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Dealing with Trad IRA tax rate & early withdrawal penalty
Old 01-19-2017, 10:38 PM   #1
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Dealing with Trad IRA tax rate & early withdrawal penalty

Hey everyone, new guy here. Lately I've been devouring information about FI, having discovered a surprising wealth of content out there about this topic. I've been a diligent saver/investor since I started working and am in the fortunate position of considering the very real possibility of early retirement.

My biggest concern is the ratio of my savings between liquid and tax-deferred accounts, and the impact of both taxes and the early withdrawal penalty before 59.5. Of my invested assets, about 2/3 is in a Traditional IRA and the other 1/3 is liquid. Most of it is invested in a diversified set of Vanguard index funds.

Most calculators like this one seem to disregard any taxes or penalties, and I feel give an overly optimistic picture of when one can expect to retire.

I expect to hit the $1.25-1.5MM total that represents 25x of my annual spending in probably 4-8 years. I currently save about $40K a year, maxing out my Roth 401k ($18K) and Traditional IRA limits ($5.5K) and putting the rest into my Vanguard brokerage.

However, since I aim to retire well before 59.5, and I definitely don't have enough in my brokerage account to last the ~20 years before that, I'm wondering if I should change my investment strategy to divert ALL of my savings to my brokerage account and sacrifice the deferred tax benefits of the Roth 401k and Traditional IRA. My company doesn't match at all and my income level makes none of my IRA contributions tax deductible.

Of course, I'll get hit with taxes on dividends every year until then, but perhaps the savings on distributions when I do need to withdraw might make it worthwhile? (at least 25% tax + 10% penalty for the Trad IRA vs. 15% capital gains on my brokerage)

If real numbers are helpful, here's the rough breakdown:

Cash + regular brokerage: $230K
Real estate equity: $180K
Roth (401k + IRA): $55K
Traditional IRA: $500K

Would really appreciate any insight from others who are in or have dealt with a similar situation!
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Old 01-20-2017, 07:15 AM   #2
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Not sure about the Roth 401k, but IIRC you can withdraw contributions from the Roth IRA anytime after 5 years... have you considered this possibility in your planning?

Also, Quicken's Lifetime Planner will show the decay in your taxable savings separately from tax-preferenced savings if you plan to rely on taxable savings... you can also use the what-if functionality to compare alternative savings mixes
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Old 01-20-2017, 08:34 AM   #3
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Actually you can withdraw Roth contributions anytime, conversions after 5 yrs.
Are you able to convert any of the TIRA w/backdoor? That would free up more assets after 5 yrs. How much of TIRA is deductible/how much not? Does your 401K accept incoming TIRA assets?
https://www.bogleheads.org/wiki/Backdoor_Roth_IRA
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Old 01-20-2017, 08:56 AM   #4
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You can play with various scenarios (large amount in IRA vs taxable after early retirement) using ORP. It's a free web based tool that handles the various types of accounts. https://www.i-orp.com/

Might also get familiar with 72t withdrawal rules from an IRA. I'm not very familiar with them but think that's one way you can take early tIRA withdrawals at some point without penalty.
https://www.bogleheads.org/wiki/Subs...iodic_payments

In regards to your specific question, I would suspect that anything that you get some matching money in (401k) is worth continuing contributions to. Other than that, you'd need to run some numbers for you specific situation.
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Old 01-20-2017, 10:00 AM   #5
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First of all, welcome to the forum!

Looks like you're off to a great start, but consider the following:

1. From your post I infer that you would like to retire in your thirties? The 25x earnings target is based on the 4% "rule" from the Trinity study, and is for a 30-year retirement (withdrawal) period. If you plan to be retired and not working for much longer than that, you would be much safer with a lower withdrawal rate, maybe 3% or less. That would require saving 33x spending.

2. Most here discount the equity in real estate when counting their savings. You can't withdraw 4% of the value of your house each year to buy groceries.

3. That calculator you linked to is pretty darn worthless, IMO. One of the calculators of choice here is firecalc.
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Old 01-20-2017, 10:03 AM   #6
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One question I'd have is given your talking about $1.2-1.5M, are you sure you are really going to be in the 25%+ tax bracket? I think you need to run some numbers of how you will be withdrawing money and how much. Given those numbers I'm assuming your fairly close to the 15% tax bracket and once you include the fact you will partially be withdrawing your own money which obviously won't be taxed, I don't see why you wouldn't be able to fall in the 15% bracket and thus dividends and LT Gains would become tax free and you could ideally be in the ZERO tax bracket. Given that I do suggest you run some calculations and likely start putting more away in taxable accounts.

I'm not sure what your age is, but given you already have $500K in your tIRA, I'd suggest looking at that as a seperate entity and what would it grow into by 59.5 and would that be enough 59.5+. Then you can just focus on 59.5 and sooner and how much you will need as a two part equation. Obviously you don't have the benefit of compound growth, so that # is going to be relatively high, which is why I think you'll end up concluding you need to save more in taxable accounts. Or you may conclude you want to go to part time instead or reduce spending early on to allow it to grow.
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Old 01-20-2017, 01:00 PM   #7
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Thanks all for the very helpful responses! I'll check out the leads you guys sent and build some spreadsheets to model some of this out.

Providing a little more detail on some of the clarifying questions:

I'm currently 33...would love to be FI by age 40 but that doesn't mean I'll stop working 100%. I definitely plan to have work be a much less significant part of my life, but my main goal is to be location independent for much of the year allowing me to travel and experience the world as a local instead of visiting places 2 weeks at a time.

I'm also married. My wife likely will continue to work past 40 for at least a few more years. She takes home a pretty big salary so together we would definitely be in the 25%+ tax bracket if not the 28%...

@pb4uski & @kaneohe -- I thought Roth distributions before 59.5 after 5 years were only tax & penalty-free for certain qualified expenses such as medical expenses or first-time home purchases? (Roth IRA early withdrawals and penalties - Fool.com)
EDIT: Nevermind! Just realized that the penalty is incurred only on investment gains and not the original contribution amount, so it sounds like I can withdraw up to the amount I contributed without getting hit.

@Whisper66 - No match from my current company so the Roth 401k is really just for maximizing earnings and having potentially tax-free distributions in the future.

@GalaxyBoy - Good callout on the assumptions from the Trinity Study. My timeline is likely to be more like 40-50 years...so may require a few more years of work than I was hoping to allow a margin of safety.

@karen1972 - Part time work is definitely an option that I'll likely pursue so I don't dip into too much of the warchest. Another option I've considered is relocating to international locations with much lower cost of living...
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Old 01-20-2017, 03:29 PM   #8
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One last note, anyone retiring that early needs to consider how much they will get for Social Security, you can log into the SSA.gov website, download their calculator and plug in the numbers... Since the calculator takes the best 35 earning years, at 40 your likely going to have to be entering a whole bunch of zeros and that needs to be factored in if your counting on SS to help out in the later years.
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Old 01-20-2017, 03:47 PM   #9
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Quote:
Originally Posted by karen1972 View Post
One last note, anyone retiring that early needs to consider how much they will get for Social Security, you can log into the SSA.gov website, download their calculator and plug in the numbers... Since the calculator takes the best 35 earning years, at 40 your likely going to have to be entering a whole bunch of zeros and that needs to be factored in if your counting on SS to help out in the later years.
Yeah, I ran the full program calculator with an estimated retirement age of 45 (6 more years) and my estimated benefits at 62 dropped to $1,350/month, or about 2/3rds of what my SS statement estimates when it assumes I'll be working a lot longer.
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Old 01-20-2017, 03:52 PM   #10
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Hi Dream--regarding the withdrawal rate, check out ********.com for making your own estimates.

Also, I want to repeat the reference to SEPP / 72t plans that allow you to withdraw from tIRAs without penalty (but with restrictions). Start with www.72t.net.

Roth conversions may be ok--but given your savings, I'm guessing the tax cost is prohibitive.

Tax reduction seems to be the key driver in my plans.
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Old 01-21-2017, 05:52 AM   #11
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I believe that if you are fully retired, you can withdraw from a 401K at age 55.

Quote:
The 25x earnings target is based on the 4% "rule" from the Trinity study, and is for a 30-year retirement (withdrawal) period. If you plan to be retired and not working for much longer than that, you would be much safer with a lower withdrawal rate, maybe 3% or less. That would require saving 33x spending.
25X is also based on historic investment returns over the last 30-50 years. I believe that various economic and demographic factors will not produce the same returns that we have seen over this period. To be prudent, I suggest 40X. That is what I am doing.
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Old 01-21-2017, 07:09 AM   #12
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I believe that if you are fully retired, you can withdraw from a 401K at age 55.



25X is also based on historic investment returns over the last 30-50 years. I believe that various economic and demographic factors will not produce the same returns that we have seen over this period. To be prudent, I suggest 40X. That is what I am doing.
+1

The 25x (4% rule) is for a high likely to succeed for 30 years. The likelihood drops at the length extends. While I don't use the average market conditions as my metric for success, that would give you a better shot for what I would expect would be a 60 year retirement plan.

I believe to taking the 401k penalty free is to leave working after 55 or 55.5.

Have you really looked at what health insurance and care will cost now and in the future?

If you want to estimate the tax and penalty cost, just increase your spending requirement to cover the taxes and penalties. To do this you would need to estimate your tax burden.
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Old 01-21-2017, 11:25 AM   #13
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Originally Posted by DrRoy View Post
I believe that if you are fully retired, you can withdraw from a 401K at age 55.
There 's a gotcha with the age 55 rule. You must be retiring from the company you have the 401K with at age 55 or after. (I have a 401K from a company I left at age 30. I have to wait until I'm 59.5.)

Regarding the sustainable withdrawal rate (4%), I use ********.com to backtest. It supports different asset allocations (stock, bonds, cash, gold) for whatever length of time and for whatever date range you want (it goes back to the late 1800s; however, the most important times are the Great Depression and the inflation hit in the 70s).

The 4% rule didn't include social security or other sources of income (which ******** allows you to add). When I was the OPs age, I didn't include Social Security in my planning either. Now that I'm in my 50s, I feel more confident it doing so.

The original paper on the 4% rule is here: Bengen 4% Rule
Published in 1994, it backtested various withdrawal rates and allocations (stock, bonds) from 1926 to 1976.
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