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Retirement (401K/Roth) and Non-Retirement Portfolio Allocation
Old 06-29-2013, 08:10 PM   #1
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Retirement (401K/Roth) and Non-Retirement Portfolio Allocation

Hello,

I am sure this has been discussed here, but I thought I'd start a new thread anyway.

I am 24 and believe I am on a good track to achieving FI at a relatively young age (40ish~).

I am confident in my investment decisions and allocations. However, I am "uneasy" with my current and future allocations of taxable investments (standard investments - ETFs, stocks, mutual funds, etc) and non-taxable/retirement investments (ROTH 401K and IRA).

Currently, my portfolio is as follows:
Roth 401K/Roth IRA (nontaxable): 12.5%
ETFs (taxable): 84%
Cash: 3.5%

As it stands now, most of my "long term saving/investing" is going into my retirement/nontaxable accounts. I do save here and there into my taxable funds when I have extra money.

As time passes, I believe the allocations of taxable/nontaxable will even out more (unless my salary increases sizably, which I anticipate happening in the long run!).

My concern is that I will eventually have enough money invested (overall) to achieve FI, but may face huge penalties/tax consequences in order to do so (if this is achieved by say 40-45).

For example, imagine if I am 45 and have (in today's dollars) $1,200,000 in taxable investments and $1,200,000 in retirement accounts. One might argue that if one had access to the entire $2,400,000, then I would easily be FI.
But...if I only could access the $1.2m without stiff penalties, I would be reluctant to consider myself FI or "quit the daily grind".

Does anyone have any suggestions?
The quick and dirty answer would be to put more/all of my money into my taxable accounts. But then there is the huge opportunity cost (tax advantages lost) by ignoring my retirement accounts.

I've asked people who are fairly financially savvy, and they always promote the retirement accounts - but usually my conversations with them are fairly modest, as I do not wish to disclose details of my portfolio balance, savings rate, or future plans with friends or acquaintances.

I know that there is the 72t rule. This seems logical for someone who may be in their early to mid 50s. But it does not seem practical for a 20-30 year time span.

Thanks for your input.
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Old 06-29-2013, 08:53 PM   #2
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It seems as if you've outlined the problem very well. I was about to suggest the 72t route for you, but that does come with some issues for someone with as many retirement years as you have. But let's say you segregate an account with a specific amount in it, such thay the 72t payments would cover only your essentials. Then the non-taxable could cover the big irregular expenses? Why would that not work?
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Old 06-29-2013, 09:38 PM   #3
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You can withdraw your original contributions to Roth IRA's at any time, which might help a little. I think you have to go ahead and build up you taxable accounts to a level that makes sense to you. I think you want to do that by filling your retirement accounts early on. Then in the last years before you retire stop maxing out the retirement accounts and plow almost everything into the taxable accounts. That will maximize the time spent in the retirement accounts and minimize capital gains taxes. You will still want to pick up any company match of course.

Given what will probably be many years of relatively low income, you will want to Roth convert your traditional retirement accounts while it is tax-efficient to do so. The taxes on that creates an additional burden on your taxable accounts that you should plan for.
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Old 06-30-2013, 09:51 AM   #4
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Both good suggestions.

I have to look into the 72t payment calculations, but my recollection tells me that the payment amounts were not very large even given a substantial nest egg/ROTH balance.

Relying on the 72t also comes with reliance on the government in that they won't change the formalities for this rule.

Withdrawing the principal balance from my ROTH accounts could be enough to supplement the FI, but would severely weaken my FI due to inflation erosion.
I am skeptical how this actually works though. Has anyone actually withdrawn their principal balance before 59.5? I always hear that you can do that, but have never read the fine print or heard stories of people doing so.

@Animorph,

this is a good suggestion, however it comes with the implications that I will have higher income in my later working years.

I guess there is no clear cut answer; each route comes with pros and cons.

My dad has suggested that I max out my Roth 401K and use my taxable funds to supplement cost of living gaps that I would incur by maxing out my 401K.

This seems like a good idea for someone who plans to work until their 59.5 - but i don't want to tie all my money up in retirement accounts.
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Old 06-30-2013, 11:02 AM   #5
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What you are concerned about is a common issue for retirees younger than 59 1/2 (which would include me). I am relying on my taxable accounts from my ER at 56 but only have a couple years to worry about.

In my case, I focused my saving on tax deferred accounts until my income and savings increased such that I maxed out those accounts and any additional savings went into taxable accounts. It worked out by dumb luck, but if I had been thinking ahead more (like OP) it would have been more of a cognizant choice.

A 45 yo would have 14 1/2 years to worry about so would need to have a sizable nestegg in taxable funds to pull it off. As others have mentioned you can also access certain Roth account contributions without penalty before 59 1/2.

One suggestion would be to use Quicken Lifetime Planner as it shows the growth and decay of taxable funds separately from tax-deferred funds. Unfortunately, for some reason it doesn't handle tax-free funds separately but includes them in tax-deferred.

I would think that if you had half of your nestegg in taxable accounts as in your example that you would be fine in that you could withdrawal from your taxable accounts from 45-59 1/2 without exhausting your taxable accounts (assuming a 3.5% WR and a positive real rate of return) and then shift to your tax-deferred accounts.

You could create a model in Excel or Quicken Lifetime Planner to see where the pinch points might be.
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Old 06-30-2013, 12:09 PM   #6
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Originally Posted by pb4uski View Post
What you are concerned about is a common issue for retirees younger than 59 1/2 (which would include me). I am relying on my taxable accounts from my ER at 56 but only have a couple years to worry about.

In my case, I focused my saving on tax deferred accounts until my income and savings increased such that I maxed out those accounts and any additional savings went into taxable accounts. It worked out by dumb luck, but if I had been thinking ahead more (like OP) it would have been more of a cognizant choice.

A 45 yo would have 14 1/2 years to worry about so would need to have a sizable nestegg in taxable funds to pull it off. As others have mentioned you can also access certain Roth account contributions without penalty before 59 1/2.

One suggestion would be to use Quicken Lifetime Planner as it shows the growth and decay of taxable funds separately from tax-deferred funds. Unfortunately, for some reason it doesn't handle tax-free funds separately but includes them in tax-deferred.

I would think that if you had half of your nestegg in taxable accounts as in your example that you would be fine in that you could withdrawal from your taxable accounts from 45-59 1/2 without exhausting your taxable accounts (assuming a 3.5% WR and a positive real rate of return) and then shift to your tax-deferred accounts.

You could create a model in Excel or Quicken Lifetime Planner to see where the pinch points might be.
This pretty much describes my ER plan when I ERed 4 1/2 years ago at 45. I split my ER plan into two part - the first part was how to get from age 45 to age ~60 using only my taxable accounts. This was the hard part. The second part, far easier, was how to continue passed age ~60 once I had access to my "reinforcements" such as unfettered access to my rollover IRA, my frozen company pension, and Social Security.

Like you, Younginvestor2013, I was concerned about having the "wrong" mix between my taxable accounts and my retirement accounts. In the years leading up to my ER, I had about 2/3 of my money in the latter. However, part of my plan was to liquidate half of the retirement account (1/3 of my overall portfolio) which was company stock and combine it with my taxable account, thereby reversing the original ratio so it would be 2/3 taxable and 1/3 retirement (Rollover IRA). I chose the company stock because I was able to use NUA to cash it out using long-term cap gains on 97% of its value and keep the tax bill down.

I consider the 72t option as a backup plan, one I do not see using at any time. In fact, my portfolio (taxable and IRA) has risen nicely since I ERed so I have been able to live on about 60% of the dividends (taxable account only) it has generated while reinvesting the rest.

As a Fidelity client, I have used their Retirement Income Planner a few times including in the ER planning stage back in 2007-08 to make sure my projections were reasonable. It showed what I exected it to show - a reasonably good plan through age ~60 before an explosion in wealth once the reinforcements kicked in.

What I think you need to do is to figure out how much you will need in your taxable accounts to make sure you don't "undersave" in them as you build up your retirement accounts ("reinforcements"). In your example, perhaps having $1.6M in your taxable accounts and $800k in your retirement accounts is a better mix to be able to ER at a young age while preparing yourself well for your older years.
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Old 06-30-2013, 04:29 PM   #7
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When I retired at 39 I had roughly twice as much in my taxable account as my IRAs. 13 years later I have slightly more in IRAs than my taxable account. Now part of that is due to rental and personal real estate transactions but it also because the income generated in my taxable accounts in some years fell short of my expenses.

In your case say you retire @40 with 1.2 million in each account. Your spending is $70K and you generate 3% (real) income from dividends, interest and the modest cap gains distributed from your ETFs. The balance on your taxable account will decrease 34K on your first year. Lets say that also means a decrease of 1K in income, (ball park figures) each year. By the time you are 59 the balance in your taxable account will be 400K at which point you can start tapping your IRA. That seems to me to be a decent cushion. Now if the ratio of your taxable to deferred was 1 to 2, I think there would be an issue.

I agree with Animorph,the last several years before you retire really cut back on your 401K saving just do enough to get the company manage. Index equity funds are so tax efficient that there isn't an advantage to saving in IRA/401 the last few years before retiring.
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Old 06-30-2013, 04:33 PM   #8
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Originally Posted by younginvestor2013 View Post

My dad has suggested that I max out my Roth 401K and use my taxable funds to supplement cost of living gaps that I would incur by maxing out my 401K.

This seems like a good idea for someone who plans to work until their 59.5 - but i don't want to tie all my money up in retirement accounts.

You are right and your Dad's advice might make sense for somebody retiring in their 60s, but I don't think makes sense for an early retiree. The only time Roth make sense is when you are just starting out and your tax bracket is very low 10 or 15% or after you've had an early retirement and do Roth conversions.
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Old 06-30-2013, 05:01 PM   #9
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I would suggest that you not let taxes dictate things. The tax laws can be changed at any time and I would be very skeptical about the 401k and Roth IRA tax benefits remaining unchanged for your entire lifetime (50+ years).

My guess is that at some point the government is going to eye all of those 401k accounts as a nice new piggy bank to raid just as they have done with social security.

The truly wealthy do not have nor care about retirement accounts. Just as social security is irrelevant to them. More importantly, the vast majority of people in this country save absolutely nothing for retirement. So, perhaps I am just paranoid, but my guess is that when the government comes for our 401ks their won't be much opposition to it. Note, I don't think they will confiscate anything, but I do think they will add new taxes to it.

Having said that I would still suggest you take advantage of everything available to lower your taxes. I just wouldn't let it stand in the way of your goals. What I do is use my 401k entirely for bonds, my Roth IRA entirely for REITs and my taxable account has all of my stocks and cash. In terms of asset allocation this works out great for me.

My plan is to early semi-retire sometime around 45+ (I'm 37 now). I will use dividends from my stock investments to pay for part of my living expenses while working part-time for the rest. Then sometime when I am 59+ I will completely retire by replacing my w2 income with my 401k, Roth IRA, pension and social security money.

Given the current interest rates if you wanted to use cash in place of bonds in an asset allocation, I don't think it would make much difference. So I think you would be fine just using cash and stocks in a taxable account, and retiring off of that. You can always add in municipal bonds in the future when it becomes worthwhile.
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Old 06-30-2013, 05:15 PM   #10
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While I concur that we don't want the tax tail wagging the investment dog, the fact is that for most middle/upper income people, taxes are an important part of retirement planning. I would tend to favor Roths over tax deferred savings as long as you marginal tax rate is less than 25%. Once you breach the 25% tax rate in a meaningful way, I think maxing out tax deferred accounts make more sense than tax-free savings. The idea is to defer taxes when you are earning a lot and pay less in taxes when you use the money in retirement.
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Old 07-01-2013, 08:18 AM   #11
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@OP: You haven't specifically said whether your strategy is to live off of dividends when you retire early. Is that the case? Because that will probably have an effect on the type of advice that would be most helpful for you.
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Old 07-01-2013, 05:20 PM   #12
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While I concur that we don't want the tax tail wagging the investment dog, the fact is that for most middle/upper income people, taxes are an important part of retirement planning. I would tend to favor Roths over tax deferred savings as long as you marginal tax rate is less than 25%. Once you breach the 25% tax rate in a meaningful way, I think maxing out tax deferred accounts make more sense than tax-free savings. The idea is to defer taxes when you are earning a lot and pay less in taxes when you use the money in retirement.
+1 here.

From age 33-43 we were in the 25-33% rate and we max'd out the 401k's and something we really are glad we did was...DW qualified for differed compensation, up to 50%.

We knew she would be quitting in a couple years, so her $70k she put away comes in handy now that we're under the 15% tax rate (by design). We now get 1/5 annually what it has grown to now.

We also lived on one salary from 99' and kept it close to the same all the way to 2011-12, even though our comp tripled.

We have roughly 1/2 in deferred accounts and 1/2 in taxable and live nicely on the dividends and interest and maybe 1-2% draw-down, tops.

Another thing to consider is if you'd like to experience living abroad in a lesser cost part of the world. Travel a bit between now and then to places like Equador (friends are moving from TX to there in Jan). They also lived in Mexico and somewhere north of S. Africa. All 1/2 to 1/4 the cost of the cities of US.

My $.02
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Old 07-01-2013, 09:42 PM   #13
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Well, I suppose my ultimate goal is to live off dividends/market appreciation so as to not deplete the principal, accounting for inflation (so ideally when I die I will die with the same (time adjusted) portfolio balance.

That is probably unrealistic to begin with. But that would be the ultimate goal. I don't wish to die with not a penny, or even only half of my (time adjusted) FIRE portfolio balance.

All of my retirement account savings are in Roth (I have no traditional IRA or 401K). I have roth IRA and a roth 401k. Fortunately, my company offers a roth 401k.

While I do see the advantage in tax savings in the present by using the traditional 401k option, I think all tax savings in the present are overweighed by the roth benefits given my time horizon (20+ years)........aside from the fact that with a Roth, one can withdraw the principal in the future (I don't believe this is an option with regular 401Ks).

In talking with my accountant and other financial professionals, many seem to agree that "already stored away" roth funds likely wouldn't be taxed in the future but the government. But, many also agree they could see the roth tax benefits disappearing in the future.

I have lately given consideration to maxing out my roth 401k and dipping a bit into my taxable funds so as to "build up" my retirement account. If I do this, I have to be comfortable with the opportunity cost of losing free cash on hand.

Thanks for your suggestions!
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Old 07-09-2013, 01:17 PM   #14
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I agree with you that Roths are likely advantageous to you. I doubt they'd be taxed either, but I half expect a VAT to be introduced in the next 15 years or so, and a national sales tax like that would hit your Roth dollars from the other side. Still, a Roth would be better to have in that scenario than a traditional.

You may want to consider deliberately creating a pre-retirement pot in a regular brokerage account that you plan on using just from ages 40-59.5. Then at 59.5, when everything in your Roths will be accessible without either penalties or jumping through hoops, anything you have left in your pre-retirement fund can become fun money or emergency money. (DH and I have our own investments divided this way, as do some others on this board.) Because you know the exact timeline for your pre-retirement pot - 19.5 years - you can make a more detailed, deliberate strategy for using that money than you can with your Roth investments.

Just a thought.
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Old 07-09-2013, 01:31 PM   #15
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When I retired at 39 I had roughly twice as much in my taxable account as my IRAs. 13 years later I have slightly more in IRAs than my taxable account. Now part of that is due to rental and personal real estate transactions but it also because the income generated in my taxable accounts in some years fell short of my expenses.

In your case say you retire @40 with 1.2 million in each account. Your spending is $70K and you generate 3% (real) income from dividends, interest and the modest cap gains distributed from your ETFs. The balance on your taxable account will decrease 34K on your first year. Lets say that also means a decrease of 1K in income, (ball park figures) each year. By the time you are 59 the balance in your taxable account will be 400K at which point you can start tapping your IRA. That seems to me to be a decent cushion. Now if the ratio of your taxable to deferred was 1 to 2, I think there would be an issue.

I agree with Animorph,the last several years before you retire really cut back on your 401K saving just do enough to get the company manage. Index equity funds are so tax efficient that there isn't an advantage to saving in IRA/401 the last few years before retiring.

I agree with this thinking.... use your taxable account....

As you posted.... you would have $1.2 mill in both accounts... but if you were 40 then you need to be planning to fund at least 40 years of retirement.... so the taxable needs to do 20 years and the deferred needs to do the next 20....

If you plan on 50 years... then your taxable should cover 25 years... either way, you are in your early 60s or mid 60s and no tax penalty for withdrawals from the deferred accounts...


But worst case is that you might have to pay some penalty for a couple of years... if it is more, then most likely you failed in RE....
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Old 07-09-2013, 01:51 PM   #16
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What a great problem to have

There is no easy answer, because your priorities 20 years from now will be different and you will wish then you had made different choices now. This is true no matter what you do.

The most important thing is to maximize your total saving today, because you can. Then, maximize the Roth portion, because it gives you great flexibility later in life. How you split the difference between taxable and tax deferred after that matters less than making sure you have a fair amount of each.
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