Seeking Advice

[camfused]

Hi. Newbie here. I believe I am (will be) FI and planning to RE the end of 2018, when I reach 59.5, so I am starting to get my ducks lined up. I have been working on a retirement income plan.

We will have $1.9M essentially all in regular 401Ks. My estimated yearly expenses will be $63K, current dollars. DW, who will work until 62 (2020), has a low-paying ($45K) job.

Goal: Enough in Cash bucket each year to cover expenses, and to have the most possible left over if I hit 100, to pass on.

I am seeking advice from the fine folks here about my Plan A and Plan B...Which is really better, and am I missing some sort of better Plan C?

Plan A
====
As soon as I retire, start converting large sums ($250K) each year from the 401K to a Roth IRA. In 7 years, all will be moved from 401K to Roth IRA. This completely avoids RMDs. During those 7 years, I will also be pulling yearly needs from 401K into Cash bucket. All taxes, which will be quite large those first 7 years, will also be payed from Cash bucket. The 401K and Roth IRA will be set up to produce about 2.5% dividends, which will go into Cash bucket. I won't run out of Cash bucket until I am 89, then I can dip some from Roth IRA.

So, I am basically getting money transferred from 401K to Roth as soon as practical, to avoid RMDs.

My spreadsheet says I will have enough in Cash bucket each year, and have $5.5M left over at 100.

Pros: 1) No Fed taxes after I get everything over to Roth IRA, 2) Larger amount left over than Plan B.

Cons: 1) Paying huge amounts in taxes the first 6 years (but then no RMDs to be taxed on later), 2) Cash bucket has no more than one year's needs, some of the time.

Plan B
====
As soon as I retire, pull only what is needed each year from the 401K bucket into the Cash bucket. Keep about 2 years of Cash in the bucket. The 401K will be set up to produce about 2.5% dividends, which will go into Cash bucket. If Cash bucket becomes too large, then transfer to a taxable bucket. All taxes will be payed from Cash bucket.

My spreadsheet says I will have enough in Cash bucket each year, and have $4.4M left over at 100. I never deplete the 401K bucket, so pay RMDs every year after 70.5.

Pros: 1) Way less taxes the first 6 years.

Cons: 1) Gotta do RMDs, 2) Gotta pay taxes on the RMDs, 3) Less left over at 100 than Plan A.

For both Plan A and Plan B, I have simulated stock returns to start with a 25% loss, then repeat the pattern of 3 years random gain (0% - 25%), and 1 year of random loss (0% - 25%), with a 40 year average of 4% gain. I have adjusted for inflation, have SS kicking in at FRA for me and 70 for DW. I have SS benefits being cut to 77% in 2034. I have the new tax rates in the plans.

Thanks for the help, and let me know if I missed any data needed.

 

[Souschef]

I do not think that converting $250K to a Roth is a good idea. You would be paying 28% federal plus X% state tax on it . That is quite a bite, about 70K per year for a total of about 560K. According to you, 70 K is what your yearly expenses are.
I am in the throes of RMDs, I only have to take out 5% and pay 25% tax on it. On your 1.9M, at 5% and 25% bracket, that is $23,750, or about a third of what you would pay if you did the Roth conversion.I know the RMDs go on forever, but it will be on a declining balance.

 

[camfused]

Yeah, the taxes are quite large. The funny thing though is Plan A comes out ahead. I think this is because the Roth gets loaded up early, having a chance of earning tax-free dividends early, plus I load Cash bucket up early so that it lasts 19 years without dipping into the Roth.

The large taxes in Plan A rub me the wrong way, but the numbers seem to say it is the better plan. The $560K in Roth conversion taxes are actually less than the taxes in Plan B over the long term.

That's why I started the thread... to see if y'all think I am nuts.

 

[camfused]

One more thing: Up to about age 82, Plan B is actually ahead of Plan A for net worth. After that point, Plan A starts pulling ahead. I guess that should be a factor in my decision too.

 

[Souschef]

One thing you also have to consider is the present value of the future taxes.
Money paid later is less than money paid now. At 5%, $100 10 years from now is only approximately $61 now

 

[camfused]

Ok, yes, I have that factored in, with a 3.35% (the 97 year historical average I found somewhere) rate.

 

[RobbieB]

You seem to be planning for a long life. Good on you.

But, other than medical expenses, me thinks you will blow (or want to) more dough from 60 to 80 than from 80 to death.

 

[pb4uski]

Your Plan A is similar to what i-ORP would typically recommend (albeit more extreme) and does seem to optimize the nestegg if you live long. My spreadsheet gives a similar result if I do really big roth conversions in the early retirement years. I suspect because of decades of tax-free growth vs tax-deferred growth.

Given that, I suspect that if you do the whole thing in one year it probably does even better.

I am just loathe to write such big checks for taxes on the come. Who knows what will happen 20-30-40 years from now.

Have you allowed for increases in the tax brackets at the rate of inflation?

Also see http://www.iarfc.org/docs/journal/Vol 15 Issue1.pdf#page=49
and the following from i-ORP.

ORP's modus operandi is to not allow IRA to Roth IRA conversions because many ORP users are unnerved by the large taxes conversions that are incurred early in retirement. Conversions reduce income taxes later in retirement but at the cost of increasing income taxes early in retirement. Some retirees find it daunting to make large retirement savings withdrawals just to pay taxes.

A popular strategy for many retirees, at least those who participate in Internet retirement forums, is to determine which tax bracket their total day to day spending puts them in and then make partial annual conversions that puts their total, taxable income at the top of that tax bracket.

ORP assists you with this issue with an IRA to Roth IRA conversion drop down list gives you three options:

No partial conversions,
Allow conversions to the top of the selected Federal income tax bracket.
Allow ORP to compute the true optimal conversion level.
The drop down list includes seven Federal income tax brackets. Select the bracket that fits your situation and ORP will make partial conversions with income taxes no higher than the top of the selected tax bracket. If you select too large of a tax bracket then ORP is running in the unconstrained mode. Pick a ceiling that is too low for your income situation and ORP will cough back an infeasible model; that is the model has no solution for the specified parameters.
The Federal income tax bracket cap applies only to the first half of retirement, when IRA to Roth IRA conversions are normally done.

IRA to Roth IRA conversions before age 59 1/2 are not subject to the early retirement penalty.

For more on IRA to Roth IRA conversions see the Journal of Personal Finance Page 47.

 

[Souschef]

You seem to be planning for a long life. Good on you.

But, other than medical expenses, me thinks you will blow (or want to) more dough from 60 to 80 than from 80 to death.

I agree- when we got married 10 years ago, we were spending about $40K a year on travel. As we aged, our travel became more and more limited.
Now, with DW not being able to fly long distances, we are traveling a lot closer to home.
Carpe Diem. Do all you can while you can!

 

[camfused]

You seem to be planning for a long life. Good on you.

But, other than medical expenses, me thinks you will blow (or want to) more dough from 60 to 80 than from 80 to death.

It's more like I might screw up and live that long! I sincerely doubt I will, but with medical advancements now, you never know. One does not want to run out of money (which I read somewhere is the #1 retiree's concern).

You have a good point about spending more the first years. I already have in the plan additional expenses the first 5 or so years, but maybe I should consider doing that for some more years.

 

[camfused]

pb4uski, thanks for the link. I will check that out.

So, this makes me think of a Plan C (which I am plugging in now) that makes sure my Roth conversion stays under the 22% tax bracket limit, with more reasonable yearly taxes.

First pass looks like it does nearly as well as Plan A, and better than Plan B.

Also, no, I did not allow for tax brackets increasing at the rate of inflation. I was not aware that happens. With the new tax plan, aren't they locked in for something like 8 years?

 

[Sunset]

OP - Why are you thinking: " SS kicking in at FRA for me and 70 for DW"

If you are the major earner, which I think because you claim her job is low pay at 45K, then the maximize SS, you should take it at 70, being the higher earner. This way since odds are one of lives to 90 something, that person gets a larger SS.

 

[Sunset]

OP - It seems to me you are going to pay the ROTH conversion taxes from the IRA withdrawals as you don't have $500K sitting outside a tax sheltered account.

This does fly in the face of many conversion thoughts I read about, because you will need to withdraw $125,000 to put $100,000 in the ROTH and pay $25,000 tax on JUST the conversion (as you will also withdraw $63,000 for living expenses, you will really need to take out $79,000 so you can pay the tax on the $63,000 ($16,000 roughly).

You are of course pushing all your dividends from 0% tax to 15% tax, with this plan.

 

[rayvt]

1) Offhand, it looks to me that you view RMD as some sort of boogeyman, to be avoided at all costs. Why?
Any distribution from an IRA is taxed the same. From that aspect a Voluntary Distribution is no different than a Required Distribition. The only thing different is which year the tax goes in.

2) It also looks like you attribute some magical characteristics to "Cash Bucket". Money is fungible; it doesn't work differently depending on which piece of your asset allocation it comes from. The fungibility isn't so evident before you retire, since you always have new money coming in from your paycheck. Once you retire you see it more clearly. After a few years I realized that all that was happening was that it was just shuffling my money around between my accounts (and asset allocation categories).

3) "No Fed taxes after I get everything over to Roth IRA." This is an unwarranted assumption. You cannot assume that the tax laws of today will continue to be the same in the future. The government is quite able to put a tax on ROth withdrawals. If that happens, you'd be paying tax now on IRA to Roth conversions *and* tax later on Roth withdrawals.

I already know how they'll do it, if they ever do.
1st will be a small "fee" on withdrawals.
2nd will be a "temporary surcharge" on the fee for "this current national emergency". -- Not a real tax increase at all, just a temporary thing.
3rd will be to make that "temporary surcharge" permanent. -- Not a real tax increase at all, just making what you've been paying these last few years as the "surcharge" permanent.

 

[racy]

1) ....3) "No Fed taxes after I get everything over to Roth IRA." This is an unwarranted assumption. You cannot assume that the tax laws of today will continue to be the same in the future. The government is quite able to put a tax on ROth withdrawals. ...

+1 Who'd have believed that social security income would be taxed?! (For the youngsters info: it started in 1983,[mod edit])

 

[MrLoco]

I do not think you should convert all of the money in the 401 k to a Roth. Convert enough up to the 22% tax bracket perhaps. You may still be able to utilize the medical deduction in future years if needed.

Think about this example. 25 years from now, you (or your wife) are in your 80's and may need nursing home (memory care) at a a cost of about $200,000/ year. Maybe you have a LTC policy that covers part of this.

The cost of taxes due by drawing from a Traditional 401 k (IRA) in future years could be offset by the medical deduction. If all the money is already in a ROTH you lose the ability to offset any future taxes due with the medical deduction available ( assuming the medical deduction stays....and it probably will in some form with the cost of medical care for seniors rising every year).

Keep some money in a taxable account. Some in a Traditional 401k (IRA). Some in a ROTh account. This gives you options in future years to withdraw money on the most tax efficient basis possible.

 

[Golden sunsets]

We had been stoically anticipating the "tax bomb" to hit this year for DH(70.5 this year) and a double whammy in two years when I hit 70.5 and also start collecting SS under my own record. We did not do Roth conversions as we had earned income that precluded us from converting at lower tax rates. Under the current code we would have been kicked into the 28% bracket in 4-5 years. However looking at the new brackets I think we will be able to remain in the 24% bracket indefinitely(if the new rates were to be made permanent) which will help to reduce the tax bomb, so our decision not to massively convert, which IOrp modeled, may turn out to be a wise one. As Pb4uski said, we just couldn't stomach writing such large checks to Uncle Sam on the front end.


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[PatrickA5]

If you do go with Plan A, I'd keep enough in the 401K to where the RMD would be equal to your standard deduction + exemptions. Some of your pre-tax money would actually be tax free. No reason to pay 25% tax on money that could end up being 0% taxed. Having some money pre-tax, some tax free (Roth) and some taxable leaves you with a lot of options on how you want your taxes to look like in the future.

 

[pb4uski]

Wouldn't it be deduction + exemptions - 85% of SS?

 

[Sunset]

If you do go with Plan A, I'd keep enough in the 401K to where the RMD would be equal to your standard deduction + exemptions. Some of your pre-tax money would actually be tax free. No reason to pay 25% tax on money that could end up being 0% taxed. Having some money pre-tax, some tax free (Roth) and some taxable leaves you with a lot of options on how you want your taxes to look like in the future.

Yes, nicely said.
This morning I was thinking at breakfast how OP is planning to pay 22% or 25% tax on money, which if it was RMD'd, would be taxed at 0% or 10% or 12% (depending on tax laws).

 

[Sunset]

I do not think you should convert all of the money in the 401 k to a Roth. Convert enough up to the 22% tax bracket perhaps. You may still be able to utilize the medical deduction in future years if needed.

Think about this example. 25 years from now, you (or your wife) are in your 80's and may need nursing home (memory care) at a a cost of about $200,000/ year. Maybe you have a LTC policy that covers part of this.

The cost of taxes due by drawing from a Traditional 401 k (IRA) in future years could be offset by the medical deduction. If all the money is already in a ROTH you lose the ability to offset any future taxes due with the medical deduction available ( assuming the medical deduction stays....and it probably will in some form with the cost of medical care for seniors rising every year).

Keep some money in a taxable account. Some in a Traditional 401k (IRA). Some in a ROTh account. This gives you options in future years to withdraw money on the most tax efficient basis possible.

Excellent consideration, I hadn't thought of this when thinking of this OP plan.

This itself would lead me to want to have $800K by the time I'm 80 in IRA/401K as that would only be 4 years coverage, or maybe just 2 years each.

 

[capjak]

Keep some money in a taxable account. Some in a Traditional 401k (IRA). Some in a ROTh account. This gives you options in future years to withdraw money on the most tax efficient basis possible.

+1, the tax future is unknown and having flexibility may be the answer

 

[camfused]

OP here. Thanks all for great feedback! I have thought this through and now have Plan C as follows:

Plan C
====
As soon as I retire, I start converting from 401K to Roth IRA in amounts that keep me inside the 22% bracket. The first couple years, the amounts are small, because DW is still working and I am trying to build up Cash bucket. After that, I can convert around $120K per year (may adjust up as limits change over the years). I am fully converted around age 77. RMDs are never a concern since the Roth conversion amounts are always greater than the yearly RMD amounts. Yearly spending needs and taxes are always paid for from Cash bucket. The 401K and Roth IRA will be set up to produce about 2.5% dividends, which will go into Cash bucket. I won't run out of Cash bucket until I am 84, then I can dip some from Roth IRA.

My spreadsheet says I will have enough in Cash bucket each year, and have $5.3M left over at 100.

I like this plan the best now. Y'all gave me some great advice and I plan on paying it forward by helping others here as I can.

Perhaps the following is for another thread: I am always puzzled how "normal" people doing things financially. For the past 20+ years, I have had every aspect of my current and future finances planned out in various spreadsheets (I have every car purchase planned out until I die). My family makes fun of me, but of course have no problems driving those cars or doing the nice travel we do (enabled by budgeting and savings).

I am just amazed how people get by without all the type of knowledge that is in these threads. DD just graduated from college with a humanities degree, and is pretty intelligent. Yet, she doesn't know squat about anything financial, like car loans, mortgages, investments, etc. I have been teaching her, as she becomes interested, but it is amazing what the education system does NOT teach people.

 

[camfused]

Also, as per leaving some in the 401K bucket, to take advantage of deductions for potential medical expenses, I am still thinking that one through. I did a Plan D like that, with several variations. It does fairly well ($5.0M left at 100, and lower yearly taxes), but none of the runs do as good as Plan C. But, I am still playing with this one.

 

[pb4uski]

....RMDs are never a concern since the Roth conversion amounts are always greater than the yearly RMD amounts. ...

Roth conversions do not count towards RMDs... so once RMDs are required you need to take the RMD as a withdrawal and then if you wish to you can do Roth conversions on top of the RMD.