How To Prepare For Drawdown During Early Retirement

How To Prepare For Drawdown During Early Retirement

We all know that we are great at building up our portfolio income in preparation for early retirement. But, most of us are so busy with our eye on the prize of a great retirement that we don’t really know what to do with it when it is finally here.

Once we are at the point of early retirement, how do we ensure that we are using our portfolio income to the maximum ability during drawdown?

Passive Income

This is one bucket that we plan to use regularly during our retirement. Building up passive income through real estate is something we have been working on for a few years now. We don’t plan to stop building up our passive income until we are ready to retire.

Even if you don’t have passive income from real estate, you could be getting it from a multitude of other places. If you have generated passive income, this is the first part of your portfolio income you should account for during drawdown.

Drawing from your passive income sources first can significantly reduce having to pull money from any of your other accounts. The less you can pull from your retirement accounts, the better and longer your retirement can be.

So if you don’t have passive income coming in yet, but are working towards retiring early, you may want to consider building some.

Example:

  • Our family of seven currently has monthly expenses totaling $5,000.
  • We bring in approximately $1,000 through passive income.
  • Therefore, we would need to draw an additional $4,000 per month from our other retirement streams to make the numbers work.

Taxable Investments

If you have money in taxable investments, such as stocks or bonds, then this is the next place to take money from during drawdown. This is especially true if you happen to fall into the 0% category for Long-Term Capital Gains Tax Rate. For 2019, that rate is $77,000 if married filing jointly or $39,375 if filing single.

Any taxable investments that you plan to sell during drawdown will have capital gains for the amount you sell it for over your initial purchase price.

Example:

  • If you bought 100 shares in a stock for $50 per share ($5,000 total) and are selling all of those shares for $100 per share ($10,000 total), then your capital gain would be $5,000.

The best way to handle taking taxable investments if you fall into the 15% or 20% long term capital gains brackets would be to sell the taxable investments with the lowest capital gains first, therefore taking less of a tax hit on the money.

But if you fall into the 0% category for capital gains, then sell whichever taxable investments make the most sense for you at the time.

Related: The Advantages Of The Individual Investor: Why You Can Beat The Professional Money Manager

HSA Withdrawals

If you have a Health Savings Account (HSA) and haven’t used all of it for qualified health expenses, then this is another avenue you can tap into. After age 65, you can withdrawal HSA funds for whatever strikes your fancy without penalty; however, if used for non-qualified medical expenses, you will need to pay standard tax rates on this disbursement.

A trick of the FI Community is to pay for medical expenses with your normal income without seeking HSA reimbursement while you are working and save the receipts for reimbursement at a later time. In retirement, you can start reimbursing yourself for medical expenses you paid during your working career, taking that money tax-free out of your HSA. However, you do have to keep good records to prove those withdrawals are reimbursements and not withdrawals.

Related: How The HSA Fits In With Your FIRE Plans

Roth And Traditional IRA Distributions

Since money put into a Roth IRA is after-tax, it makes these retirement accounts some of the most tax friendly. Not only before retirement but after retirement as well.

Roth IRA’s don’t have a Required Minimum Distribution (RMD), so you can continue to put money into them as long as you like and let them grow, though contributions are limited the amount of earned income you have for that year.

Therefore, if you have other retirement accounts, it is best to draw from them first. Then tap into the Roth IRA accounts, so they can continue to grow as large as possible in the interim.

SEPP Withdrawals

Substantially Equal Periodic Payments (SEPP’s) are withdrawals you can take before age 59 ½ that can be a much better option when retiring early. These withdrawals can only be taken from a retirement account, such as a 401(k), 403(b) or a Traditional IRA. Additionally, you can’t initiate a SEPP plan on an employer retirement account if you’re still employed by that employer. There are a few different ways  SEPP distributions can be set up. They are:

  • Required Minimum Distributions
  • Fixed Amortization
  • Fixed Annuitization

If you decide to take out SEPP withdrawals before age 59 ½, it will eliminate the 10% early withdrawal penalty, but you will still owe income tax on whatever amount you withdraw. So this can be a good option for drawdown, before taking your pension or social security.

Related: How Substantially Equal Periodic Payments Can Help Your Early Retirement

Deferring Pension

If you are lucky enough to have a pension, this is a great asset to defer, if possible. The reason is that pensions can grow, like Social Security, during the deferment period. Each pension has different rules, but the average it can grow is approximately 6% per year. You would need to look into your specific pension to see what the rules are and how long you are allowed to defer distributions.

Therefore, if you can wait to begin taking out your pension for an additional two years, you could potentially be getting 12% more. However, this means that you will have to take more out of your other retirement accounts, or savings, for the first couple of years during retirement.

Instead of the traditional 4% distribution per year, you might be taking something closer to 6% – 8%. This would only be during the two or so years you are deferring your pension. But, it means you need to ensure that you have the liquidity to handle this extra draw during this period of time.

Delaying Social Security

Once you reach your full retirement age (FRA) you can begin collecting your full Social Security benefits. As of right now, the FRA is 67, for anyone born in 1960 or later.

Waiting until your FRA to collect Social Security equates to receiving the full benefit allowed. But, waiting until you are 70 to file instead, will earn you an extra 8% per each year you deferred until then. That can be huge!

Example:

  • Your Social Security Benefit Calculation at your FRA of 67 = $1,850
  • Deferment until age 70 is an additional 24% (3 years x 8% = 24%)
  • $1,850 x 124% = $2,294
  • That is an extra $444 monthly, or $5,328 annually!

Obviously, this extra income comes at the cost of the 36 months of missed payments though. Consideration of your current health and projected longevity should be taken into account. The better the health you are in, the more likely you’ll live long enough to see the crossover in the higher monthly returns outvalue the missed payments you could have received on your full retirement age.

Related: When To Claim Social Security

Overall Drawdown Plan

No matter what, every situation is unique. However, disregarding that, the general plan you can consider to maximize your portfolio income during drawdown is as follows:

  1. Utilize your passive income streams
  2. Take money from your taxable investments to make up for the remaining expenses not covered by passive income
  3. Use unreimbursed qualified medical expenses to take tax-free distributions from the HSA
  4. Take Roth and/or Traditional IRA distributions
  5. Take SEPP withdrawals from your traditional employer-sponsored retirement accounts if they make sense
  6. Defer your pension for as long as the program allows to maximize the increased allowances for extra years during deferment
  7. Delay collecting Social Security until at least Full Retirement Age, and consider delaying until  70 years of age for maximum benefits

If you can pull from these buckets accordingly, then you will undoubtedly maximize your full retirement potential.

What are some of the drawdown tactics you have either implemented or have planned to maximize your portfolio income during retirement?

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