Overthinking Funding Early Retirement?

[FIREd]

When I started thinking about early retirement 2 years ago, I had a pretty clear idea about the way to get there. Assess my annual expenses, accumulate about 25 times that number, retire, and take out 4% of my portfolio the first year.

But the more I think about it and the more I am getting confused because by the time I retire (hopefully at age 50 or before; I am currently 33), there is a good probability that about 1/2 my portfolio will be in taxable accounts and about 1/2 will be tax-deferred accounts if I don't make any changes to the way I currently invest my money. Right now I would need an annual income of 60K in retirement which would require a nest egg of 1.5M (in 2007 $). I have thought of 3 options:

1) I don't change anything. Let's imagine that I have 700K in taxable accounts and 800K in tax-deferred accounts when I get ready to retire. The 700K in taxable accounts alone can only provide about 28K a year at 4%. For me to be able to get an income of 60K at age 50, it means that I would have to withdraw about 8.6% from my taxable accounts the first year. Eventhough, it would still represent only 4% of my total portfolio, it makes me cringe because I am worried that I could run out of money in my taxable accounts before reaching 59.5 at which time I could start digging in my tax-deferred accounts.

2) I start shifting more savings towards taxable accounts so that by the time I reach 50 I have a higher percentage of my portfolio in taxable accounts. The problem with that approach is that my current tax bill would go up and that it will take longer to reach the 1.5M mark, but when I do I will have more money in taxable accounts and would be able to withdraw a safer percentage (maybe 5-6%) of my taxable portfolio until I can start accessing money in my tax-deferred accounts.

3) The 3rd option is to build a sustainable portfolio in my taxable accounts, meaning a portfolio of 1.5M that could generate every year the 60K needed for my annual expenses (at 4% SWR). That way for the 10 years prior to age 60 I would not deplete my taxable portfolio and when I turn 59.5 I could continue living off of my taxable portfolio and I would have the tax-deferred accounts as cushion. That's the scenario I would prefer because it offers a lot of security, but at the same time I will require me to probably save about 35 times my annual expenses before I can pull the trigger and retire. Again, it will postpone my retirement date by a few years and will increase my current tax bill as I may have to cut contributuons to tax-deferred accounts to achieve that plan.

All these options are doable financially, but which one do you think is best? Or do you think I am overthinking the all thing? Becoming FI ASAP is my top priority, early retirement is too but not as the expense of financial security down the road.

 

[LOL!]

You have many more options. As many have written in these here parts, one can take money out of retirement plans without penalty before you reach age 59 1/2. Therefore there are an infinite number of ways to allocate withdrawals between taxable and tax-deferred.

 

[LOL!]

Also I would imagine that in quite a few years, your taxable portfolio would go up by more than 8%, so you could take the annual distributions and realize some LT cap gains and stay in good shape.

 

[brewer12345]

Yeah, I agree with LOL: get the money together first. You can twiddle with various withdrawal options later.

 

[Rich_by_the_Bay]

I think your time horizon allows for so many imponderable variables that it is not a productive thing to worry about right now. I have the same dilemma but being a year or two from FIRE, I have 90% in taxable accounts. I just "gross up" my required income, thereby raising my savings target. What changes is how soon I can retire. Everything else is the same.

The 2010 change in Roth regulations are just one example of how much things might change for you. I'd say just save, don't worry, be happy and be flexible on your FIRE date.

 

[FIREd]

The reason I ask is because I could be only about 8-10 years away from FIRE if I continue to save as I do now (so I could be there at age 41-43. 50 is kind of my ultimate deadline for FIREing, so there is some flexibility there in terms of FIRE date). I was thinking that if I have to adjust the way I invest my money (taxable Vs. tax-deferred accounts), I may have to make the adjustment sooner rather than later. I don't want to wait too long to only find that most of my money is locked into tax-deferred accounts when I need it.

I am aware about the rules that allow you to take money from tax-deferred accounts before 59.5, but somehow I feel that I shouldn't do it (I guess I have been brain washed by the all financial advisors who insist that retirement accounts should never be touched before 59.5).

So from what you guys are saying, I should just continue to save like I have been doing and not worry so much about where the money is going for now. Then when I am getting closer to retirement, I can start figuring out how I am going to withdraw the money. Right?

 

[Alan]

title?? - methinks this is a new feature

So from what you guys are saying, I should just continue to save like I have been doing and not worry so much about where the money is going for now. Then when I am getting closer to retirement, I can start figuring out how I am going to withdraw the money. Right?

I think that is the right advice. I don't have anything else to say, I just wanted to use the new software.

 

[maddybeagle]

I agree with everyone else but seems like you would naturally be hitting taxable account fairly hard anyway right....maxing out 401k type accounts and roth only get you so far if you plan on early retirement in your 40s and need that much income (60k)....

 

[FIREd]

That's right maddy. So far I have been investing a bit more in tax-deferred accounts than I have in taxable accounts, but the trend should reverse this year. Our income tends to increase much faster than the contribution limits on 401Ks and IRAs, so each year the percentage of savings going to taxable accounts increase.

 

[CyclingInvestor]

I retired last year at 48 with 87% of my financial assets in IRAs.
I use 72t distributions (easy calculation method) for most of my
cash flow. It is pretty simple to do. I think you should concentrate
on saving enough money and investing it well first, then worry
about distribution methods as you approach the date. There are
plenty of options.

 

[walkinwood]

You should probably pay more attention to your asset mix in taxable v/s tax-deferred accounts. The accepted wisdom seems to be to put your fixed income/cds assets into your tax deferred accounts first in order to defer the higher income tax.

That will exacerbate your problem - since your taxable accounts, with their higher weighting in equities, will tend to grow faster over time than your tax-deferred accounts.

But like others have said - get the money in your grubby little fists first. Figuring out how to withdraw your life's savings is a nice problem to have.

Congratulations on being so far ahead of your FIRE schedule.

 

[FIREd]

Cpereira,

I do have a mixture of stocks and bonds in my taxable accounts. These bonds are mostly tax-exempt though. I keep the taxable ones in my 401K. I have been pretty good at saving my money so far (I am already 1/3 of the way to my $ FIRE target) and I intend to keep it up for as long as I can. So I don't worry much about being able to "get the money in my grubby fists". My main concern would be a drop in income which would slow the accumulation phase. We can however, cut our current expenses in half if needed to maintain a fairly steady savings rate. We have done it in the past, and we will do it again if required.

 

[LOL!]

Why have muni bonds in a taxable account when you can have higher paying non-muni bonds in your tax-deferred accounts? That is, once you figure out what percent of assets you want to be fixed income, try to put all fixed income in a tax-deferred account.

 

[megacorp-firee]

Why have muni bonds in a taxable account when you can have higher paying non-muni bonds in your tax-deferred accounts? That is, once you figure out what percent of assets you want to be fixed income, try to put all fixed income in a tax-deferred account.

sometimes it is done because you have exhausted all of the allowance for non-taxable account and are forced to contribute to taxable account.. and want/need more bonds to fill out you AA. Tough life huh?

 

[FIREd]

Why have muni bonds in a taxable account when you can have higher paying non-muni bonds in your tax-deferred accounts?

Well this was part of the initial question really. Last year I started building a taxable portfolio that could stand alone (the idea was to live on the income from that portfolio in the first few years of retirement and leave alone the tax-deferred accounts until 59.5, that was option 3 in my original post). So my taxable accounts have 80% stock and 20% bonds and so do my tax-exempt accounts. The difference is that I tend to have more equity index funds and tax-exempt bonds in my taxable accounts to reduce the tax bite. You guys showed me that I should consider my savings one big pot and not treat the taxable and tax-deferred accounts like 2 different pools of money. So I will correct that by putting all bonds in my 401K/IRAs and by keeping the equity index funds in the taxable accounts.

 

[rogerc1944]

Maybe annuities would help

Currently, immediate annuities pay a bit over $700/mo for life for every $100k invested. If you were to invest $700k, you would be pretty close to the 60 grand a year you want. Of course, there are drawbacks such as loss of control over a fairly large investment or the possibility that the insurance company could go belly up. As you are planning an early retirement, you may also want to look into longevity insurance. Generally, longevity insurance policies are purchased at around age 60 to 65 with the payout beginning at age 85. The payout is pretty generous ($2k/mo per $25k invested plus some fees) but you do have to last long enough to collect. Otherwise, it all stays with the insurance company (tho there are some variations to be had at a price). This would cut the fear of outliving your money.

 

[teejayevans]

So from what you guys are saying, I should just continue to save like I have been doing and not worry so much about where the money is going for now. Then when I am getting closer to retirement, I can start figuring out how I am going to withdraw the money. Right?

Maximize 401k/IRA first
Then taxable accounts second

you can always do the 72t thing, but assuming you rather keep that as a
plan B, figure out how much per year you need, and when you hope to
retire, then using basic annuity calculation, figure how much you need in
taxable accounts to get you to 60.

in other words, lets assume you'll retire at 45, you need 45K/year, your
return is 6% (since you're tapping this right away, it should be somewhat
conservative investments, at least 5 years worth anyway), you'll need
about $465,000, with no adjustments for inflation

Then when you retire at 45, you can start transferring funds into a roth
ira a little at a time if you are in a low tax bracket (if only income
from the $465,000), by the time you reach 60, you should have a combo
of roth (now tax free) and regular (taxable).

TJ

 

[brewer12345]

Currently, immediate annuities pay a bit over $700/mo for life for every $100k invested. If you were to invest $700k, you would be pretty close to the 60 grand a year you want. Of course, there are drawbacks such as loss of control over a fairly large investment or the possibility that the insurance company could go belly up. As you are planning an early retirement, you may also want to look into longevity insurance. Generally, longevity insurance policies are purchased at around age 60 to 65 with the payout beginning at age 85. The payout is pretty generous ($2k/mo per $25k invested plus some fees) but you do have to last long enough to collect. Otherwise, it all stays with the insurance company (tho there are some variations to be had at a price). This would cut the fear of outliving your money.

Keep smoking that crack.

You want a 40-something retiree to buy a fixed annuity? Pull the other one, its got bells on.

 

[tryan]

We faced alot of the same decisions getting out at 43 ... for us rental income will bridge the gap between taxable and tax deffered accounts.

Not for the weak heart .... but another "solution".

PS Annuituies are for blue heads.

 

[FIREd]

Currently, immediate annuities pay a bit over $700/mo for life for every $100k invested. If you were to invest $700k, you would be pretty close to the 60 grand a year you want.
Roger, annuities are not for me at this point. I want to keep control of my money and retain more financial flexibility.

Maximize 401k/IRA first
Then taxable accounts second
Tee, that's what I have been doing so far and after reading you guys' suggestions, that's what I'll keep doing in the future.

We faced alot of the same decisions getting out at 43 ... for us rental income will bridge the gap between taxable and tax deffered accounts.
I have considered using rental income as well. It's definitely on the table, but I would probably not rely 100% on rental incomes to fund early retirement like some people do. I would use rental properties as a way to diversify my income which could be beneficial.

 

[jIMOh]

When I started thinking about early retirement 2 years ago, I had a pretty clear idea about the way to get there. Assess my annual expenses, accumulate about 25 times that number, retire, and take out 4% of my portfolio the first year.

But the more I think about it and the more I am getting confused because by the time I retire (hopefully at age 50 or before; I am currently 33), there is a good probability that about 1/2 my portfolio will be in taxable accounts and about 1/2 will be tax-deferred accounts if I don't make any changes to the way I currently invest my money. Right now I would need an annual income of 60K in retirement which would require a nest egg of 1.5M (in 2007 $). I have thought of 3 options:

1) I don't change anything. Let's imagine that I have 700K in taxable accounts and 800K in tax-deferred accounts when I get ready to retire. The 700K in taxable accounts alone can only provide about 28K a year at 4%. For me to be able to get an income of 60K at age 50, it means that I would have to withdraw about 8.6% from my taxable accounts the first year. Eventhough, it would still represent only 4% of my total portfolio, it makes me cringe because I am worried that I could run out of money in my taxable accounts before reaching 59.5 at which time I could start digging in my tax-deferred accounts.

2) I start shifting more savings towards taxable accounts so that by the time I reach 50 I have a higher percentage of my portfolio in taxable accounts. The problem with that approach is that my current tax bill would go up and that it will take longer to reach the 1.5M mark, but when I do I will have more money in taxable accounts and would be able to withdraw a safer percentage (maybe 5-6%) of my taxable portfolio until I can start accessing money in my tax-deferred accounts.

3) The 3rd option is to build a sustainable portfolio in my taxable accounts, meaning a portfolio of 1.5M that could generate every year the 60K needed for my annual expenses (at 4% SWR). That way for the 10 years prior to age 60 I would not deplete my taxable portfolio and when I turn 59.5 I could continue living off of my taxable portfolio and I would have the tax-deferred accounts as cushion. That's the scenario I would prefer because it offers a lot of security, but at the same time I will require me to probably save about 35 times my annual expenses before I can pull the trigger and retire. Again, it will postpone my retirement date by a few years and will increase my current tax bill as I may have to cut contributuons to tax-deferred accounts to achieve that plan.

All these options are doable financially, but which one do you think is best? Or do you think I am overthinking the all thing? Becoming FI ASAP is my top priority, early retirement is too but not as the expense of financial security down the road.

I think the others have the right advice- save, diversify account types and keep saving.

The 60k expenses... have you analyzed this? How much is mortgage payment (for example)... how much is car payment (for example)...

some of these costs might go away.

In addition, does the 60k expenses include the "estimated taxes"? If so, consider 60k in a 401k is less than 60k in a taxable account... because the taxed you would likely pay on the taxable account are much lower (currently 5% or 15%...)

 

[FIREd]

jIMoh,

Actually we are currently living on 60K. Of that 60K, 20K is discretionary (entertainment, travel, dining out...), and 40K is mandatory. Of that 40K we spend about 15K on mortgage payments and 25K on other bills (food, utilities, insurance...). By retirement, the plan is to pay off the mortgage. Plus once we are retired other expenses which are mandatory right now (like disability insurance) will go away. So as of right now, in retirement, our mandatory expenses could be as low as 20K (in 2007 $) + health insurance premiums. But the wife wants to keep at least 20-25K a year for discretionary and so once you add taxes I figure you get back to about 60K a year.

 

[firewhen]

It can be a good thing to withdraw from tax-deferred before 59.5. If you figure you will be only receiving dividends and interest then, which is taxed at the lower rate, any ordinary income you will have will come from withdrawing from the retirement plans with the 72t. If you total income is 60k, as married folks, you will never get out of the 15% bracket, which goes up to 61.3k even on the ordinary income. Remember your taxable income will be lower, as you will have personal exemptions and standard deduction, which add up to 17k, so your gross income could be almost 80k and still be in the 15% bracket. (You could even take out more than you need any convert it to a Roth.)

If you wind up taking big IRA distributions in later years, coupled with social security, this will likely make it taxable and increase your overall taxable income. Remember, when you take 10k out of a taxable account, only a portion of that is taxable (the gain) and that is currently taxed at a favorable rate, whereas the whole 10k is taxable from the tax deferred and at ordinary rates.

Save as much as you can in both buckets, and when the time comes, I suggest using the 72t which will lighten the tax deferred pool while you are paying very little taxes anyway.

 

[FIREd]

Firewhen,

you are making an excellent point.

I am definitely starting to see the light thanks to you guys.

 

[fin_indie]

Interesting thread. I wonder how many others on this board intend to retire this early (early 40's). I'm on a path to retire around age 40 and would like to see more discussion around early-early retirement like this.

Btw, I'm a long time lurker here and now, first time poster.