Status quo or Roth pipeline?

[SecondCor521]

Hi all.

I thought I understood this FIRE finance stuff, but I'm unclear on how to proceed with my current situation.

I asked on Bogleheads about this situation and got some advice. I'm asking here now to perhaps get some different and additional eyeballs on it.

I am 54 and single. I have a traditional IRA, Roth IRA, and taxable account (among other things).

I currently spend all of my taxable dividends, any gifts, some side gig income, and miscellaneous income. I am left with an annual cash flow deficit of $X per year.

My taxable is about 5 * $X. My Roth is about 23 * $X. My traditional is about 41 * $X.

I value flexibility, simplicity, depleting my traditional IRA (for long term tax planning to reduce RMDs) and preserving my Roth (for tax free growth) and my taxable (for flexibility).

There are three plans I could follow:

1. Status quo. Currently I sell $X from my taxable each year to meet my cash flow deficit. Since my taxable is about 50% basis, this creates $X/2 of AGI. I then Roth convert on top of this up to my AGI target. I've been doing this for the past eight years basically.

2. Roth pipeline. I could stop selling from taxable to fund my cash flow. This would enable me to Roth convert all of what I was doing under my status quo, plus Roth convert another $X/2. I would instead draw $X from my Roth to cover my cash flow.

3. SEPP. I could stop selling from taxable to fund my cash flow. I could then Roth convert much like in plan #2. I would set up an SEPP from my tIRA for $X each year to cover my cash flow. The main drawback of this plan is it's lack of flexibility and lack of simplicity.

I'm fairly convinced that based on my values, plan 2 is better than plan 3. It's more flexible, simpler, and has the opportunity to reduce my tIRA more.

I am struggling with which is better between plan 1 and plan 2. Plan 2, the Roth pipeline, is more flexible, but a bit less simple, but reduces my tIRA the most. The other reason I tend not to like plan #2 is that relatively speaking it drains my Roth compared to my taxable.

I was planning on doing the SEPP starting in January of 2024, and that is what has got me thinking about this again.

Advice? Thoughts?

 

[Sunset]

You don't say your age, if over 59.5 I would say the simplist is withdraw from IRA to get the needed $$.
Has advantage of reducing RMD's later and leaving Roth alone.

Number 2. - Seems maybe you are under 59.5, and using roth covert and withdrawal to avoid penalty.

 

[SecondCor521]

You don't say your age, if over 59.5 I would say the simplist is withdraw from IRA to get the needed $$.
Has advantage of reducing RMD's later and leaving Roth alone.

Number 2. - Seems maybe you are under 59.5, and using roth covert and withdrawal to avoid penalty.

Sorry, edited my post after your reply.

I'm 54, and thus would prefer to avoid the 10% early withdrawal penalty, which is where plans #2 and #3 come into play.

 

[RunningBum]

I have a similar cash flow challenge and a similar situation of much of my taxable holdings having large unrealized cap gains. Pre-ACA days I didn't mind liquidating some of those holdings for spending money, but once the ACA started I tried to avoid extra income. I'm a little older than you, 62 (today!) but not starting my SS until age 70. With full SS benefits I won't need much more than that plus a small pension, annuity, and distributions from taxable investments, so I only worry about cash flow to age 70.

The ACA subsidy wasn't that large for me the first year, so I skipped it and sold some extra holdings to build up a cash reserve. Then the subsidy got bigger, and I realized one of my managed funds (PrimeCap) tended to throw large and unpredictable distributions, so in 2017 I dumped it, skipped the subsidy again, set up a DAF to offset a lot of those gains, made a sizable conversion, and put the rest of the proceeds in cash equivalents that I could draw from for quite a while. My concern was not going over the ACA cliff for as many years as I could.

Since then I've kept my taxable income low enough so QDivs aren't taxed, made small Roth conversions to that point, and manage my cash investments to give me enough with a safety margin now, with extra cash locked up in T-Bills, CDs, and I-Bonds coming due over time. If I don't need the cash yet when they mature, I reinvest in cash holdings, otherwise I keep them in high yield MM funds to sweep into checking as needed.

Depending on my spending level, I may have to take some from my Roth around age 68, in 6 years, to bridge the gap. I'm not trying to under-spend, but if I do I may not have to touch the Roth. I try to leave the taxable ETFs alone for my heirs with stepped up basis upon my death, but first for later LTC care if needed.

So, that's a possible option 4 for you, to sell some holdings with high gains now to bridge the gap for some number of years. It was kind of a perfect storm for me to get rid of a managed fund that did well for years but created a cash distribution problem that was probably going to keep me from getting subsidies when the ACA cliff existed. Had I known it would go away I might have done things differently but I don't see the point to reexamine that.

I don't have a problem with taking from my Roth (and HSA to the extent of medical receipts first). I saved that money to spend later, not hoard. It took some self-convincing to treat the Roth as a very viable source of spending money even at a relatively young age.

It's very wise of you to think about this cash flow issue, especially before you can withdraw from any tax-deferred account. We are both probably set no matter how we do the withdrawals, but why not try to do them in the most tax efficient way to maximize our wealth, spending and legacy (to heirs and causes)?

I don't know if this really helps or not, but I thought sharing my train of thought on my similar situation might be of some help. Sorry if it's a little scattered.

 

[Exchme]

I wasn't clear if $X included the taxes on the Roth Conversions. If it did, then you are just about in balance to run taxable down by the time you are 59.5, after which time you can access your tIRA. Spending down taxable reduces tax drag, so the math favors plan #1 if you have sufficient taxable assets to make the cash flow work.

But life has risks and emotions that aren't captured by math, I can see that prior to 59.5, there is a risk that if you pull down taxable too fast and then have a lumpy expense, market setback, no side income, etc, that you have created a problem for yourself. So your option #2 (or do option 2 for a couple years until you are closer to 59.5 and then go back to option 1) is a clever way to access some tIRA money prior to age 59.5 without penalty.

I don't see any advantage of Option 3.

 

[SecondCor521]

Thanks for the replies.

@RB, I appreciate your (scattered ;-) ) thoughts. Based on your comments, I think there are some differences. My taxable is invested entirely in index funds, so throw off very little dividend income. Basically I can spend all my dividends and miscellaneous income, draw from taxable (which generates LTCG), and I still have available headroom to do Roth conversions because my annual spending is less than my target AGI for long run tax planning.

And yes, I am set as well, but am trying to do things in an optimal way anyway.

@Exchme, yes, the $X is the difference between what I spend on everything, including taxes, and what I bring in through miscellaneous sources (dividends, gifts, side gig income, etc.). The risk of running my taxable completely down and then having a lumpy expense (new car or new roof in my case) is a point well taken and why one of my top goals and priorities is flexibility.

I like your idea of doing some combination of #1 and #2 - I could take half from the Roth pipeline and half from taxable each year, for example.

Thanks for the thoughts, both of you - helpful to trigger and clarify my thoughts.

 

[FlaGator]

I adopted a version of your Roth pipeline late last year.

I have liquated all the high tax-cost holdings and cash from my taxable account over the last 8 years, as well as drawing down my HSA. Primarily to stay w/in ACA subsidy limits. Now on an attractive COBRA plan arising from the recent divorce, so no longer shackled to those limitations. But, now need to draw down the Trad and/or Roth for living expenses. Gains in the taxable account are >100%, and inclined to hold them forever to let the kids get the step up in basis. I'm nearly 64, with Medicare less than 18 months away.

For tax year 2023, I converted the majority of the Trad IRA distribution to the Roth. Did as big a conversion as I could tolerate tax-wise, and have drawn down the Roth as needed this year. Shielded several thousand $$ of interest income from taxes, and it looks like some of those converted $$ will remain, having spent less than expected. I will do the same this year, converting to the tax pain threshold and drawing those funds from the Roth as needed. Also stopped reinvestment of Divs from the taxable and Roth accounts and use those for living expenses.

No idea how this would work for your situation, but I think you're on the right path to draw down the Trad IRA and maximize the tax-preferenced accounts.

 

[JBTX]

I am not sure how to evaluate any of this without knowing current and future expected marginal tax rates. Social security and whether you are using ACA plays into it also.

While long term having Roth gives flexibility, it is worthwhile to keep enough traditional throughout retirement such that you can fill up the lowest tax brackets, which could include medical expenses in later years if agi isn’t too high. How much that would be depends entirely on what other income sources you have in addition to social security.

Traditional vs Roth decisions have a lot of moving parts, and you can’t make broad brush conclusions on generalized situations.

 

[FLSUnFIRE]

FWIW, I'm in a similar situation although I'm a bit younger and my taxable and Roth are about 7x my expenses (a bit more than cash flow needs) and my TSP(401K) is about 30x. My approach is to spend taxable until approx 2x at which point I'll start a SEPP (timing will depend on personal inflation and market performance). Roth conversions are not a great option for me due to losing ACA subsidies (makes the effective current rate significantly higher). Also, with most of my funds in TSP if I let it grow I'll likely eventually have pretty high RMDs so the SEPP should help keep some of that in lower tax brackets and as the SEPP exceeds my income needs I can reinvest AT and use that to provide cash without realizing as much taxable income. My rIRA I will let ride and will have the contributions available for any shortages without impacting taxes. Personally, I'd like to get more into my Roth but I'm just doing that by utilizing my earned income (approx 10% of cash flow needs this year) and then realizing taxable LT cap gain/principle to cover my expenses.


If you are on ACA, converting would impact your MAGI and thus cost subsidies in addition to income tax boosting your effective rate by reducing/eliminating subsidies.

 

[DrRoy]

I have been doing 1 with the thought of maximizing tax free growth.

 

[SecondCor521]

@JBTX: I can make my current marginal rate pretty much whatever I want. For purposes of discussion you can assume a marginal tax rate of approximately 25% in my late 70's and early 80's. I will be collecting SS at age 70, and SS by itself will be about 2 * $X. I am using ACA with a Bronze HSA plan because I am currently a low utilizer of health care. I incorporate the loss of ACA subsidies when calculating my current marginal rate.

 

[oldphd]

My situation was kinda sorta like yours in my 50s, I'm now early-mid 60s. Main difference is I'm married, but due to health situation the prospect of me having years of single/widowed tax brackets that is frequently discussed is a definite possibility.

I chose #1, but evaluated every year. Stuck to the 0% LTCG during that time.

Part of my strategy was based on getting cash to upgrade a house, which I did when I was 59 (almost 59.5, but not quite).

Post house/59.5, I've run the numbers, and am currently taking money out of my tax deferred in the form of withdrawals and Roth conversions up to the IRMAA limits. I expect to do this through 2025. Will then evaluate where I'm at, but expect to stick to 12/15% bracket after that, possibly a little more.

At this point, I can say no regrets.

 

[SecondCor521]

Follow up in case anybody is interested.

I decided to rule out doing an SEPP. It really goes against my goals of flexibility and simplicity.

I also decided that the flexibility and simplicity between the first two options is really approximately the same.

I also realized that since my Dad is now doing annual gifting, my taxable is unlikely to run out before I get to 59.5.

So really it comes down to my values of reducing my tIRA and preserving my Roth.

For every two dollars I spend from my Roth, that's two dollars I don't have to sell from taxable. Since my taxable is about 50% basis, that means that's $1 less of LTCG, which is $1 less of AGI, which means I can convert another $1 of traditional IRA.

This comes down to gut preference (and probably my age), but spending $2 of Roth to get an additional dollar of Roth conversion simply doesn't feel worth it.

It may also be that since I'm under 59.5, I don't really want to learn the ins and outs of completing Form 8606 Part III. I could; I just don't want to.

So it looks like status quo is the winner for now.