Bogleheads Chapter Series. This episode was jointly hosted by the Starting Out Life Stage and the South Florida Local Chapter and recorded August 10, 2021. It features longtime Boglehead FiveK discussing investment funding priorities, including investment locations and tax efficiency. Bogleheads are investors who follow John Bogle’s investing philosophy for attaining financial independence. This recording is for informational purposes only and should not be construed as investment advice.

Miriam:  Welcome everyone to our Bogleheads zoom meeting, hosted by the Starting Out Life Stage chapter and the South Florida Local Chapter. I am Miriam, one of the chapter coordinators, and we’re here with a personal finance presentation by FiveK on prioritizing the investment order.

The Bogleheads is a term intended to honor Jack Bogle. Mr. Bogle created the first index fund for retail investors and is the founder of Vanguard. But Bogleheads are investors who follow or use the investing advice that Mr. Bogle advocated, and that investing advice as you know is invest early and often, develop your workable investing plan, never time the market, use index funds when possible, diversify, keep it simple, minimize taxes with cost efficient investing, and above all, to stay the course with your plan both in bull and bear markets. Just keep saving and just keep investing.

And this is where the FiveK presentation tonight will be so useful: developing the plan.

I would also like to introduce my co-moderators. Tonight we have Carol from the Pre-retirement Chapter and the Dallas Chapter and we have Jim, who you just heard, from Chicago. I would like to introduce Gail Cox, who is here. Gail is the boglehead who created the Bogleheads Life Stage Investing Chapters and we thank her for that. 

Okay, on to our presentation. FiveK is a long-time boglehead who posts regularly on the forum. He has many, many helpful posts. His kind, competent answering questions from newbies and oldies we appreciate, and he’s especially good on portfolio creation and tax efficient fund placement. He also has his personal financial toolbox, which is a huge spreadsheet, and he’s also already given a presentation on that. And you can find it on the Boglehead Blog. I believe it was in March.

Okay FiveK. Welcome, and please, the stage is yours. 

FiveK: Thank you Mariam. So everything that’s going to be covered here verbally pretty much you can find in various websites. The presentation will have links to all those. The presentation itself will in pdf form be made available after the meeting. And these are not my ideas as much as I’m just regurgitating what various groups of people have put together, as these are some pretty good ideas that you might want to follow.

Okay. I’ll just start out with some general comments. A lot of this is subjective. Reasonable people can differ on the exact ordering. Now you can stretch that, but you can’t stretch that too far. Some of the things that you’ll find at the top of the list, they belong there, and you don’t want to switch them with things at the bottom of the list. And we’ll get to the lists shortly. Sometimes the math is simple, but the equation values themselves are somewhat speculative. Like one example would be what do you think future tax rates will be when deciding traditional versus Roth, and then when we get into the risk versus reward you, know there is no deterministic answer. You can pay debt at a low known rate, you can invest at a possibly higher but possibly lower rate, and we’ll get into that a little bit also. And you know other than the above, this is all straightforward– and that should be a winking emoji there– because it’s not straightforward. But it’s simple enough.

Okay, so the next slide, and the next slide, are very high level views. After these two slides we’ll get into the details on these, but this one is the picture view that you can see. I’m not going to read things you can read the slide faster than I can talk through it. There’s some things that are high priority things that are sort of in the middle, and then things that are relatively low priority.

So that’s the picture view. You’ve got your emergency fund, your employer match, your high interest debt. Then you get into HSAs, IRAs, 401ks, you know, the whole alphanumeric lexicon. Then you get into the taxable accounts and the paying off debt.

I mentioned you can find these things on the internet. There’s a couple of lists and again we’re going to get into details on this, so don’t try to read the small print  if you find it difficult. The thing to note is all those green lines, they all match up. So the two particular lists that I’m most familiar with, the one in Bogleheads on prioritizing investments, and there’s a Mr. Money Mustache one called, what is it, investment order. They pretty much say the same thing. They may say it in slightly different words, so if one of them confuses you try the other. And the wording may be different enough that it becomes understandable, but the concepts are identical.

Okay, so without further ado these are really the top three, and these are all listed more or less in order. So the top one would be the first thing to do, and the next one the second and the third one the third, but you can mix and match. So let me just go through these a little bit here.

So the emergency fund. So when we talk about emergency fund–we’ll talk about traditional versus Roth later, we’ll talk about pay debt versus invest, any one of these individual topics we could spend an hour or two on, so this is a high level view–so emergency fund to your satisfaction I  think it’s pretty non-controversial to say that you should give yourself at least enough buffer that you don’t have to worry about bouncing checks from month to month, so you need at least the next month’s bills in your emergency fund. Beyond that you need three months, six months, a year, two years. That’s a personal thing, so to your satisfaction.

Next one would be to get the employer match if you’ve got a 401k or 403-b that’s going to give you a one-for-one match or even a 50 cent per dollar match. That’s the highest return you’re going to get, you know, even in the next point you’ve got credit cards, even if you’re paying 20%, 30% interest on your credit cards. If you can get a one-for-one match from your employer that’s a 100% return. 

But there is a reason why high interest debt, for example, credit cards, is very high on the list here. You know high is somewhat relative. What’s high for one person who’s very risk tolerant might not be the same for someone who’s more risk averse. There’s no right answer, it’s personal finance and these mix and match. 

So if let’s take the emergency fund and the paying off the credit card debts. If you’re sitting there with six months expenses in your emergency fund but you owe $10,000 on a credit card that you’re paying 25% per year interest on, you might call that credit card debt an emergency and dip into your emergency fund to wipe out the credit card debt. so emergency funds are there to be used so if you’ve got something that you think qualifies as an emergency go ahead and use it. Now if you’re using your emergency fund to pay off your credit card every month  that’s a different story. Okay so that’s the top three.

So the middle four. You can pay tax now, you can pay it later, you can pay it never on these four options here. So the first one, and the reason why it is the first one, with a health savings account, if you’re eligible for one, and again, we can get into gory details on what makes one eligible for a health savings account,in terms of having a high deductible health plan. But if you’re eligible, you get a tax deduction on your contribution, you don’t pay tax unless you live in  California and New Jersey but you don’t pay tax on any gains, and then when you take it out to pay for medical expenses you don’t pay tax.

So it is California and New Jersey,  but the other 48 they’re a great deal. They’re even a good deal in California and New Jersey, they’re just not as great. Okay, so that’s the one, sometimes you hear them referred to as triple tax free. You get the tax deduction, you don’t pay tax on annual gains and then you don’t pay tax if you take it out for medical expenses.

So then we get the next, to  the traditional IRA or Roth IRA and the employer plans.And again remember with the employer plans, the the top three, where the employer plan showed up. That was just up to getting the match, the maximum employer match. So this would be getting going up to the IRS limit, the $19,500 for 401-ks. But the reason that the traditional IRA or Roth IRA comes before the employer plans on this list, and you see there’s a double-headed arrow so they can swap, but IRAs tend to have lower fees and almost by definition they have more investing options. So if they have a lower fee then your 401k, your 403b, offer then go with the IRA first.

But they don’t always have lower fees, sometimes you get institutional funds in 401-ks, and hey just fill up the 401-k. And sometimes you want to use the 401-k because it can reduce your modified adjusted gross income for something like the earned income tax credit, whereas the IRA may not be as efficient at doing that. So you know the IRA and the 401-k, yeah, the default order is IRA first, but there’s plenty of examples where you would want to do the 401k or 403b or 457 ahead of the IRA.

And then you get into for those who happen to have it available.Typically if you work for a large company and  they offer an after tax non-Roth 401k option, you can do something called the mega back-door Roth process which is a little bit different from the plain old back-door Roth process you see in a second bullet point, but it does get after tax funds into a Roth account instead of a taxable account. So that’s a good deal.

There’s a comment, yeah there’s another example on MAGI [Modified Adjusted Gross Income] of healthcare subsidies that may be another reason that you’d want to use a 401-k in preference to an IRA.

And all these are, if you have to make a choice, if you’re in the wonderful position that you’ve got enough disposable cash that you can fill all these up, well then great the order doesn’t really matter. Questions about that middle four or anything else at this point?

Questions about that middle four or anything else at this point?

Audience questioner: Yes, I have a question. 

FiveK:  Sure. 

Audience questioner: On the mega Roth you mentioned, the mega Roth can you explain what that is?

FiveK:  So mega back-door Roth is something that goes through an employer plan, so a 401-k, 403- b. Most people are familiar with the concept that you can contribute to a traditional account in your 401-k–and when I say 401k just assume that I mean or 403-b–you can contribute to a traditional account or a Roth account. You can elect which one to do. There’s a third option that some employers offer, not all but some, and that is after-tax non-Roth. So you can contribute after tax but it’s not immediately going into a Roth account. And it sits there. It’s like a non-deductible traditional IRA contribution. So that’s nice, but not all that interesting unless the employer plan also allows you to take that non-deductible after tax account and roll that over to either the Roth version of the Roth account within the 401k, or if the employer plan allows you to distribute that out to a Roth IRA.

So you make this after-tax non-Roth contribution where if you don’t do anything with it it just sits there you’re not paying any tax on any gains while it’s sitting there, but when you withdraw it you now pay tax on the gains at ordinary income rates, unless you have the option to take that account and roll it over immediately or within a month or two or even a year into a Roth 401k or Roth IRA .

And there’s two wiki entries, one on after tax 401k, one on the mega back-door Roth process. So they’re related but not identical. Does that cover it in enough detail?

Audience questioner: Yes. But does that mean that the mega Roth, it’s a mega 401k, correct? Mega 401k Roth, that it differs from your regular 401k Roth, regular 401k. Your regular Roth 401k, on the taxing of the earnings? .

FiveK: Correct. I’ll start with the process, so there’s a backdoor Roth process which involves multiple steps and there’s a mega backdoor Roth process that also involves multiple steps. But the two of them are different, The regular backdoor Roth process refers to what you do with IRAs. The mega backdoor Roth process refers to what you do with your 401-k.

The process for both of them involves you make a non-deductible contribution, so it goes into an account you did not get to deduct that contribution from your taxes.But if it stays in that account while it grows you won’t be paying any taxes,but when you go to withdraw from that account you’ll pay tax at ordinary income rates on any gains.

So up to this point you know if you put it in the account you didn’t get to deduct  it’s growing, you’re not paying tax but then when it comes out you have to pay tax on any gains. Kind of interesting but maybe not all that interesting. What makes it very interesting is if you can take that non-deductible amount and then convert it immediately to a Roth account.So when you do that conversion, if there hasn’t been any gains, you’re not going to pay any tax. But now you’ve got it into a Roth account where you’ll never pay any tax on it.

So you’ve got people sometimes say, you know I’m going to put it in my backdoor Roth account or I’m going to use my mega backdoor Roth account. Which is playing a little fast and loose with the language. Those backdoor things are processes that involve a contribution to a non-deductible account and then a conversion to a Roth account.

Audience questioner: Does the mega backdoor Roth stay in your employer plan until you take it out and you roll it over to a regular IRA? Is that correct? 

FiveK: I’ll give you a definite maybe on that one. It depends on your employer’s plan. Some employers allow you to roll it into a Roth, into your Roth 401k account. Some employers allow you to do what’s called an in-service distribution, and you can get it out of the 401-k completely and into a Roth IRA. Either one of those is perfectly fine. It really doesn’t matter as long as your employer plan allows you to do either one.

Audience questioner: Okay thank you. 

FiveK: You’re welcome.

Co-Host: There’s a question in the chat. What tax bracket should use a Roth 401-k versus a regular 401-k?

FiveK: Oh okay. Let me go back. So you know even when the math is simple, equation values may be speculative. It really doesn’t matter what your current tax bracket is as much as it matters how does that compare to what you think your future marginal tax rate will be. And you notice I used marginal tax rate instead of bracket, and I really should use that. It depends on what your current marginal tax rate would be, which for some people is their nominal bracket amount, but for others it’s not. You need to compare that to what you think it will be in the future.

There’s sort of rules of thumb, but I really don’t like rules of thumb in traditional versus Roth because there’s a huge number of exceptions to them. And one rule of thumb would be, well if you’re in the highest tax bracket use traditional. Well that’s a great rule of thumb unless you’re going to stay in the highest tax bracket even after retirement, and then you should use Roth. Another decent rule of thumb is if you’re in the 12% bracket or lower, you know, if you’re in the 12% bracket use Roth. And that’s a pretty good rule of thumb unless this is someone who’s late to the party and they’re in their 50s and haven’t had much saved and probably never going to pay tax in retirement. So they should use traditional.  So I just don’t like rules of thumb because there’s too many exceptions when it comes to traditional versus Roth. Again that’s a personal opinion.

All right okay so now we’re kind of towards the bottom of the prioritization list and you know taking care of the top ones you get your house in order so that you’re not bouncing checks, and get that employer match, that 100% return on your investment. get those credit cards paid off, and we’re through all of the tax advantaged options the HSAs, the IRAs, the 401ks.

So now we’re down to okay, do I invest or do I pay off debt that I have. Good question. So in the bogleheads wiki you’ll see there’s three bullet points: pay off medium interest; then invest taxably; then pay off low interest. It’s a little tough since there is no maximum on taxable investment, you could reasonably ask how do you ever get to paying off low interest debt. That’s a good question. You can think of those two maybe as parallel rather than one right after the other. And it gets into your risk tolerance or your risk aversion, just how you define things. 

So there’s one definition of medium interest debt that you’ll find over on the Money Mustache. And again, it’s just a definition: 3% over the 10-year treasury note yield which has been what, about  1.25% averaging over the past year. So I might say medium would be over 4.25%. So that would say 5% would be medium interest debt. You ought to pay that off. And 4%, that would be low interest debt, so you should invest taxably.

And some people would say, yeah that makes sense. Other people would say 5% and that’s that’s pretty low, I think I’m going to earn more than that. I’m in this for the long haul. I’m 100% stocks. Away I go. Other people would say 4%, gee that’s a great return. That’s a guaranteed investment return. I’m all for that. I’m going to pay off the debt before I invest. And so it’s personal. But these are some of the things that you might want to think about when you’re making your personal decision.

Other considerations that often pop up with questions. A common question is where do you put savings for a house down payment in this ordering. That’s really up to you. You can either say, hey  we really want the house ,we’re going to consider this a day-to-day expense like going out and buying groceries, food, clothing, and an eventual better shelter. So we will do that. That’s just something that we’re not going to consider that an investment that’s at risk. You know we’re going to buy chicken and potatoes and milk and then we’re going to put a bunch into our down payment fund.

Or people can say, you know we’re okay.  We’re renting here or we’ve got an okay house, and we’ll invest. And if things work out, we’ll take money out of investments later and buy a house or buy a bigger house, but no, we’re in no rush. So again either one of those is perfectly defensible.

But that’s a personal thing. Some people consider it extremely important to be able to pay for their kids’ college. So you have that as a higher priority. And in all this, the ordering pretty much assumes that you’ve got W-2 earnings or you’re a contractor, without you don’t own capital.

So you don’t own a chain of dry cleaning stores,or you don’t own a food truck that you’re looking to grow your business. If you are self-employed in that way,if you own your own business, you really need to look and figure the return on your business investment and decide where that fits in with all the investment options of IRAs and solo 401-ks and so forth and so on.

And that is it for the formal presentation on prioritizing investments. So where are we with questions?

Co-Host Manny:: (from chat) What’s a reasonable amount to put per month into a 529 for young kids?

FiveK: I don’t have a good answer for that. You know that depends.Is your kid going to go to Harvard and you want to pay for all four years plus a Phd and whatever. Then you need to be putting in a heck of a lot. Is your kid going to go to an enormous state university and is likely to get some sort of athletic scholarship? You probably don’t need to put in as much. That’s a really personal one. I don’t have a good answer to that.

Miriam: Well one thing I would say is that the earlier you put the money into the 401-k [529] the more time it has to grow and so I i view it as kind of a front loading effort to put as I mean I realize that saving for retirement is important more important, but if there’s any way to front load the 529 early then  it has more time to grow. It only has 18 years to grow. The life of the 529 is shorter than the life of your investing for retirement, so it’s a different type of an account. iIt sort of behaves a little differently. But most of the 529 plans do have a glide path similar to a target date retirement fund where it will glide down to bonds. So if you intend to put more money in towards the end of the 18-year period you’re going to be in a more conservative portfolio or you’re going to take more risk that the market will drop before your child goes to college. So I see a reason to front load it as much as you can.

FiveK: there’s a long forum post about after tax money choice between a regular taxable account and  a mega back-door Roth and rb suggests it’s always better to use mega back-door Roth and I would agree with that. That’s why it shows up in the middle four as opposed to the bottom three. So we talked about how you can sort of flip-flop some of these, but I think that the top three, there’s a pretty bright line between the top three and the middle four, and there’s a pretty bright line between the middle four and the bottom three. Here, I suppose someone might be able to come up with an exception, but I can’t, off the top of my head.

Co-Host Manny: Okay there’s another question: My state 529 plan has a state tax deduction. I thought of this as a guaranteed return on my investment, and hence prioritize it a little higher than my taxable accounts. What are your thoughts on this?

FiveK: Yeah. That’s if you’re sure, and you get to define the word sure, if you’re sure that your kid’s going to go to college and you’re going to spend, and you want to spend the money on that. Sure that makes sense to do that.

You know what we’ve done personally, well we were lucky with what we did. Our personal finance worked out okay. But we didn’t really know what we’re doing. But what we do now with kids still going through college is we put in the maximum 529 that we can to get the state tax break. And then we take it right out the next year to use it for tuition and room and board. So yeah, if you’re in a state that gives you a state tax break, might as well take advantage of it

Co-Host Carol: A while back there was a question in the chat: If you don’t plan to retire in the US, how does any of this change, if at all? 

FiveK: Great question, and that would probably depend on where you’re going to retire and how that country treats IRAs and 401ks in the US. And I am absolutely not an expert on those, not even close to being moderately informed on those.

Co-Host Manny: Actually I asked a question as well. What if you have low to medium interest debt somewhere in between 2.50%  and you weren’t really sure how things were going to go in the future. Would you focus on paying off the debt or investing. Or I guess, how would you make that decision if you really were unsure as to the trade-off there?

FiveK: Well one you could follow these suggestions. And you know 2.5%, the Bogleheads wiki does not define high, medium, and low. The Money Mustache one gives some suggestions but I don’t think it even pretends that those are holy writ suggestions. There’s some guidelines so if we were to go with the definition of medium as being 3% over the 10-year treasury note yield, and at 1.25% roughly, so medium would be 4.25%. So you said 2.50%, so that’s under 4.25% so that would not be medium interest debt, that would be low interest debt.

And if you follow this ordering, you’d never pay it off until you paid it off by paying it monthly. But if you’re staying up at night because you can’t stand debt and you’re losing sleep, well then maybe you want to pay it off.

Audience response: Can I contribute something to that point as well.

FiveK: Sure.

Audience response: It’s rather helpful if you simplify that debt question. So for instance if you’re paying 2.5%  in interest on any form of debt you can also look at that as a way to give yourself a 2.5% on your income by eliminating that debt. Furthermore if you plan to invest while carrying the example 2.5% debt and let’s say you’re receiving a nominal, which is pre-inflation, return say 4%, you’re not really receiving that 4% because if you’re paying 2.5% on debt. But receiving 4% you could do the math and you tend to be spinning your wheels. So it’s always prudent to pay off the debt first and then jump into investing to maximize those efforts.

FiveK: That’s one way to look at it. Other people could say that they’re not investing in bonds at all and they expect their stock returns to be higher. So never say always, or how does that go, unless there’s something I’m missing, but if you take someone who’s decided they want to be 100% stocks and they’re saying that the expected return is higher and then they’re willing to run the risk that that expected return does not materialize then I think that they have made a defensible choice to not pay off their debt.

Miriam:  Christina, do you have a question?

Christina: I’m wondering as you move closer to retirement should you consider moving most of your money into an after tax account so that you’re not quote-unquote surprised by the taxes you’re paying when you’re drawing down from pre-tax accounts like 401-k or traditional IRAs?

FiveK: I think the answer is in your question and that would be don’t be surprised. You might want to do Roth conversions or you might not. While you’re still working it’s usually not beneficial to do Roth conversions because now your Roth conversion amount is being added on top of your salary or your wage income and so you’re going to pay a pretty high marginal rate, usually. 

Christina: Right, but doesn’t a Roth conversion assume like I’m, and excuse my ignorance here, but doesn’t a Roth conversion already assume that you’re making a certain amount of money. So I’m working from the point of view that you’re not making so much money that you can do some sort of mega back-door Roth, that you just basically have some basic investments in traditional retirement accounts like a 401-k or what have you, and you’re putting all your money  into that. But perhaps as you move closer to retirement, when you start to draw down from that 401-k, you’re going to be paying taxes on that, or you’re going to be paying taxes on your traditional IRA.

So at what point I’m wondering, should you be trying to move money, or should you, maybe it’s not about moving money, maybe it’s just simply about putting money now into let’s say a Roth account of some sort. I’m just really trying to figure out how you avoid paying taxes you don’t need to pay, if that makes sense.

FiveK: And that would be that you learn enough to understand your own personal tax situation. There’s lots of ways to do it. If you use, if you pay, a CPA to tell you. You could use TurboTax. And you can, you know, say well okay, here’s what it would be. Here’s my base and now if I were to do a $1,000 Roth conversion how much more tax would I pay. And, you know, what’s that divided by a thousand? So what’s my marginal rate on that and so forth and so on. You can use spreadsheets that will do all those calculations for you and give you a chart that’ll show you what your marginal rate would be for your Roth conversion.

The whole thing on Roth conversions, or traditional versus Roth, it boils down to you really want to understand the rate that you’re going to pay. 

So with a Roth conversion, if it’s going to cost you 24% to do a Roth conversion now, but you expect after you retire you can take money out of your traditional account and only pay 15%, then wait. If it’s going to cost you 12%  take your money and do a Roth conversion now. And you expect after retirement you’re going to have a pension kick in and you’re going to start Social Security so you’re going to be paying 22.2%  then don’t wait. Do that conversion now at 12%.

So it really  matters what your situation is. What your tax rate is going to be now and what you think it’s going to be later.

Christina: Thank you.

FiveK: All right. I’m sorry that I can’t give a cut-and-dried answer.

Miriam: What I can say, Christina, is that for me, for our family, we were surprised when we retired that we were in a higher tax bracket than when we were working. And we did not expect that. But life has its way of  changing your tax expectations. We have pensions and also RMDs, and then my husband went back to work  with W-2 wages, and before you know it we’re back up in a higher tax bracket than when we worked. There are many bogleheads who did find that, I read them on the forum. And also many bogleheads are in more or less the same tax bracket, just more or less the same tax bracket, when they retire as when they were working.

Christina: That’s very helpful because what you just described is what I’m talking about. It’s what you’re looking at exactly so that was very helpful. Thank you. It’s like you can try to plan but I mean, I’m not quite at or near retirement yet, but you thought you were doing all the things you needed to do and then yet you get in retirement and it’s like surprise, surprise. So that’s helpful. Thank you so much.

Miriam Oh you’re welcome. Also David you are unmuted now.

David:  Yes.

Miriam:  Ok, you’re on!

David: Yeah. I wanted to clarify the way to look at the paying down debt versus investing a decision to try to take an objective look at this. So if you pay down a loan you’re getting a risk-free return equal to the rate on the loan and so you have to decide would you rather get a risk-free return equal to the rate on the loan, or the rate on your investments. Well if you hold a bond you’re getting a low risk return equal to the rate on the bond. So that’s that. I think this clarifies a FiveK point about if you’re 100% stock. Then it might well make sense to hold a debt that’s sufficiently played by a boundary. You’d rather invest in stock and expect 7% with a lot of risk then get a risk-free 3%.  But if you hold a stock, if you hold a bond yielding 2% and a loan at 3%, then if you sell the bond to pay off, to pay down the loan, you’re getting a guaranteed 1% benefit without changing your risk.

So unless there’s some other reason you wanted–so that if you have any bonds at all–then paying, unless there’s some other reason, and there may be. You may need to keep the money liquid.

It’s often better, it’s usually better, to max out your 401-k rather than paying down a mortgage because you get tax free growth for a long time. But I think that that’s the point I tend to make on the forum. That if you are actually 100% stock then it may make sense to borrow a lot more and to borrow more than at significantly above the bond rate.

But if you hold any bonds, you can view your mortgage as a negative bond, and therefore paying down the mortgage is a better kind of “quote” bond to buy, if its rate is significantly higher. And if you can pay down then, and if you don’t get any other benefit like liquidity, and liquidity is useful, but unless you’re 100% stock I would certainly pay down a mortgage that’s 3% above the treasury yield.

Miriam: Thank you David.

FiveK: And this that’s covered pretty well in the paying down loans versus investing wiki article. That’s where it’s linked here.

David:  Yes I’m one of the contributors to that article.  It shows how I think about the problem.

FiveK:  Yes, I think it’s well-written.

Miriam: FiveK, does it depend on the type of debt. Like what about student loans, paying off student loans rather than investing for retirement. That is often discussed on the forum.

FiveK: That, I suppose, it could. That’s getting to be a really sharp pencil there, to make distinctions. And that is debt you can get into callable versus non-callable and you know all that sort of stuff. But I think if we’re going to stick with the boglehead principle of simplicity let’s just say debt is debt.

Michael: Absolutely. And then one other thing I’d like to add to the topic I think often gets overlooked because a lot of people start comparing the different rates. You know carrying debts versus investments really boils down to cash flow. If you’re carrying debts, not only are you paying an interest rate on that borrowed amount of funds, but you’re also servicing that debt. And therefore that cash flow is flowing out of your expense column rather than staying in your asset column. And so the more money that you’re paying out servicing debts of say credit cards, student loans, car payments, xyz. Just let’s just call it consumer debt. That’s less money that you’re contributing to your investment efforts and therefore a smaller nest egg at retirement. Now obviously there’s no perfect plan and as previously mentioned there is never a rule of thumb, but it’s worth considering that paying money out in terms of cash flow to service debts is money that you’re not investing and so one should seriously consider that opportunity cost.

Miriam: Thank you Michael.  Carol, do you have a question?

Carol: There was a question in the chat a while and the question was what assets should go in a Roth versus a traditional ira versus taxable account. And I know that’s a big question. 

FiveK: No, I’ll give the one or two sentence answer, and again, there’s a whole wiki article that goes into pros and cons and conflicting opinions. But the one or two sentence answer is you put your high expected growth things in your Roth, your low expected growth, like bonds, in your traditional and taxable you try to make that as tax efficient as possible. So that’s my quick answer. 

Michael: It’s also worth noting that bonds pay interest which are typically taxed at marginal rates and therefore in some of Bogle’s books he definitely highlights and mentions some of the potential benefits of placing fixed income within Roths which are obviously a post-tax contribution. So the interest earned on those bonds within your Roth as it compounds over many decades is a serious advantage because you’re not paying any taxes on those interest payments.

John: Right, so this is John. I’m the one that posed the question. I struggle with the question of what to put in my Roth account because those are a finite amount of assets. I mean it’s not as large as my taxable or my 401-k so I’m trying to be choosy about what I put in my Roth account and so I struggle between, you know like you mentioned, higher growth stocks.But we also have things that pay  pretty good dividends that I don’t necessarily want to pay taxes on, like a high-yield junk bond fund or a Verizon, for instance, that pays 4.50%. So that’s just my struggle, and I just retired. So that’s my context.

FiveK: Congratulations.

FiveK:  [addressing chat Q] Oh don’t worry about being confused. Did you join the crowd on that, the whole whether it’s a regular backdoor or a mega back-door? They can get confusing. So what you would need to understand is do you have a third option in your 401-k. So you have the traditional pre-tax, you have the Roth, it goes in after tax. And you need to find out if your employer also offers after tax Non-roth. That’s the first step.

So does your employer–so you can contribute up to $19,500, or if you’re older some more, to either the traditional or the Roth. But then there’s that $58,000 limit, that’s employer contributions and the $19,500 and anything else that you kick in. So that’s where the after tax non-Roth comes in. That if your employer hasn’t matched you 2x or whatever, you still have this room, if your employer allows you to, put in after tax non-Roth. You can do that, and then you need to. So that’s step one.

Step two is does your employer also allow you to then immediately, or in the relatively near future, allow you to take that contribution and roll it over into a Roth account, either inside the 401k or out to a Roth IRA. So it’s a two-step process and you need to check with your employer on whether both of them are allowed.

Co-Host Manny: Someone asked, in terms of the gains before the mega backdoor is completed, I believe taxes are paid on the gains, correct?

FiveK: Correct, taxes are paid on the gains, that’s correct .So you know if it’s gone up by 25% because you waited a month you’re going to pay tax on that 25%. But I wouldn’t let that hold you back.

Co-Host Mannyl: Okay sounds good. It sounds like the best way to really find out about that is to contact your employer and your plan. Okay that makes sense. We have a question, does a sale of a rental property capital gain affect the distribution from IRAs on your tax return.

FiveK: Well it depends. So if you’ve got a capital gain, if you’re in one of those zones where your capital gains aren’t not being or not being completely taxed, or you know, you’re hitting the NIIT [Net Investment Income Tax] boundary, and so they’re going to be taxable–If you’re in one of those then additional ordinary income gets taxed at a higher marginal rate. Otherwise, no. So that’s another one of those “it depends” answers. Does that make sense? And if it does make sense to everyone I’m amazed because it’s not something that’s obvious.

Co-Host Manny:  Sounds like it’s a complicated answer but I think that that makes sense to me.

Jim: I just mentioned in the chat, the presentation you gave us in Chicago a few months ago where you use the Financial Tool Box. That was a really good thing to play around with some numbers to see the financial impact, and the tax consequences, and marginal rates, effective rates, all that. So I put the link in the notes.

Miriam: FiveK, would you say that our young investors should aim, or it would be good to arrange their investing order so that when they reach retirement they pretty much have a nice pot of money in their pre-tax, a nice pot of money in their after-tax Roth, and money also in their taxable account.

FiveK: It really depends what their marginal tax rate has been through their employment. And this is a common question, people say well what percentage should be in which bucket. And it’s really not the best as the percentage is a consequence not a goal.

So the goal is you want to fill up your traditional account up to, but no higher than you want to fill it up by saving as you put into your traditional account. You’re saving some certain marginal rate, 12%, 22% you know whatever. If you’re in the earned income tax credit area you know you can be saving a high marginal rate you know if you’re paying it you can be saving a higher marginal rate etc.

You want to keep filling up that traditional account by saving at whatever marginal rate you’re saving at, until it gets large enough that you think that when you start to withdraw from that traditional account you’re going to be paying somewhere close to that same marginal rate.So if you’ve got someone that’s making relatively low income they may end up with 90% of their investments in traditional because they’re going to be pulling it out at a fairly low marginal rate.

Where you take someone, you’ve got a brain surgeon who’s making half a million a year whatever, they’re going to have a relatively small amount in traditional because they can only put so much in there. And they’re going to have a whole bunch in taxable and Roth because it’s spilled over. So I can understand why people want a percentage because that’s a nice easy thing to look at, but it’s really the percentage should be an outcome not a goal.

Miriam: We actually have a question in chat on that. Is there such a thing as too much money in a Roth versus traditional IRAs? In other words, if I only have Roth funds, with no more traditional IRA funds, aren’t I wasting some of my efficiency.

FiveK: Yeah if you have if you have everything in Roth, and I mean everything, so you’re not paying any tax at all in retirement, then yeah you missed a beat.You should have made some traditional contribution and saved taxes back at that point.

Manny: Any thought on placing similar asset allocation funds in taxable and tax deferred accounts. It wouldn’t be 100% tax efficient but you’d avoid behavioral issues and you’d get automatic rebalancing. And what are your thoughts about that?  And the other advantage that they pointed out was you might be able to do a similar amount withdrawal across all accounts when you need to spend at retirement.

FiveK: It’s a trade-off between simplicity and optimization and both of those are somewhat subjective. One person’s simple as another person’s complex, and one person’s optimum is another person’s not worth it. I can’t improve on the pros and cons in the tax efficient investment wiki.

Manny:  I’m curious, I’ve never actually looked at what are the percent differences in the accounts if you did that versus something that is more tax efficient.  How much difference does that make at retirement time?

Miriam:  Manny, could you ask your question again. Was it your question or a question from the chat?

Manny: It is my question. I’m just more curious, essentially you know they were saying simplicity versus more complexity, if you had similar asset allocation in tax and tax deferred accounts versus doing a more tax efficient asset allocation. What’s the actual difference in retirement? Like what’s the percent difference you might have in the amount you’re able to withdraw in retirement?

Miriam: Are you talking about tax efficient by putting stocks versus bonds in your pre-tax versus your Roth?

Manny: Yeah. If you were to rather than just putting similar asset allocations across taxable and tax deferred, exactly to put them in a more tax efficient manner so you wouldn’t be committing tax drag. 

Miriam:  Well even when I was working, my Roth account, I had mostly stocks. And the reason was I wanted it to grow because it was my account I was anticipating to be used for health reasons, since we have health insurance but we don’t have long-term care insurance. And so I wanted it to be big for that, and also to leave to the kids.

I simply wanted it to grow. I could not get over it, it just seemed to me that it was tax free, all the growth in my Roth IRA was tax free. It was just going to grow and grow and grow. And it just seemed to me I just could not get over how it would grow big if I had a lot of stocks in there for what I needed in the long term future.  Is that what you’re talking about? 

Manny: Yeah, yeah. No, that makes sense, and I was really wanting like what is the actual difference in retirement if someone didn’t do that, and they put you like equities and bonds in their tax protected accounts, like what would the actual difference be. But it sounds like it’s beneficial really, or it could be beneficial to leave stocks in those tax free accounts.

Michael: In Jack Bogle’s guide to investing book, there’s a chapter near the back of the book somewhere, I actually have it here in my library, where he does a small little breakdown of exactly what you’re asking and does a comparison of putting X amount of dollars in a taxable account and then taking the same amount of dollars and putting it in a tax-deferred or advantaged account, additionally whether you select equities or bonds and what the resulting investment total would be at the end, considering tax drag that you’re referencing. So I don’t know if you can get your hands on that book, but I think that may point you in the direction to what you’re asking.

Miriam:  You’re talking tax drag from a taxable account, Michael, is that right?  Not the tax drag that comes or the taxes that you pay when you withdraw from your traditional 401k or your traditional IRA right?  You’re talking about a taxable account versus a traditional IRA or a traditional 401k?

Michael: Yeah I was just trying to reference that chapter in the book that may have helped the gentleman ask him the question, if it may have helped clarify his question. It just came to mind because what he was asking seemed to be similar to what I recall reading in that chapter of the Bogleheads Guide To Investing book.

Miriam:  Thank you.

FiveK:  Let’s see, a question about I-bonds, with which I am not familiar, so if someone would like to weigh in on Bob’s question on I-bonds.

Miriam:  All right FiveK, I do have another question on teachers and 403b plans. We do have many teachers on the Bogleheads, and I know that they have a weird setup with their 403b plans. How does that fit into your investing priorities? Should they abandon, get out of them if they really could, and move into Roths and traditional? They also have annuities which sometimes are not the best investment for them.

FiveK: There’s one, I know there’s a link in the Money Mustache one, I’m not sure if there’s a link in the wiki, if there’s not, I’m sure we could put it in there. But it goes something like, if you have poor choices in your 401k, and it refers people to the Bogleheads wiki article on how do you decide how poor is too poor.

And David could go into more details on that. But there’s some calculations you could do. There was a recent thread where someone was paying, I think, a total of about .30% in their 401k or maybe was a 403b, and they thought this was terrible. While it’s not as good as a 0.04% for a 401k or 403b, it’s by no means terrible. If you’re getting up into 2% and 3% that can be terrible. And especially with teachers who may stay with the same school district for a long time.

But yeah, that’s just something that they need to look at– just how bad is it. And sometimes 90% of the funds are really terrible, but there’s a Vanguard S&P 500 one in there that the salesmen never tell you about, but if they look closely they can see it.  Or something similar.

Miriam: Okay, thank you.  Megaman, do you have a question?

Megaman: I wanted to circle back to the Roth versus traditional IRA, and the question was is it possible to have too much in the Roth and I think the answer is yes, if you got 100% you’re losing tax efficiency at some point. I’ve got about 70% in my Roth and I’m retired for 10 years. So really it’s nice to have both because it gives me great flexibility for taxes, especially when you look at the tax brackets. There’s a jump from 12% to 22% tax, and that’s if you’re making $20,000 a year up to $81,000 you’re paying just 12% tax. So that’s a 10% spread. So I can use my taxable funds up to the $81,000 and then if I need more, I can just take it from my Roth. So I can, you know, 300, 400 thousand for that year, I can take out of my Roth.

So, I think in that bracket is 8% or 10% spread, and then the spread from $173 000– this is joint  married couples–up to $330,000, that’s a 24% bracket up to a 32% bracket. So that’s an 8% spread. So if you’re in that bracket you’d take your traditional up to the $173,000 and pay 24%, but use Roth money if you need more beyond that because you don’t want to be in the 32% bracket. 

So that’s what I like is keeping the bracket, and I know where my tax is going to be and I have the flexibility because I have a lot of Roth and and I also have traditional.

Miriam: Interesting, thank you. 

Megaman: Sure.

Miriam: FiveK, you have comments on that?

FiveK: I agree. And I see that LadyGeek has put the link to the expensive or mediocre choices and some I-bonds as well. So I love it when there’s a good person filling in the answers in chat. So thank you.

Miriam: Okay thank you. Could you go over, FiveK, what the difference is between tax brackets and marginal tax rate, and how young investors who don’t want to learn, who do not want to get into the weeds of taxes, but they want to just create their portfolio, a simple portfolio– do they have to worry about marginal tax rate versus bracket? Can they just look at their tax bracket and they’ll be pretty safe in assessing their portfolio or their investments and where to put them?

FiveK: Probably I mean the whole Roth versus traditional thing, we’re just nibbling around the edges on that anyway.  You know if someone’s going to agonize over Roth versus traditional, they should just invest and flip a coin. So the short answer is yeah, they can just use their tax brackets.

But you did ask about young investors. So I’m going to make the perhaps unwarranted assumption that if you’re talking about a young person, they can handle a spreadsheet.  So I’m going to show how easy it can be.

So let’s say we’ve got a young married couple and they’re both 35.  Can people see the spreadsheet?

Miriam: Yes, is this your Personal Toolbox Spreadsheet?

FiveK: Yeah it’s the one. As I’ve said, I can answer probably most questions about it and detailed questions go back to the Money Mustache forum where it’s hosted there. But yeah, I can probably answer any beginner’s questions about it. I find it a very useful tool.

So okay, we’ve got married, oh let’s say they’ve got two kids they’re both under 18. Yeah they’re both under 13, one of them’s under 6, and they both qualify for earned income credits. That depends on what kind of earnings. So let’s say we’ve got one of them making $60,000 a year, the other one’s making $40,000 a year, and they want to know if they make 401k contributions, how much is that going to save them. 

So they are firmly in the 12% bracket. So if all they knew was that they were in the 12% bracket, that would have been fine because they are so firmly within that, if they both contribute the maximum to their 401k, then they get down and they just reach the first tier of the Savers Credit. But because they had to put over $30,000 in there just to reach the first tier of the Savers Credit, it really doesn’t change their marginal rate very much at all. They’re still at 12%. 

So if you’ve got someone in that situation, they say, I’m in the 12% bracket, I’m going to roll the dice and figure this is the lowest tax rate I’m ever going to pay and they go all Roth, that’s a defensible choice.

But let’s change things a little bit around here. Let’s say one of them decides, I’m going to go back to school for two years to get a better nursing degree or whatever, so that drops out. Well now that changes things a bit. Now you’ve got someone that, good grief, they’re in the earned income tax credit zone now. They’re saving more than 50%, and I’d have to change the scale here. So they’re actually, now this gets into can they afford it, so now only one of them can possibly contribute.

But let’s say maybe they received an inheritance and bemoaned the fact that they got the inheritance, but now they got it, they’ve got this cash that they can live off for a couple of years while one of them goes back for a better degree. Well you might think that they’re in the–earning $40,000–they’re in the bottom of the 12% or top of the 10% even.  But because of the earned income tax credit, they can actually save 80% on at least some amount of traditional contribution. So that they ought to do, here they ought to make a traditional contribution. Maybe up to $5,000, they do all traditional, and they’re still at 20%, which is, you know, maybe they go traditional, maybe they go Roth, that’s 80% they should do traditional, and then once they get up to contributing $15,000, while they’re not paying any tax, they’re not getting any credit. They should put it all in Roth.

So that’s a quick “it depends” answer to your question about can they just go by tax bracket or do they need to look at the marginal rate. But the point of using a tool like this, it’s just very, very fast to get a quick look at what the marginal rates are.

And for someone who’s 92 years old and has never used a spreadsheet, I wouldn’t suggest this. But someone in their 20s or 30s and they used spreadsheets in college, they ought to be able to handle something like this.

Miriam: FiveK did a presentation on this spreadsheet, The Personal Financial Toolbox, I think it was in March, for the Chicago Chapter, and it is on the Bogleheads Virtual Presentation List, I believe it’s all there.  And it is also in our wiki, in the Tax Efficient Fund Placement wiki or in the Tools and Calculators wiki.

FiveK:  It’s the Personal Finance Toolbox or the Case Studies Spreadsheet, it’s the same thing.  It’s in the Tools and Calculators wiki.

Miriam:  FiveK is there a time at which point the taxes you have paid to convert a traditional to a Roth are outpaced by your earnings in the Roth that are now tax free? What point would that be? How would we see that?

FiveK: That sounds like a return on investment thing, and I know that’s a hot topic these days. Personally I don’t get the whole return on investment idea of analyzing traditional versus Roth. You have to pay tax. You either pay it now or you pay it later, or your heirs pay it now or your heirs are going to pay it later, or if you leave it to a charity you know no one’s going to pay tax.

But it’s not like you’re going to take $1,000 and invest it in stocks and hope to get your thousand plus gains back.  And if you’re paying tax, you’re paying tax – it’s just when are you paying it and at what rate are you paying it. So it’s all about the rate. It’s not about the amount of tax you pay, because if you go by the amount of tax you pay, Roth is going to win every time, because you pay a little bit of tax now and after, let’s say it’s grown ten-fold, well you’re going to pay 10 times the amount of tax later, even if it’s at the same rate. But it ends up being the same amount after tax. So looking at the amount of tax paid is just not the right way to look at it. You’ve got to look at the tax rates.

And so the traditional versus Roth wiki, there’s a common misconception section, that’s the second one. The second one is the one that says look at the amount of tax paid. No, that’s a misconception. And the first misconception is that you get to save at a marginal rate but you only pay at your effective rate. No you don’t get to start from zero on every single withdrawal. So  that section of the Roth versus traditional wiki covers those two common misconceptions. One favors Roth, one favors traditional, but neither one is correct.


Chat and Slides

You can access the chat session and the slides used in this presentation at the following links:


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