Your advice on a withdrawal strategy

[Finance Dave]

Ok...excuse me if a bit long-winded...but would like your thoughts on my situation.

• Age 46, wife 50
• No kids
• Hope to retire when I'm 52 in 6 years, wife will be 56
• Currently $850k in retirement accounts, split amongst 401k, Roth, traditional, and some after tax 401k as well.
• $75k in MM fund as our emergency fund
• All proper insurance in place, including $1M umbrella (may have to increase to $2M soon )
• House will be paid off in 5+ years
• Minimal car debt...will be paid off in 10 months
• No pension...company has a cash balance plan, and the amounts for that are included in the $900k above.
• Including both our contributions and our company's contributions...we are adding $61k/year to our retirement balance currently
• I'm estimating our balance at retirement to be $1.8M in all accounts (using an 8% growth rate for the next 6 years…a bit risky for sure)
• Currently combined gross is $160/year, but I’ve done a complete retirement needs analysis and estimate we'll need about $85k/year net to live on after retirement (just stopping our retirement savings along will save us $45k net...and the house will be paid off..saving another $25k/year)
• We’ll most likely have to purchase health insurance on the open market…I’ve included that in our needs analysis

Now here's the question. Most experts recommend withdrawing tax-deferred money last so that it can grow. However, if we do this, we'll be using up all our after-tax money in the early retirement years. The implication of this is that later, we’ll be withdrawing ~$85k/year of pre-tax money, so we’ll be paying higher marginal rates on all $85k.

Keep in mind I’m making several simplifying assumptions to keep the analysis from getting overly complex. For example, we actually plan to work PT in retirement…but we’ll leave that out for now.


Scenario 1:

• Follow popular wisdom of taking all AT money first.
• Pay zero taxes in first 5 years, effectively depleting after-tax amounts
• Then start using PT money and pay taxes on full amount
• Years 1-5 – pay zero taxes
• Years 6 - ?? pay $13,930/year (adjusted up for inflation)

Scenario 2 (my preferred method)

• Each year in retirement, take out just enough from the pre-tax money to get us to the top of the 15% marginal bracket (~$61k in 2008, then take all additional amounts from monies that have already been taxed. This would limit our tax rate to 15% for all future years
• Years 1-?? – pay $3,600/year (adjusted up for inflation)

I suppose I could run a discounted cash flow analysis using a 6-7% investment opportunity cost rate, and see what NPV comes out ahead…but was wondering if I’m thinking of the opportunity correctly in my specific case.

Thanks,

Dave

 

[bongo2]

Your intuition is correct, you want to use up the lower brackets.

This calculator may help you: Retirement Calculator

You might do a little better with Roth conversions instead of spending to use up the low brackets.

 

[Midpack]

My circumstances and plan are similar to yours. I intend to do what you describe in Scenario 2 as well. But not only because it will be all taxable income at the end in Scenario 1.

You (and hopefully many others including me) will have a very long retirement. As you may be implying, I don't see any way possible that tax rates/brackets won't rise in the future, probably considerably. I suspect the current rates are as low as we will ever see in our lives (read The Coming Generational Storm for reference). So I want to be withdrawing from my brokerage and tax deferred accounts throughout my retirement up to the limit of the 15% bracket when I start retirement. But I assume you/we will have some ST (taxable as income) and LT gains (capital gains) from my brokerage account holdings that will also have to be figured in - so we'll have to be careful how much tax deferred cash we withdraw to keep total income under the 15% bracket. My 2¢...

 

[baldeagle]

Finance Dave,

I think you're onto to the right idea, but you should run your own numbers.

The advice to take already taxed money first works for me PROVIDED I incur taxes anyway to do Roth conversions. Otherwise, my IRA grows bigger, and RMDs (7 more years for me) move me from the 15% to the 25% bracket for the rest of my life!

I did some modeling of various alternatives for my particular situation, and posted results at www.geocities.com/baldeaglenw

 

[kumquat]

Would you guys quit teasing me with your thread titles?

 

[jIMOh]

I am about 18 years behind you- meaning I expect to encounter this problem in about 18 years. I like scenario 2 or hidden scenario #3.

You have 6 years to implement a hybrid strategy of #2 and other choices:

1) can you divert most new contributions to retirement accounts with either a Roth status or taxable status?
2) are you eligible for Roth conversions now if you do #1? Probably not based on income, but something to consider.

The goal- get the 75k cash account up to 6 figure range in 6 years. You will be 52 when you retire, you have 17 years before you HAVE to withdraw the tax defferred accounts.

The question- if you have 1,445k in taxable accounts (1.445 M=17 years*85k of annual expenses), you have enough to live on while converting the tax deferred to a Roth status. That should lower future tax bills more than the scenario 2 you presented. Might raise current taxes some, but only for 6 years. You would need to calculate the tax cost (25%* converted amount) and compare to the $3600*17=$61200 bill you would have otherwise.
17 years is 65100*17=~1,200k worth of tax deferred assets you can convert to a Roth at 15% tax bracket- you don't have 1.2 M now, so your case is less than this.

I realize you do not have (and probably will not have) 1.4 M in taxable accounts or 1.2 M in tax deferred accounts. But take those two extreme examples, and find the middle which allows all your 401k, rollover and tax deferred monies to be converted to a 100% Roth flavor before age 69.5.

It's possible you have most of this done by age 59.5 and the whole strategy is then tax free for remainder of your life (even less than the $3600/yr you estimated).

Probably makes most sense to do the conversions when you are in 15% tax bracket, so you might need to wait 6 years to do this (as opposed to taking advantage of 2010 limit elimination).

 

[Lsbcal]

We've been basically doing your scenario #2 (maxing out IRA -> Roth conversions). The amount you can convert is:
convert = A + B + C - D - E - F

A = top of 15% bracket
B = exemptions
C = Sch A itemized deductions
D = interest
E = dividends
F = cap gains

When doing this it's best to be a little conservative as it's no fun at all to have to do a recharacterization and file a 1040X as I found out.

 

[37andhappy]

Withdrawal is not a 100% safe

My girlfriend told me the withdrawal method is not entirely safe!

 

[Lsbcal]

My girlfriend told me the withdrawal method is not entirely safe!

Funny, I've often thought the same but felt it impolite to point this out as so many find pleasure with it.

 

[Finance Dave]

Would you guys quit teasing me with your thread titles?

I don't understand your comment.

 

[Finance Dave]

I am about 18 years behind you- meaning I expect to encounter this problem in about 18 years. I like scenario 2 or hidden scenario #3.

You have 6 years to implement a hybrid strategy of #2 and other choices:

1) can you divert most new contributions to retirement accounts with either a Roth status or taxable status?
2) are you eligible for Roth conversions now if you do #1? Probably not based on income, but something to consider.

The goal- get the 75k cash account up to 6 figure range in 6 years. You will be 52 when you retire, you have 17 years before you HAVE to withdraw the tax defferred accounts.

The question- if you have 1,445k in taxable accounts (1.445 M=17 years*85k of annual expenses), you have enough to live on while converting the tax deferred to a Roth status. That should lower future tax bills more than the scenario 2 you presented. Might raise current taxes some, but only for 6 years. You would need to calculate the tax cost (25%* converted amount) and compare to the $3600*17=$61200 bill you would have otherwise.
17 years is 65100*17=~1,200k worth of tax deferred assets you can convert to a Roth at 15% tax bracket- you don't have 1.2 M now, so your case is less than this.

I realize you do not have (and probably will not have) 1.4 M in taxable accounts or 1.2 M in tax deferred accounts. But take those two extreme examples, and find the middle which allows all your 401k, rollover and tax deferred monies to be converted to a 100% Roth flavor before age 69.5.

It's possible you have most of this done by age 59.5 and the whole strategy is then tax free for remainder of your life (even less than the $3600/yr you estimated).

Probably makes most sense to do the conversions when you are in 15% tax bracket, so you might need to wait 6 years to do this (as opposed to taking advantage of 2010 limit elimination).

Not sure I follow this...let me summarize and see if I get it....

You're suggesting I take the max out of my 401k each year up to the 25% bracket, and put that into a Roth WHILE I'M RETIRED so that I effectively convert my 401k into Roth money by the time I must take RMDs?

If so, that sounds like an option I should look at.

You asked if I could divert new contributions from my 401k to a Roth? No, my income is too high.

Can I divert them to taxable accounts? Yes, but then I lose the company match and my current tax rates go up. I suppose I could put in just 6% (enough to get the match), and the other 12% (yes, I'm saving 18% pre-tax today and 8% after-tax in my 401k).

I guess I'd have to run some complex numbers to see if that strategy makes sense....basically paying more taxes now so that I will have lower taxes later.

Thanks for the suggestion.

Dave

Edit: In addition to the 18% and 8% in my 401k, I'm contributing $4,000/year to a Traditional NON-DEDUCTIBLE IRA. I'm doing this so that I can do the conversion to Roth in 2010 Plan now to make most of 2010 Roth conversion rules | Gazette, The (Colorado Springs) | Find Articles at BNET.

 

[Finance Dave]

We've been basically doing your scenario #2 (maxing out IRA -> Roth conversions). The amount you can convert is:
convert = A + B + C - D - E - F

A = top of 15% bracket
B = exemptions
C = Sch A itemized deductions
D = interest
E = dividends
F = cap gains

When doing this it's best to be a little conservative as it's no fun at all to have to do a recharacterization and file a 1040X as I found out.

Isbcal,

Were you talking about MY scenario #2? Or the guy who posted just before you?

I was not planning on a CONVERSION...rather just withdrawing the 401k money and spending it. Please clarify...I'm a bit confused now.

Thanks,

Dave

 

[walkinwood]

This is the kind of scenario that ESPlanner could help you with. Given a rate of return, it will tell you what scenario will get you the best consumption over your lifetime taking into account taxes, RMD, SS & taxes on it etc.

I don't think it can take movement of funds from IRA/401K to Roth IRAs into account, but not sure.

 

[Finance Dave]

This is the kind of scenario that ESPlanner could help you with. Given a rate of return, it will tell you what scenario will get you the best consumption over your lifetime taking into account taxes, RMD, SS & taxes on it etc.

I don't think it can take movement of funds from IRA/401K to Roth IRAs into account, but not sure.

Yes, thanks...I'll try ESP Planner...just need to find an hour of solitude.

 

[Lsbcal]

...Were you talking about MY scenario #2? Or the guy who posted just before you?

I was not planning on a CONVERSION...rather just withdrawing the 401k money and spending it. Please clarify...I'm a bit confused now.
...

Sorry Dave, I misread your post. My reply was assuming that the conversion amounts were what kept you within the 15% bracket. Of course, if you have to withdraw to get the living expenses you need then my reply was inappropriate.

 

[Finance Dave]

Sorry Dave, I misread your post. My reply was assuming that the conversion amounts were what kept you within the 15% bracket. Of course, if you have to withdraw to get the living expenses you need then my reply was inappropriate.

Thanks for clarifying isbcal. Yes I will have to withdraw to live on the money. But we do have lots of options since we're different ages (we turn 59 1/2 at different times and reach SS age at different times...so our access to money is all over the place...actually I see this as a "good" thing).

Dave

 

[firewhen]

nondeductible IRAs

I'm contributing $4,000/year to a Traditional NON-DEDUCTIBLE IRA. I'm doing this so that I can do the conversion to Roth in 2010.

Be careful with this. You have to pay taxes on this proportionately meaning if you have $10,000 in nondeductible IRAs and $90,000 in deductible, if you convert the $10,000 you cannot "pick" the nondeductible part. The government says $9,000 came from deductible and only $1,000 from nondeductible, so you would owe taxes on 90% of the conversion.

I do not think 401ks count in the equation, but you mention you have some traditional IRAs. Depending on the amount, it may not make sense to do the conversion while you are still working.

 

[2B]

FD,

Reading your initial post looks like almost all of your money is in sheltered accounts. If so, you will have a hard time limiting your marginal tax rate to 15%. You might want to go and max out the 25% tax rate and convert taxable IRA money to your Roth. That will leave you with the ability to not get forced to go over the 25% bracket between SS and RMD.

I didn't see when you were planning to start SS. I tend to assume that people with assets will defer to age 70 but since your wife is older the benefit to her is less. Unfortunately, taking SS drastically increases your marginal tax rate. That's why its good to move money into your Roth for use after you start taking SS.

It's obvious the FA business pays pretty well.

 

[jIMOh]

Not sure I follow this...let me summarize and see if I get it....

You're suggesting I take the max out of my 401k each year up to the 25% bracket, and put that into a Roth WHILE I'M RETIRED so that I effectively convert my 401k into Roth money by the time I must take RMDs?

YES, this is what I was referring to as a third scenario. I think it was mentioned by another poster too.

You asked if I could divert new contributions from my 401k to a Roth? No, my income is too high.

I guessed that, but that option needed alknowledgement.

Can I divert them to taxable accounts? Yes, but then I lose the company match and my current tax rates go up. I suppose I could put in just 6% (enough to get the match), and the other 12% (yes, I'm saving 18% pre-tax today and 8% after-tax in my 401k).

I would stop the taxable 401k contributions and at least divert those funds to a taxable account option. This will give you more flexibility (get the taxable account balance higher so you have options).

I understand saving on taxes now- you are in 25 or 28% bracket, I believe. If the 401k is not lowering your current tax bracket, I would seriously look at getting taxable account balance higher.

I guess I'd have to run some complex numbers to see if that strategy makes sense....basically paying more taxes now so that I will have lower taxes later.

Thanks for the suggestion.

Dave

Edit: In addition to the 18% and 8% in my 401k, I'm contributing $4,000/year to a Traditional NON-DEDUCTIBLE IRA. I'm doing this so that I can do the conversion to Roth in 2010 Plan now to make most of 2010 Roth conversion rules | Gazette, The (Colorado Springs) | Find Articles at BNET.

 

[Finance Dave]

Be careful with this. You have to pay taxes on this proportionately meaning if you have $10,000 in nondeductible IRAs and $90,000 in deductible, if you convert the $10,000 you cannot "pick" the nondeductible part. The government says $9,000 came from deductible and only $1,000 from nondeductible, so you would owe taxes on 90% of the conversion.

I do not think 401ks count in the equation, but you mention you have some traditional IRAs. Depending on the amount, it may not make sense to do the conversion while you are still working.

Thanks for pointing this out...although that's not a concern to me. I have two IRAs currently.
1) A Roth
2) A non-deductible traditional IRA

In 2010 I plan to transfer all the traditional money into the Roth...and at that point all of my IRA money will be non-taxed. Yes, at the point of conversion I'll have to pay tax on any earnings in the non-deductible traditional...and I'm ok with that.

I think the key point is that I do not have any deductible traditional IRAs...thus simplifying my situation.

Dave

 

[Finance Dave]

FD,

Reading your initial post looks like almost all of your money is in sheltered accounts. If so, you will have a hard time limiting your marginal tax rate to 15%. You might want to go and max out the 25% tax rate and convert taxable IRA money to your Roth. That will leave you with the ability to not get forced to go over the 25% bracket between SS and RMD.

I didn't see when you were planning to start SS. I tend to assume that people with assets will defer to age 70 but since your wife is older the benefit to her is less. Unfortunately, taking SS drastically increases your marginal tax rate. That's why its good to move money into your Roth for use after you start taking SS.

It's obvious the FA business pays pretty well.

2B, thanks for your response. Yes, the vast majority of my money is in sheltered accounts. However, the marginal rate for married-joint is 15% at $65,100...so I'm not understanding your comment about having a hard time limiting my rate to 15%. If I pull $65,100 out of my 401k...I am only paying in the 15% bracket. I can supplement this amount with other non-taxed funds such as savings, Roth IRA, etc...right?

As far as SS...I'm not certain when I'll take it...but mostly likely the wife will take it early (62), and I'll wait as long as I can. Given that women tend to live longer than men and she's pretty healthy...I think this may be our best bet...but I'll certainly run the numbers when we get closer...we're still several years away. I see your point about SS increasing our marginal bracket...so I'll have to think through that...it may mean deferring wife's SS to later as you mention.

Can I move my 401k balance into my Roth at some point? I guess I've not really thought about that...it's a large balance...so I'd have to pay taxes on it one time...doesn't feel like the right thing to do...advice?

Thanks for all the thoughts...keep 'em comin!

Dave

Edit: 2B, you mention the "FA" business...I presume that means "Financial Analysis"? Were you saying that my occupation pays well to allow me to save so much? If so, I can clarify...my wife and I both work at good-paying jobs, we are both LBYM-types of people, I am mechanically inclined to the point that I rarely hire any professionals for work around the house (I can do the "basics" of plumbing, electrical, used to be an auto mechanic, fix my own lawnmowers, finishing our basement myself, am a hobbyist woodworker, etc.) and we do not have children. Combining these facts allows us to save more than most people.

On the downside, we have some moderately expensive hobbies. We both like to travel, my woodworking is expensive ($25,000 worth of woodworking tools in my basement), and I collect musclecars (have two of them...total value about $100,000). Fortunately I can afford to pursue the hobbies...and if something really bad were to happen financially...it would be much easier to drop a hobby as opposed to not eating...we are very fortunate in that regard.

 

[Finance Dave]

YES, this is what I was referring to as a third scenario. I think it was mentioned by another poster too.

I guessed that, but that option needed alknowledgement.
I would stop the taxable 401k contributions and at least divert those funds to a taxable account option. This will give you more flexibility (get the taxable account balance higher so you have options).

I understand saving on taxes now- you are in 25 or 28% bracket, I believe. If the 401k is not lowering your current tax bracket, I would seriously look at getting taxable account balance higher.

Thanks jIMOh, but I don't understand how diverting the after-tax money will give me any more options. I've already verified with my employer than I can withdraw any after-tax funds at any time I want without penalty. perhaps you mean more investment options...and if that's what you mean I understand fully.

Yes, we are in the 28% bracket...and given where our country is headed, I would say I'll be in a 31-35% bracket in about 3-4 years (I think Congress will raise rates...especially for high-income individuals).

 

[jIMOh]

Thanks jIMOh, but I don't understand how diverting the after-tax money will give me any more options. I've already verified with my employer than I can withdraw any after-tax funds at any time I want without penalty. perhaps you mean more investment options...and if that's what you mean I understand fully.

Yes, we are in the 28% bracket...and given where our country is headed, I would say I'll be in a 31-35% bracket in about 3-4 years (I think Congress will raise rates...especially for high-income individuals).

The after tax money will be withdrawn from 401k at 25%, 28% or 33% marginal rate.

That same money in a taxable account would be taxed at 5% or 15%. So why put money into a 401k which does NOT save you taxes now? I would argue contribute this money to a taxable investment, and then realize you have a more complex withdraw plan (taxable accounts, tax deferred accounts, tax free accounts).

IMO the goal would be to have as much in tax free as possible (Roth) and then have as much in taxable as possible. This is to minimize the tax bill and allow you to keep more of what you have worked hard to save.

 

[2B]

2B, thanks for your response. Yes, the vast majority of my money is in sheltered accounts. However, the marginal rate for married-joint is 15% at $65,100...so I'm not understanding your comment about having a hard time limiting my rate to 15%. If I pull $65,100 out of my 401k...I am only paying in the 15% bracket. I can supplement this amount with other non-taxed funds such as savings, Roth IRA, etc...right?

You said you needed about $85K to live on. Add to that the money needed to pay the taxes on it and I doubt you can supplement the $65,100 with $30,000 or so from after tax money for very long. I might have missed something. If I did you can stay at the 15% marginal rate.

Once you cross over you might as well maximize the 25% bracket to get as much money transferred as possible to avoid the higher tax rate when you start SS. Retiring at 56 gives you a few years to move money no matter when you start SS.

I was just giving you a non-nasty (I thought) ribbing on your income. I'll make my financial post when I feel closer to the moment and give everyone a shot at me. Our family income isn't much different than yours.

 

[Finance Dave]

The after tax money will be withdrawn from 401k at 25%, 28% or 33% marginal rate.

That same money in a taxable account would be taxed at 5% or 15%. So why put money into a 401k which does NOT save you taxes now? I would argue contribute this money to a taxable investment, and then realize you have a more complex withdraw plan (taxable accounts, tax deferred accounts, tax free accounts).

IMO the goal would be to have as much in tax free as possible (Roth) and then have as much in taxable as possible. This is to minimize the tax bill and allow you to keep more of what you have worked hard to save.

We must be talking past each other....the after-tax money will be withdrawn at zero percent...I already paid taxes on it.