152R | Can I Retire Yet?

152R | Can I Retire Yet
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Big ERN comes on the show today to break down the numbers of Becky’s retirement plan. He works through their real numbers to determine how solid their retirement plan is.

Taking Stock

A lot of retirees have this fear of touching their principal and part of it is justified. But there is also part of it that is unjustified, right, because unless you have a constraint that you have to maintain your capital because you want to leave a big bequest, it’s ok to draw down your capital at a measured pace and slowly. So don’t deprive yourself. Don’t have a scarcity mindset. And you should do your withdrawals confidently because that is what your retirement should be about. It should be fun. It should be confident. It should be comfortable. Don’t have this scarcity mindset where you live like misers in retirement because you are afraid to touch your principal.

Taking a look at Becky’s story, the first thing Big ERN did was ask questions about their plan. Since this is a real-life study, it is not as simple as an academic study. There are different spending constraints and variables to consider in each individual’s retirement plan.

A lot of times, your retirement is basically a multi-phase withdrawal strategy.

Right now, Becky and her husband Steven are in their early 60s. In six years, they plan to start taking their Social Security benefits at age 69 and 70. Steven will get $3,500 a month and Becky will get half of that through the spousal benefit.

There annual spending is $80,000, Social Security will come to around $61,000 a year. When Social Security kicks in, they will be able to basically live off of that and minimally withdraw from their reserves. But for now, they have a large cash flow demand on their portfolio of $1.35 million.

Check out Big ERN’s full post about Becky’s numbers here.

Listen to Becky’s full episode here.

Recommendations

Big ERN recommends that they not be afraid of the drawdown during the early period of their retirement. If they draw it down by half over or all the way to $500,000 in the first 6 years, they will still have a viable plan to supplement their social security.

He wants everyone to get away from the mindset that you can’t ever touch the principal. Although it can seem scary to withdraw around 6.9% of their portfolio this year with the market highs, it is only for a short amount of time.

Tax Liabilities

Their budget of $80,000 a year does not include their tax liabilities, so they will need to withdraw a little bit more to pay their taxes. It is important to have a tax strategy in place.

The first $30,000 of their income will be tax-free. Everything else will be based on brackets. These brackets start a 10% and 12% but then jump to 22%. The goal is to avoid the 22% tax bracket. Plus, they live in Colorado, which has state income taxes around 4.6%.

In the earlier years of retirement, they also plan to do Roth conversions of around $10,000/year. However, the majority of their assets are in a taxable account. Less than 50% of their portfolio is in a 401k. Unlike many retirees who face minimum distribution requirements with their 401k, Becky and Steven do not have to worry about this. After they spend down the taxable accounts, they will be basically living tax-free because most of their money is in a Roth. Except for their Social Security which will be taxed at the federal level.

Each year for the next six years, they will need to look at where they stand in the tax brackets. After they determine how much taxable income they’ve already produced, they can use the rest of the bracket allowance to do Roth conversions. To do this, simply subtract your year-to-date income from your brokerage account from the tax bracket limit and convert that amount. Since $100,000 in total income will keep you in the 12% bracket, they will have some room to work.

An important note is that if you go over into the 22% tax bracket slightly, your entire income will not be taxed at 22%. Only the amount that is over the 12% tax bracket limit will be taxed at the higher rate.

Preparing For Your First Year Of Drawdown

Big ERN is cautious about the bucket strategy because it sounds a lot like market timing.

My personal preference would be that in retirement that you would do the exact same thing as what you did saving for retirement, you automate your savings. Right, you do regular contributions to your 401k, regular savings into your other taxable accounts, you do the whole pay yourself first approach. I think the same approach works very well on the way out when you withdraw money. So you automate it.

If you have a cash bucket and the market goes down, then you are likely to wait until the market recovers. However, there is no guarantee that the market will recover quickly. At some point, you’ll need to replenish your cash bucket so if you wait too long you might end up hurting yourself.

He would recommend setting up withdrawals in an automated way to match your budget. The only thing that you would need to take out manually is any big expenses that pop up.

Automatic withdrawals could start with the interest and dividends that your portfolio throws off. No need to continue dividend reinvestment. For Becky, this would equate to around $14,000 in income. After that, you can start withdrawing from the highest cost stocks. This can be identified by a lot number that is based on the day you bought your stock. Also, you should avoid short term capital gains of less than a year to be more tax efficient.

To Have A Mortgage Or Not?

In retirement, Big ERN likes not having a mortgage. Although it can be useful in the accumulation phase, a mortgage is like a short term bond. Most retirees will favor a 60/40 split of stocks and bonds in retirement. If you have bonds in your portfolio, then why would you have a mortgage?

There are some exceptions like the tax consequences of paying it off in one big chunk or having an extremely low mortgage.

Can Becky Retire Yet?

Yes! According to Big ERN, Becky and Steven are safe in their decision to retire. Even with the worts bear markets of the past, they would have survived. They should even have money left over in 30 years.

Head over to Early Retirement Now to get the full breakdown from Big ERN.

If you’d like to find out more about your own path to retirement, then sign up for our newsletter and score our free ebook! The guide can help you determine your own path to a successful retirement.

New Podcast Announcement

Thank you for taking a minute to tell us why and how you feel stuck along your journey. After reading through your responses, we started to look for patterns. It seems like some of you want someone to speak to you on your journey.

We’ve partnered with Jillian Jousarnd from Montana Money Adventures to launch a new podcast that seeks to meet you where you are at. “Everyday Courage”

She wants to help listeners lead a better life through bite-sized chunks of inspiration and small tips to improve their life. This podcast will launch soon, stay tuned for more information!

Book Release

MK recently released a new book, The Infinite InfiniteIf you are looking for a fun mystery adventure, then check it out!

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13 thoughts on “152R | Can I Retire Yet?”

  1. Couple of comments for your consideration:

    First, you almost never want to deplete your pre-tax accounts (401k and IRAs) down to zero. Doing Roth conversions at a 12% tax rate doesnt make sense if you have small RMDs in the future that will be in your standard deduction that you pay NO taxes on! This, of course, depends on other sources of ordinary income. In addition, there is the tax torpedo to consider. If you can get your combined income below certain thresholds, there is no taxation of social security. Planning for the tax torpedo will likely cause more aggressive Roth conversions than planning for standard deduction.

    Second, as a reminder, capital gains tax stacks on top of ordinary income tax. In the episode, you conflate the capital gains tax brackets with the ordinary income tax brackets. Cap gains stack on tax of ordinary income but use a separate tax scale. See https://www.fiphysician.com/capital-gains-stack-on-top-of-ordinary-income/

    In this case, they probably want to do partial Roth conversions until the Tax Cut and Jobs Act expires in after 2025 and do some capital gain harvesting in addition!

    • @FiPhysician:
      I don’t think I’m the one conflating anything:
      As I said, the $61k p.a. in Social Security will put them squarely into the 12% bracket in the future. There is no way around having 85% of their SS taxed as ordinary taxes and then at a 12% marginal rate. They will also be hit with a 12% marginal tax on every dollar that comes out of the 401k/T-IRA, whether RMD or pre-RMD. So, in the best possible case – tax brackets stay post-2025 & all taxable cap gains and dividends are tax-free (fed) due to staying in the first two brackets – it’s a wash between converting in the 12% bracket and keeping the money and paying 12% later. But in the worst possible case: taxes go up in the future, you’re better off converting now.
      Also, I agree that there are cases where keeping the taxable money around is optimal for tax and estate planning purposes; the heirs get the step-up basis. But this doesn’t apply here because there are scenarios where almost all the assets will be depleted along the way.
      I never meant to say that cap gains don’t stack on top of the ordinary income. Not sure when/how I said that. But the capital gains and dividends DO crowd out Roth conversions because you have to limit your conversions to the standard deduction PLUS the top of the 12% bracket MINUS the cap gains and dividends. If you don’t and you max out the 2 brackets with Roth conversions, you’d push the tax rate of the captial gains from 0% to 15% on your federal return. You’d create a 27% marginal tax on your Roth conversion (12% ordinary income tax + 15% for the crowding out effect). I have written about this effect on my blog back in 2016 (back then it was still 15+15% for a total of 30%):
      https://earlyretirementnow.com/2016/07/13/that-sneaky-30-federal-income-tax-bracket/

      • Correction: You’re right, you take only 1/2 of SS and factor that into the formula. So, they might still keep some of their future 401k/T-IRA withdrawals within the standard deduction at 0% taxation. So, you don’t have to go as wild with the Roth conversions. Probably max out only Standard deduction plus maybe-maybe the 10% bracket. This was (I hoped) a little side issue beyond the pure SWR calculations and I should have been more careful with this.

        • Yes, it is complicated! Taxation of social security is a mess. CPAs just put in the numbers and it spits out line 5b on the 1040, which is part of your AGI for the purposes of your standard deduction. But to calculate the taxable portion of your social security, you use 1/2 of the social security received, plus other income, plus muni bond income. Again, easier to just plug in the numbers and let the software do the work. But to avoid the tax torpedo, you have to understand where just a bit more ordinary income pushes your social security to a higher level of taxation. These numbers haven’t been adjusted overtime with inflation, whereas the tax brackets do inflate over time….

          As to the capital gain issue, I agree that Roth conversion can push your capital gains up from 0 to the 15% cap gains bracket. Kitces has great stuff on the topic https://www.kitces.com/blog/long-term-capital-gains-bump-zone-higher-marginal-tax-rate-phase-in-0-rate/

          • Agree! Let me write an update on the Roth conversion. And I will run it by you to confirm! 🙂
            But the gist of the exercise will still be the same: You do Roth conversions early on, just not quite as aggressive, maybe in the 50-60k range, not all the way up to 80-90k. You keep enough money in the T-IRA throughout retirement to fill up the standard deduction and enjoy a 0% rate on your T-IRA withdrawals. Perfect!!!

            But also notice: for every dollar you go over the Std. Deduction, you owe not just the 10% marginal tax but also an additional marginal tax of 5 to 8.5% marginal through the backdoor, i.e., through the impact the additional income has on the Social Security taxability calculation (see Kitces article). So, it’s absolutely a good idea to convert even into the 12% bracket. Not less (that would generate high taxes in the futures) and not more (you’d “waste” space in the Std. Deduction in the future)
            Also notice that this backdoor marginal taxation applies to dividends. Even though they APPEAR tax-free on your return, they impact the SS taxability equation and can then have a sneaky 5-8.5% marginal tax, even if you’re in the lower two brackets. So, I think it’s still a good idea to liquidate the taxable brokerage accounts and focus on Roth and T-IRA.

  2. BIG ERN:

    I have absolutely loved every single one of these analyses that you have executed. They are some of the best personal finance material that I have read over the past three years.

    I have questions if you have time to help clarify two topics in my head:

    One involves the ability of a spouse to take 50% of social security of the greater earning partner. I though that I had read that this maxed out at the higher earner FRA. That is even if the higher earner waits until age 70, the spouse can only claim 50% at that spouses FRA (67 in most cases). Am I way off? I am the higher earner by far and I am about 4 months younger than my wife. If I wait till age 70, will she get 50% of my SS at age 70 or 50% of what I would have gotten at age 67?

    My other question involves inflation. It seems like we may be assuming that they will only need $90K year after year without adjusting this upward for annual inflation. Am I missing something? I am sure I am.

    Thanks again. Sorry if my questions are pretty basic. I love your work but I have to honestly read it 2 or 3 times to fully get it. And I am an engineer! Your work is that good!

    Thanks!

    • Your spouse doesn’t even have to be eligible him/herself (under the 10-year 40 credit point calculation). It’s enough if one spouse if eligible. The other spouse can get spousal benefits and then also get the survivor benefits.

  3. Just to be clear, you cannot rollover RMDs into a Roth because it is not allowed under the rules. So you can’t do a Roth conversion after 70.5.

  4. The advice giveN to Becky to take half of her husbands benefit is not an option if Becky is born after 1954 and her own benefit is more that 1/2 of her husbands benefit at this full retirement age. Please check the updated Spousal rules for Social Security implemented in 2016.

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