debt reduction v. savings, recent graduate

[landonew]

I am looking for some advice on income allocation, specifically in the context of becoming financially independence. The following describes my situation:

Net income = $6,000/month.

Debt liability = $2,000/month (arising from $190,000 (@ 8% APR) in student loans)

Expenses = $700/month

Assets = $4,000 (Savings Account)



Thus, I have about $3,300/month to either pay down debt or invest. I am 25 and have only recently (3 months ago) become gainfully employed after graduating law school in 2009. I am currently living with my parents ($500/month rent), and intend to continue living with them until I make some headway on my loans.

Up until now, my entire paycheck (minus expenses) has been used to reduce debt. However, my ultimate goal is to become financially independent. Accordingly, I have considered opening an IRA, e.g. VFINX. I cannot participate in my employer’s 401k program until October (i.e. 6 month from start date), but intend to contribute the maximum ($15,500). My employer’s contribution is discretionary at the end of the year, but has historically been between 50-50% match. I have also considered purchasing some ETFs with after tax dollars.

Finally, a fair amount of my compensation comes (or should come) in the form of quarterly bonuses. The bonus structure is based on net billable hours, and therefore is largely dependent on efficiency. Furthermore, clients aren’t billed immediately and payment can lag 3-4 months behind the rendering of services. Assuming 70% efficiency, I anticipate my after tax bonus will be in the neighborhood of $10,000/quarter. I have been advised not to expect my first bonus until December, due to the aforementioned lag.

Any advice would be very much appreciated.

 

[Gumby]

(arising from $190,000 (@ 8% APR) in student loans)

OMFG

Any advice . . .

The only advice I can offer is to "live on your base and bank the bonus". Do not ramp up your expenditures in anticipation of getting a bonus. If and when the bonus money comes, then you can determine whether it makes more sense to apply it to debt or invest it. My initial thought is to first fund a 401k sufficiently to get the matching funds, then put any bonus toward debt reduction, as it represents a risk-free 8% return on your money.

 

[dex]

Gumby has it correct.

700/mo expenses looks low - do you have a written budget?

"Thus, I have about $3,300/month to either pay down debt or invest." Does this include the 401K contribution? if not, you have about 2K or 24K/yr + the 40 bonus-taxes = 25K or total of 49K/yr or about 4 years to pay off the debt.

After paying off the debt you can focus on investing. That will be in about 2015.

 

[Leonidas]

OMFG

My initial thought is to first fund a 401k sufficiently to get the matching funds, then put any bonus toward debt reduction, as it represents a risk-free 8% return on your money.

Ditto.

Congrats on finishing school and getting a job - something that the media says many of your peers have not been able to do. They're also living with their parents, but not bringing home a decent salary.

That's a big number - I would go for the guaranteed return and devote most of the extra cash to retiring that debt. You never know what the future is going to bring, but you know that right now you have the means to live cheaply and make headway on paying it off.

 

[Ronnieboy]

Heck, I'm glad that you are looking to paying off the loan. With so many news reports of new graduates that feel they can't (or don't want to) pay their loans, it is refreshing to see someone ask how they can do it best.

When I graduated I had huge loans and luckily the interest rate was lower than current mortgage rates, but I still had to extend the repayment period to have a comfortable payment. But I never considered not paying them, they repo the loans by taking off your head.....

 

[landonew]

Gumby has it correct.

700/mo expenses looks low - do you have a written budget?

"Thus, I have about $3,300/month to either pay down debt or invest." Does this include the 401K contribution? if not, you have about 2K or 24K/yr + the 40 bonus-taxes = 25K or total of 49K/yr or about 4 years to pay off the debt.

After paying off the debt you can focus on investing. That will be in about 2015.

Yes, I do have a written budget. $500/month goes to my parents. It pays room/board, car insurance, and utilities. My firm pays my cell phone bill.

I live less than 7 miles from work (14 mile round trip), or about $3/day in gas for my truck or about $90/month (assuming a 7 day work week, I typically go in for at least 4-5 hours on saturday and sunday). I spend about $120/month on lunch.

I suppose there may be some other miscelanous expenses. For instance, hair-cuts cost $20/month. Maybe I do need to revisit my budget, but for the most part I don't spend any money.

 

[landonew]

Ditto.

Congrats on finishing school and getting a job - something that the media says many of your peers have not been able to do. They're also living with their parents, but not bringing home a decent salary.

That's a big number - I would go for the guaranteed return and devote most of the extra cash to retiring that debt. You never know what the future is going to bring, but you know that right now you have the means to live cheaply and make headway on paying it off.

I definitely feel for many of my peers. I worked for almost 12 months @ $13/hour before landing my current job. It was depressing, I just felt like I was rotting away ... like my future was slipping away. It is rough out there, and I think that a lot of people just don't understand how bleak the job atmosphere is right now - Especially for recent graduates looking for entry level professional jobs.

It is a big number, but I was very fortunate to be approved for financing with little or no credit history. I almost had to drop out for lack of financing, so I am [-]happy[/-] content to repay the loans.

 

[jIMOh]

I am looking for some advice on income allocation, specifically in the context of becoming financially independence. The following describes my situation:

Net income = $6,000/month.

Debt liability = $2,000/month (arising from $190,000 (@ 8% APR) in student loans)

Expenses = $700/month

Assets = $4,000 (Savings Account)



Thus, I have about $3,300/month to either pay down debt or invest. I am 25 and have only recently (3 months ago) become gainfully employed after graduating law school in 2009. I am currently living with my parents ($500/month rent), and intend to continue living with them until I make some headway on my loans.

Up until now, my entire paycheck (minus expenses) has been used to reduce debt. However, my ultimate goal is to become financially independent. Accordingly, I have considered opening an IRA, e.g. VFINX. I cannot participate in my employer’s 401k program until October (i.e. 6 month from start date), but intend to contribute the maximum ($15,500). My employer’s contribution is discretionary at the end of the year, but has historically been between 50-50% match. I have also considered purchasing some ETFs with after tax dollars.

Finally, a fair amount of my compensation comes (or should come) in the form of quarterly bonuses. The bonus structure is based on net billable hours, and therefore is largely dependent on efficiency. Furthermore, clients aren’t billed immediately and payment can lag 3-4 months behind the rendering of services. Assuming 70% efficiency, I anticipate my after tax bonus will be in the neighborhood of $10,000/quarter. I have been advised not to expect my first bonus until December, due to the aforementioned lag.

Any advice would be very much appreciated.

Basic advice is starting out, save 20% of gross pay, and put at least 15% of gross into retirement accounts.

Use Gross for retirement monies, because gross and 401k and pre-tax reasons (401k goes in pre-tax, so listing it as a percent of net makes little sense).

If your income allows for a Roth IRA, consider using the Roth option, when available (401k or IRA).


If you save 20% of gross
and put 15% to retirement
and 5% to short term needs (like emergency fund or debt paydown) you will make headway into debt repayment. You have the ability to save more than 20%, and I suggest putting excess into the debt because at 8% interest rates that should be a good return for you.

Beware of consolidation- if the terms to pay back 190k are 10 years, many consolidations will extend the term and that might have you paying double or triple the interest. Focus on paying back debt sooner for best results IMO.

**edit to add**
if employer will match 50-50 on every dollar up to $15,500, you are best served to max out 401k (once eligible) before paying extra on student loans. Whether the $15,500 is 20%. 50% or X% of gross does not matter, whether you are eligible for a Roth IRA does not matter. The match could represent $7750 added to your account each year, and it would be tough for paying down the loan to save you $7750 in any given year (meaning get the match- its best return on your money you can find).

 

[dex]

Yes, I do have a written budget. $500/month goes to my parents. It pays room/board, car insurance, and utilities. My firm pays my cell phone bill.

I live less than 7 miles from work (14 mile round trip), or about $3/day in gas for my truck or about $90/month (assuming a 7 day work week, I typically go in for at least 4-5 hours on saturday and sunday). I spend about $120/month on lunch.

I suppose there may be some other miscelanous expenses. For instance, hair-cuts cost $20/month. Maybe I do need to revisit my budget, but for the most part I don't spend any money.

I think you need some line items in there for entertainment, vacations, and suits (an investment - don't 'go cheap' for them) for example. And, you might consider that it will take you 4 years to pay off the debt so you might get your own place in that time.

 

[SunsetSail]

I agree with the previous posters on allocation - especially don't forget some entertainment.

I was in a similar situation as you about ten years ago or so (law school, large loans, etc.).

Some unsolicited advice - The student loan rates are way too high. I assume that you used a combination of private and public loans to finance law school. If so, you should be able to consolidate your loans under the federal consolidation program to get a much better rate. I know the rules have changed from when I did a consolidation, but I believe the program is still around in one form or another.

I would add that I put a relatively small amount (maybe $200 a month) in a taxable investment because it gave me a mental boost that I wasn't just working down the student loans, but also building up investments outside of tax deferred accounts.

Good luck and if you are at a megafirm w*rking 80 hours a week to bill 30 always know that once you build some experience there is a better work-life balance available at megacorp (where I am now).

 

[myself]

Yes, I do have a written budget. $500/month goes to my parents. It pays room/board, car insurance, and utilities. My firm pays my cell phone bill.

I live less than 7 miles from work (14 mile round trip), or about $3/day in gas for my truck or about $90/month (assuming a 7 day work week, I typically go in for at least 4-5 hours on saturday and sunday). I spend about $120/month on lunch.

I suppose there may be some other miscelanous expenses. For instance, hair-cuts cost $20/month. Maybe I do need to revisit my budget, but for the most part I don't spend any money.

That's funny. You eat lunch for $6.00/person/day, and me and my family average $5.30/person/day for 3 meals + snacks (feeding 2 adults and 4 kids + 1 dog). Not saying anything bad, just pointing it out.
You do know you can eat lunch for $1 or so every day if you pack it?

 

[ronocnikral]

That's funny. You eat lunch for $6.00/person/day, and me and my family average $5.30/person/day for 3 meals + snacks (feeding 2 adults and 4 kids + 1 dog). Not saying anything bad, just pointing it out.
You do know you can eat lunch for $1 or so every day if you pack it?

and with only 7 miles one way, one could ride a bike as well. i pack my lunch and ride my bike (6 miles). and i retired my SL debt over a year ago.

 

[landonew]

That's funny. You eat lunch for $6.00/person/day, and me and my family average $5.30/person/day for 3 meals + snacks (feeding 2 adults and 4 kids + 1 dog). Not saying anything bad, just pointing it out.
You do know you can eat lunch for $1 or so every day if you pack it?

and with only 7 miles one way, one could ride a bike as well. i pack my lunch and ride my bike (6 miles). and i retired my SL debt over a year ago.

I considered this but determined that it would cost me more in lost income than it would save me in fuel costs. As i mentioned before, bonus incentives comprise a large portion of my compensation package. Any time I spend commuting is time I cannot bill.

I actually own a pretty nice road bike, and ride 40-50 miles on Saturday and Sunday mornings (80-100 miles/week).

Packing my own lunch, on the other hand, may be a good idea.

 

[ronocnikral]

I considered this but determined that it would cost me more in lost income than it would save me in fuel costs. As i mentioned before, bonus incentives comprise a large portion of my compensation package. Any time I spend commuting is time I cannot bill.

while my bicycle commuting suggestion was just that, a suggestion that may not be suited for everyone, i find your logic to be a little odd. have you watched any TV lately? how much money do you loose for each minute of TV you watch? how about go to the gym? eat? BS-ing on an online forum?

i have found that riding my bike adds about 15 minutes to my total morning routine (from the time i roll out of bed to the time i plop down in my w*rk chair). and about 30 minutes to my afternoon (as i didn't take a second shower before). but, it's nice to get the heart pumping in the morning and i truly walk into w*rk fresh and more alert. is your bonus tied strictly to quantity and not to quality? and if i had a hard a day, i can blow off some steam on the way back so it doesn't get unloaded on DW.

 

[HFWR]

Packing my own lunch, on the other hand, may be a good idea.

Of course, sandwiches are a quick, easy way to pack your lunch, and if you mix it up - ham/swiss, turkey/provolone, roast beef/cheddar, you can avoid getting "sick and tired" of sandwiches. One thing I do is prep a pot of chilli, or spaghetti and sauce, maybe a roast in the the slow cooker, a meatloaf, etc. on Saturday or Sunday, then eat that for the week. Warning, though, you'll get sick of this on about Wednesday...

But it IS cheaper, and usually more nutritious than your average junk food meal.

 

[FUEGO]

For the $3300 or so each month:

1. Take advantage of whatever amounts of 401k match you think you will potentially get. If the match is 50% of first 6% of base comp, do at least that much. Above that, I would be inclined to say max out your 401k each year (if the 401k has good investment options). I assume your federal rate is at least 25%, and you may have a state income tax also?? So you'll be "saving" 25% on every dollar you put in there.

2. Take what is left after maxing the 401k and pay down debt aggressively. See if you can get some 0% credit cards or some other way to borrow money more cheaply to "refinance" your student loan debt.

The assumption here is that you will have many years of investing ahead of you. Once the debt is gone, you will likely be investing a good bit of money in a taxable investment account. Each year you forgo maxing out the 401k to the limits is some wasted tax-deferred investment capacity that you can't get back. If you stay at your current profession and advance at a typical pace, you will be desperately needing income tax breaks in the future, and paying taxes out of pocket on capital gains and dividends will be expensive. Hence get your money in a tax favored account if you can.

 

[landonew]

For the $3300 or so each month:

1. Take advantage of whatever amounts of 401k match you think you will potentially get. If the match is 50% of first 6% of base comp, do at least that much. Above that, I would be inclined to say max out your 401k each year (if the 401k has good investment options). I assume your federal rate is at least 25%, and you may have a state income tax also?? So you'll be "saving" 25% on every dollar you put in there.

2. Take what is left after maxing the 401k and pay down debt aggressively. See if you can get some 0% credit cards or some other way to borrow money more cheaply to "refinance" your student loan debt.

The assumption here is that you will have many years of investing ahead of you. Once the debt is gone, you will likely be investing a good bit of money in a taxable investment account. Each year you forgo maxing out the 401k to the limits is some wasted tax-deferred investment capacity that you can't get back. If you stay at your current profession and advance at a typical pace, you will be desperately needing income tax breaks in the future, and paying taxes out of pocket on capital gains and dividends will be expensive. Hence get your money in a tax favored account if you can.

Thanks for the advice. Do you think I should contribute the max to an IRA as well? It will extend my loan repayment, but maxing out both retirement accounts (401k & IRA) from 25-59.5 (assuming a reasonable rate of return) should guarantee at least a comfortable retirement.

 

[FUEGO]

Thanks for the advice. Do you think I should contribute the max to an IRA as well? It will extend my loan repayment, but maxing out both retirement accounts (401k & IRA) from 25-59.5 (assuming a reasonable rate of return) should guarantee at least a comfortable retirement.

I'm not really sure about the IRA issue. I imagine you will earn too much to be eligible to contribute to a traditional IRA. For a Roth, you will likely be at a lower tax bracket when you ER versus today (correct me if I'm wrong there). So you may be able to "save" on taxes, or at least break even on taxes by buying tax efficient index funds in a taxable account later (and pay down debt now) versus investing in a roth now and extending the term of the loan.

It's only $5000 a year, so not a huge deal in the grand scheme of things. If it was me, I would probably skip the Roth and prepay the student loans to guarantee myself an 8% tax free return on the money now.

The dollar amounts are probably big enough here that you may be best served by putting together a spreadsheet to investigate your different alternatives and see if there is much difference between your alternatives.

 

[ronocnikral]

a roth is a sexy option if you have little savings. you can always pull out your contributions penalty free. that was how i justified saving for retirement, "i'll put this money in my roth and if anything happens, i can always pull out my contributions (if they're still there)." i was building (slowly) my emergency fund as well. i got lucky and never had an emergency and i would be in dire need before i pulled out my contributions now...

are these private student loans? i can't believe any stafford loan would be at 8%.

 

[jIMOh]

Thanks for the advice. Do you think I should contribute the max to an IRA as well? It will extend my loan repayment, but maxing out both retirement accounts (401k & IRA) from 25-59.5 (assuming a reasonable rate of return) should guarantee at least a comfortable retirement.

Understanding the 401k match would be helpful- I realize it fluctuates, but if you put in $15,500, would you possibly get a match of $7750?

Once that is maxed, you have more than enough to put some into an IRA and some into a taxable account and some to debt paydown.

If you are eligible for a Roth, that money grows tax free and is withdraw tax free- both are good things
If you put money into a traditional IRA, you can convert it to a Roth later (your income might exempt you from Roth)
If your only monies outside a 401k are in taxable accounts, you cannot convert that money to a Roth later unless you have earned income in the year you choose to "convert" and these would be contributions (not a conversion), so while capital gains rates look attractive now, in 30 years about 7 Presidents and there administrations will have changed the taxes on taxable investments. Why take that risk- use an IRA.

 

[jIMOh]

I'm not really sure about the IRA issue. I imagine you will earn too much to be eligible to contribute to a traditional IRA. For a Roth, you will likely be at a lower tax bracket when you ER versus today (correct me if I'm wrong there). So you may be able to "save" on taxes, or at least break even on taxes by buying tax efficient index funds in a taxable account later (and pay down debt now) versus investing in a roth now and extending the term of the loan.

It's only $5000 a year, so not a huge deal in the grand scheme of things. If it was me, I would probably skip the Roth and prepay the student loans to guarantee myself an 8% tax free return on the money now.

The dollar amounts are probably big enough here that you may be best served by putting together a spreadsheet to investigate your different alternatives and see if there is much difference between your alternatives.

Check your language

anyone can contribute to a traditional IRA if they have earned income in that tax year. Whether a person can DEDUCT that contribution on their tax return is what get phased out with income.

The Roth contributions phase out at about the same incomes as the tax deduction on a traditional IIRC, but that does not prevent contributing after tax to the traditional.

This means if you put $5000 into a traditional IRA and it grows to $6000, you have $5000 which is withdrawn tax free and $1000 which is taxed at withdraw. Keep good records to show this.

 

[FUEGO]

Check your language

anyone can contribute to a traditional IRA if they have earned income in that tax year. Whether a person can DEDUCT that contribution on their tax return is what get phased out with income.

The Roth contributions phase out at about the same incomes as the tax deduction on a traditional IIRC, but that does not prevent contributing after tax to the traditional.

This means if you put $5000 into a traditional IRA and it grows to $6000, you have $5000 which is withdrawn tax free and $1000 which is taxed at withdraw. Keep good records to show this.

Yes, your distinction is correct but your statement regarding the income limits for Trad IRA deductibility phaseouts is wrong.

There is a distinction between eligibility to CONTRIBUTE and eligibility to DEDUCT traditional IRA contributions. You can contribute to the limits when you have earned income. Deductibility is fully allowed for MAGI's of $56000 and phases out at MAGI's above that up to $66000, where no deductibility is allowed. These thresholds apply to taxpayers who have 401k's available to them from their employer and are single.

For the same taxpayer, MAGI's up to $105,000 allow the full $5000 contribution to a Roth, and that contribution limit phases out to zero at MAGI's of $120,000.

Based on the OP's stated facts I assumed that he would fall above the income limits for DEDUCTIBILITY but below the income limits for Roth contributions. I imagine there are cases where one may want to contribute to non-deductible IRA's instead of Roth's, but my imagination can't produce any examples right now. Assuming the OP is eligible for Roths I would recommend that over a non-deductible IRA contribution. Heck for the OP I would be tempted to recommend regular taxable investments in tax efficient index ETFs or the like versus non-deductible IRA's, if anything to simplify paperwork and tax record keeping requirements. But you would also be paying only cap gain rates (on the actual gains) when you sell your taxable investments versus ordinary income rates on the withdrawal of the growth of your trad IRA contributions. And you can sell your taxable holdings in a tax savvy manner by selling the highest cost basis shares first - not an option with non-ded. trad IRA withdrawals IIRC. My thinking was why would anyone forgo a Roth in favor of a non-deductible traditional, even though the tax laws technically allow it. I think it would be crazy for anyone in that $66000-$105000 MAGI bracket.

I guess I should have phrased my post more clearly! And see disclaimer below of course.

 

[Amethyst]

Congratulations to the OP for planning to max 401K before s/he even has one to max!

Lots of great advice here, but I didn't see anything about amassing an emergency fund. Is that because the OP lives with parents and presumably does not need one?

Amethyst

 

[landonew]

Understanding the 401k match would be helpful- I realize it fluctuates, but if you put in $15,500, would you possibly get a match of $7750?

Once that is maxed, you have more than enough to put some into an IRA and some into a taxable account and some to debt paydown.

If you are eligible for a Roth, that money grows tax free and is withdraw tax free- both are good things
If you put money into a traditional IRA, you can convert it to a Roth later (your income might exempt you from Roth)
If your only monies outside a 401k are in taxable accounts, you cannot convert that money to a Roth later unless you have earned income in the year you choose to "convert" and these would be contributions (not a conversion), so while capital gains rates look attractive now, in 30 years about 7 Presidents and there administrations will have changed the taxes on taxable investments. Why take that risk- use an IRA.

The 401(k) match is discretionary, but I've been told it has historically been from 60-80%. I was under the impression that it was dollar-for-dollar, but it may be less. I will find out some more details pretty soon, but fully intend to participate when I'm eligable in October.
Great point on the IRA. I will likely not be phased out for the ROTH this year because I am only receiving 8-months of income. As a single filer, the phase out occurs from $106,000-$121,000 MAGI. It is likely that my bonuses will phase me out next year.
I believe that traditional IRAs can be rolled over into Roth IRAs regardless of income, after 2010. (source, Roth IRA - Wikipedia, the free encyclopedia)


EDIT: redudandant after reading p.2 posts.

 

[ronocnikral]

Congratulations to the OP for planning to max 401K before s/he even has one to max!

Lots of great advice here, but I didn't see anything about amassing an emergency fund. Is that because the OP lives with parents and presumably does not need one?

Amethyst

i thought of it, but what are his expenses? when your living with the rents and have very little responsibility, you can shoot from the hip. and i say that with jealousy.

and he does $4k somewhere...that's 8 months of expenses.