Use of Retirement and Non-Retirement Accounts

[ZMAN]

DW (55) is out of mega-corp for good in February. I (57) have been in the large law firm business, for better and for worse, for 27 years. I plan to open a solo part time practice in January. Income will be a fraction of current. And if it still drives me crazy might bag it for good.

We live in upstate NY, in the fourth cheapest area for houses according to a recent Money report. Mortgage is paid off and only 1.5 years of college left.

Firecalc shows that at 4%-4.5% we can afford to FIRE based on our entire portfolio.

57% of our investment assets are in non-retirement accounts and available for use. 18.6% of our investment assets are in DW's 401(k) and IRA plans and a similar 18.6% of our investment assets are in my 401(k) and IRA plans. The balance is in a pension annuity for DW that we cannot touch until age 65. We have it all (except the annuity) in an integrated plan at Vanguard at 50% equities (with a nice mix) and 50% bonds.Vanguard did the allocation plan for us.

The non-retirement funds are sufficient for us to FIRE, but we would exceed the 4% from those accounts, but not the 4% overall.

My concern is the impact of drawing from the non-retirement funds until my retirement funds are available in 2010 and DW's are available in 2011. Will our overall plan be hurt by first drawing down from these nonretirement assets? Or is that the best way to do it in any event. I looked at a lot of threads and could not find one on the best order of use. So a direction to a thread would also help.

One last question. What am I not thinking about? What issues come up in early retirement that might surprise me?

Thanks for the help.

Zman

[LOL!]

You may wish to take a look at Retirement Calculator which is a calculator to suggest withdrawals.

Another thing to think about is how to reduce your tax bracket so that you can convert traditional IRA money to a Roth IRA gradually between your early retirement date and when you begin to receive social security benefits. Between the ages of 57 and 70, you can live off your non-retirement accounts and pay little in the way of taxese because you will be getting return of capital (not taxed) and realized long-term capital gains (taxed at 15%). Add in taxes on Roth conversions (stay in 15% marginal income tax bracket though) and you become golden.

This may be a bit tricky, because studies show that withdrawing your low-return assets first helps. And your low-return assets willl probably be bonds and they should not be held in your taxable accounts. Your fixed income should be held in your tax-advantaged accounts.

[Rich_in_Tampa]

Originally Posted by ZMAN

My concern is the impact of drawing from the non-retirement funds until my retirement funds are available in 2010 and DW's are available in 2011. Will our overall plan be hurt by first drawing down from these nonretirement assets? Or is that the best way to do it in any event. I looked at a lot of threads and could not find one on the best order of use. So a direction to a thread would also help.

Zman, general advice usually encourages you to use nonretirement money first.

The theory is that it lets your qualified money grow tax free for a longer time, perhaps at a lower future tax bracket; but also it lets you meet your net expenses without grossing up your withdrawals to cover taxes, as you have to do with qualified funds like IRAs.

There are exceptions to this (e.g. minimum required withdrawal and higher future bracket situations come to mind) but generally, after-tax dollars first for most, as I understand it.

[MasterBlaster]

The brainless stategy is take from non-retirement accounts, then tax deferred accounts, then tax-free accounts so that you get the most tax free growth. However there actually is a better method as demonstrated in the ORP calculator (the linked calculator in the LOL post).

Take only enough out of your retirement accounts to fill up the 15 percent income bracket. Take the rest out of your non-retirement accounts until the non-retirement accounts are exhausted. Then take income from the tax-defered accounts.

Lastly drain the Roth IRA accounts that are tax-free. If you are in a really high tax bracket then use some of the Roth accounts earlier for money that would push you into the highest tax-brackets.

The goal is to take tax-deferred money out such that it is mostly only taxed in the lowest tax brackets. Take Roth (tax-free) money out if your income would have pushed you into the highest tax brackets.

This process can get kind of tricky, depending on growth rates and your tax brackets. The planning will span decades.

[ziggy29]

Originally Posted by MasterBlaster

Take only enough out of your retirement accounts to fill up the 15 percent income bracket. Take the rest out of your non-retirement accounts until the non-retirement accounts are exhausted. Then take income from the tax-defered accounts.

This is what I plan to do. Using current tax brackets as an example, even if it's more income than I need, I would take as much as I could out of the 401Ks and traditional IRAs up to the top of the 15% bracket. If that wasn't enough, I'd supplement income with withdrawals from the taxable account as long as there was some there. (If not, I'd start tapping the Roth.)

If withdrawing to the top of the 15% bracket left me with more income than I needed, I'd make a Roth conversion with the excess (assuming it's still an option) instead of taking it as income.

I would not allow any of the 15% bracket or tax brackets below it to go unused, unless you don't need income above the 15% bracket and your RMDs wouldn't be a killer.

Note that this might change if I faced huge RMDs that would kick me into much higher brackets. In that case I might eat the 25% bracket in order to keep my RMDs no higher than that. But there's no way to know whether that will be a concern for me over the next 20+ years until RMDs are getting closer to reality. And, of course, as tax brackets change (likely higher), so too will the equation.

[baldeagle]

Hello Zman,

As Rich_in_Tampa said, the general advice is to draw from taxable accounts first, then IRAs, and finally Roths. It's the "pay taxes later" concept in James Lange's book. Implicit in that advice are:

1. You are already paying tax on gains in the taxable account so at least spend the gains you've paid taxes on.
2. Spending capital in the taxable account may allow you to pay taxes at no higher that the 15% LT cap gain amount.
3. Not spending the IRAs as long as possible allows continued, tax-deferred compounding.

But...there are some significant exceptions to the general rule. Most notably, if you have a sufficiently large IRA, the MRDs at age 70.5 may be so much that you are forced into a higher tax bracket that you would otherwise belong, based on your actual spending needs.

That's what we are trying to avoid. We've been retired for about 2.5 years, have about 90% of our portfolio in IRAs, and comfortably live beneath the 15% IRS bracket. We don't want MRDs to push us to the 25% bracket in 7 years, so we are doing the following:

1. Making partial conversions of IRA to Roth each year to the top of the 15% bracket.
2. Spending IRA money annually on ordinary living expenses.

Our withdrawal plan is based on treating ordinary and extraordinary expenses differently. Ordinary refers to the baseline of comfortable and predictable living. Extraordinary refers to bigger and irregular things such as house painting, big trips, new car, etc.

We withdraw ordinary expenses and Roth conversions from the IRAs. To pay taxes on those withdrawals, we withdraw from the taxable account. We also withdraw from the taxable account to pay for extraordinary expenses.

No one rule fits all situations. In our case, we withdraw from both taxable and IR simultaneously for the reasons noted. It is operationally comparable to what MasterBlaster noted.

[ZMAN]

Thanks to all. It sounds like the only current strategy for us, to use the taxable accounts first, is also arguably the best strategy. Once we can withdraw without penalty from the retirement accounts we will look at the slow removal process from those accounts as part of our tax strategy.

Now how about the question of surprises. As an example is it hard to go from being a saver, building up those reserves, to being a spender, not adding to the reserves? Is it a major shock?