Asset Allocation and Fund Location for Early Retirement

[SecondCor521]

It depends on why you are paying more in taxes later. If it's because tax rates have increased, there's no correlation with being more wealthy. You may in fact be in that "much worse" situation because you are paying higher taxes when you'd have been better off paying taxes at a lower rate earlier.

I think you probably based the above paragraph on returns in your tIRA. If you have good returns you may pay more in taxes but it's fine because you have more money. I don't disagree, but I only keep fixed income investments in my tIRA, so I expect my results to be unspectacular and fairly stable, depending on interest rates.

My point is that future returns aren't the only factor in how much you pay in taxes in the future. Maybe I misunderstood your point.

You're correct that future returns aren't the only factor. I think the asymmetric risk argument still applies even if tax rates change (as they are set to do in a few years as we both know).

I probably didn't articulate the idea very well. Let me try again with hopefully better clarity on my part:

An investor is looking at Roth conversions now and believes in the rate arbitrage idea behind them (better to pay taxes at a lower rate now rather than a higher rate later). To execute on that strategy, they have to figure out that "higher rate" later. To do that, they basically need to predict their tax situation later, which is *mostly* but not entirely a function of the tax brackets then and their investment returns between now and then. (*)

Time passes and it's now "later". The investor's assumptions about returns and tax rates (and the other stuff (*)) turn out to have been, in aggregate, either too optimistic or too pessimistic.

If the assumptions were too optimistic - "I'll pay taxes at 20% now to avoid 32% later because my investments will grow and tax rates will be higher", then they paid too much in taxes earlier, and those tax dollars are dollars they probably wished they now had because their investments did not return as much as they thought so they have less money, AND the arbitrage didn't work out as well as they hoped because tax rates "later" weren't as bad as predicted.

If the assumptions were too pessimistic - "I won't do Roth conversions at all because my investments won't grow and tax rates will be the same or lower", then their investments grew and tax rates were higher, and they missed an opportunity, but at least their growing investments are there to pay the higher taxes at higher rates.

That's the idea as I've understood it. I'm not saying the outcomes are always that starkly different or clear. I'm just saying that is why, if my age 80 marginal rate is 25% or whatever, I don't convert now up to 24%; I'll stop a few percentage points below. I'm still doing conversions and still making progress but I personally err on the lower side because of the above idea.

HTH.

(*) It also needs to take into account the rest of their financial picture, such as SS, pensions, inherited IRAs, etc. of course.

 

[sengsational]

My approach is to look at asset allocation across all account types. You pick an AA (or maybe one that gets conservative for SORR at a certain span of time, then relaxes). So less worry about having this or that account type in a specific asset class. Obviously you want to avoid "selling low" when you need cash, but that's solved by concurrently selling in one account type and buying the same thing in another (selling to yourself). While it's true that there are some tax nuances that make holding different asset classes in different account types "better", I've felt people make too much out of those differences. Probably having some dividends in after tax is worth it, but so much of the other stuff isn't worth much, and fate could intervene to make it worth less.

 

[RunningBum]

You're correct that future returns aren't the only factor. I think the asymmetric risk argument still applies even if tax rates change (as they are set to do in a few years as we both know).

I probably didn't articulate the idea very well. Let me try again with hopefully better clarity on my part:

An investor is looking at Roth conversions now and believes in the rate arbitrage idea behind them (better to pay taxes at a lower rate now rather than a higher rate later). To execute on that strategy, they have to figure out that "higher rate" later. To do that, they basically need to predict their tax situation later, which is *mostly* but not entirely a function of the tax brackets then and their investment returns between now and then. (*)

Time passes and it's now "later". The investor's assumptions about returns and tax rates (and the other stuff (*)) turn out to have been, in aggregate, either too optimistic or too pessimistic.

If the assumptions were too optimistic - "I'll pay taxes at 20% now to avoid 32% later because my investments will grow and tax rates will be higher", then they paid too much in taxes earlier, and those tax dollars are dollars they probably wished they now had because their investments did not return as much as they thought so they have less money, AND the arbitrage didn't work out as well as they hoped because tax rates "later" weren't as bad as predicted.

If the assumptions were too pessimistic - "I won't do Roth conversions at all because my investments won't grow and tax rates will be the same or lower", then their investments grew and tax rates were higher, and they missed an opportunity, but at least their growing investments are there to pay the higher taxes at higher rates.

That's the idea as I've understood it. I'm not saying the outcomes are always that starkly different or clear. I'm just saying that is why, if my age 80 marginal rate is 25% or whatever, I don't convert now up to 24%; I'll stop a few percentage points below. I'm still doing conversions and still making progress but I personally err on the lower side because of the above idea.

HTH.

(*) It also needs to take into account the rest of their financial picture, such as SS, pensions, inherited IRAs, etc. of course.

I think I'd put more emphasis on holding less volatile investments in an IRA if yours could take such a hit as to knock you down a tax bracket and would put your retirement in jeopardy. But yeah, things really could go bad and if that happens you wouldn't want to have paid more taxes than necessary. My approach to handling this is defer SS as long as possible so I'll have a larger SS benefit to count on if my investments take a beating.

 

[SecondCor521]

I think I'd put more emphasis on holding less volatile investments in an IRA if yours could take such a hit as to knock you down a tax bracket and would put your retirement in jeopardy. But yeah, things really could go bad and if that happens you wouldn't want to have paid more taxes than necessary. My approach to handling this is defer SS as long as possible so I'll have a larger SS benefit to count on if my investments take a beating.

All my less volatile investments are in my IRA already.

I'm in the zombie apocalypse / asteroid hitting Earth planning zone. Age 55 with 1% WR. Mostly Roth conversions are now in the "might as well for the kids' benefit" camp.

"But yeah, things really could go bad and if that happens you wouldn't want to have paid more taxes than necessary." - that's the idea.

Also deferring SS to age 70.

Appreciate the conversations with you as always.

 

[REIJM]

So what happens if years 6-10 are bad? Especially if years 1-5 are neutral? My point is that at age 51 SORR isn't over unless those first 5 years are really good, and if you increase cash/bond holdings for years 1-5 you're less likely to get that 6% real return.

SORR wasn't a topic I was aware of when I ER'd. My buffer was to have an overall portfolio that allowed me about a 3% WR, if I recall correctly, as opposed to 4% which is considered safe over a 30 year time period. Since it looks like you are talking 3% I would say you probably also have a sufficient buffer.

I also use a VPW strategy which cuts back on the next year's target spending if returns are poor or I overspend for some reason. It also lets me ramp up spending when returns are good. I like this because it makes the changes more gradually and automatically, as opposed to having a couple of bad years and counting on a rebound that may or may not come.

Yeah, that's true regarding hitting a good stretch for the first 5 years, and a poor stretch for the next 5.

So your plan is just use a low enough WR to get you through the down year(s) until the market recovers, which may be the path we go down. My question to you is, assuming your portfolio is big enough, are you ever going to ramp up your WR, and if so, what's your target age? Or do you just plan on using the VPW strategy for the duration of your retirement, and spend as the market allows (I'll have to look in to this, thanks for mentioning it).

Do you have any bonds in your portfolio, or are you all equities and just adjust your spending on an annual basis? In the years following a strong market, where you take out more than you normally would, are you just parking that extra cash in something like a HYSA, and using it as needed (whether it be in that year for a bigger expense, or saving it to buffer spending in the years following a poor market)?

We have one child (right now), and we definitely want to leave them something, but I don't think we want to live on a 3% WR until we die, and leave them with $10M+ either.

If you want to, you can view your low WR% and budget flexibility as your SORR defense rather than bonds.

If you hit a downturn before 59.5 and keep bonds in your IRA (as I do), you can sell stocks in taxable to fund your expenses then reallocate from bonds to stocks in your IRA. This has pretty much the same effect as selling bonds from your IRA to fund your expenses, with the added bonus of a capital loss which would reduce your taxes somewhat for a while because the capital loss would offset capital gains or ordinary income, depending on the specifics of your circumstance.

But with a small enough WR% and only pulling your expenses as you need them, and some spending flexibility, it isn't as damaging as I think people worry about and talk about.

Also, for me, who retired in 2016 and has seen my portfolio essentially double, I'm now playing with house money, so to speak. I didn't even have capital losses when I sold my stock in 2022, because I had bought it for half price 6 years prior.

Thanks for outlining how to handle bonds in a tax-sheltered account prior to being able to access them. That makes sense once you write it out.

Regarding WR as a protection against SORR rather a large bond allocation in the portfolio (along with adjusting your spend depending on how bad the market is), how low of a %WR is seen as acceptable to offset the traditional thinking of having 40-50% of the portfolio in bonds upon retirement? I don't think we'd be able to pull off a 1% WR retiring near when we'd want to, but 3% should definitely be doable (and if we hit a really bad year or two in the market, we can definitely cut back more for the short term).

And yes, retiring into a booming bull market is the best case scenario. In your case, it's gone about as good as it possibly could have. Here's to hoping many of us can have the same fortune when we pull the trigger!

 

[RunningBum]

Yeah, that's true regarding hitting a good stretch for the first 5 years, and a poor stretch for the next 5.

So your plan is just use a low enough WR to get you through the down year(s) until the market recovers, which may be the path we go down. My question to you is, assuming your portfolio is big enough, are you ever going to ramp up your WR, and if so, what's your target age? Or do you just plan on using the VPW strategy for the duration of your retirement, and spend as the market allows (I'll have to look in to this, thanks for mentioning it).

Do you have any bonds in your portfolio, or are you all equities and just adjust your spending on an annual basis? In the years following a strong market, where you take out more than you normally would, are you just parking that extra cash in something like a HYSA, and using it as needed (whether it be in that year for a bigger expense, or saving it to buffer spending in the years following a poor market)?

We have one child (right now), and we definitely want to leave them something, but I don't think we want to live on a 3% WR until we die, and leave them with $10M+ either.

Variable percentage withdrawal - Bogleheads is where to start, with discussion at Variable Percentage Withdrawal (VPW) - Bogleheads.org. I modified it to be a little more conservative and run it out a few more years, just in case.

The WR% increases gradually each year, and the amount can increase more following a year with good returns.

I keep bonds, CDs, treasuries and HYSAs as well as equities. I don't take out the year's allocation at the start of the year. Instead I spend as needed, using the VPW calculation as a target for spending. I have not yet hit that target in the 9 years I've been using VPW but may this year if I decide to get the house painted. I've already put a new roof on. This is one of the things I really like about VPW. If I have major items like this I don't just shrug them off as one-time expenses. I can go over my yearly target, and it is factored into future withdrawals over time. All anomalies like good market years, bad years, underspending and overspending are factored in over my remaining years, rather than trying to get back on track the next year.

I'm sure I could just wing it since it's been a good 13 years since I ER'd, but laying it out like this shows me that I can splurge more when I want to. I don't go crazy but I now book ski-in/ski-out lodging for my ski trips even at a high price resort like Aspen Snowmass, something I rarely did before. And, if the market goes to hell for a few years, I'm ready for it and know right where I'm at, rather than having to decide when I should start paying attention, and how to manage it.

Let me know if you have any more questions after reading from the VPW links above.

 

[SecondCor521]

Regarding WR as a protection against SORR rather a large bond allocation in the portfolio (along with adjusting your spend depending on how bad the market is), how low of a %WR is seen as acceptable to offset the traditional thinking of having 40-50% of the portfolio in bonds upon retirement? I don't think we'd be able to pull off a 1% WR retiring near when we'd want to, but 3% should definitely be doable (and if we hit a really bad year or two in the market, we can definitely cut back more for the short term).

First, I think you have to decide what you think about historical calculators like FIREcalc in terms of how much you can or want to rely on the future being no worse than the past. My decision is to think that the historical calculators are the best approach we have (compared to Monte Carlo and fixed analyses). I also think that the future will be no worse than the past (and probably somewhat better - I'm an optimist).

Then I ran FIREcalc with my particulars. Note two things about FIREcalc that some folks miss at first glance: (1) There are extra tabs across the top, so I can put in my Social Security benefits, my portfolio expense ratio, my portfolio AA, my side gig, and some other things. (2) The last tab is an investigate tab, which enables me to do sensitivity analysis with things like spending rates and AA.

What is viewed as "acceptable" is mostly up to what a person thinks about the first paragraph of my response - whether a person likes historical or Monte Carlo or fixed analyses, and what they think about using the past as prologue. And I suppose withdrawal scheme comes into play also. There are plenty of arguments on all sides and plenty of withdrawal methods, and people regularly cycle through them.

To me, I think "acceptable" is whatever WR% one measures as bulletproof based on their assumptions about such things. For me, since I chose historical analysis, that the future wouldn't be any worse than the past, and the payout period reset withdrawal scheme, "acceptable"/"bulletproof" to me was 4%. I ended up working longer and a few other things happened where my initial rate was somewhere in the 2.x% area. But you have to go through the analysis yourself.

Oh, I also documented a bunch of backup plans in case things went south, which also helped me feel OK. Monitoring the situation and adjusting spending rapidly in response to worsening conditions is a pretty good backup plan - I think ERN in his series puts some numbers on that idea.

 

[aciranger]

55M single retired at 46.

Here's how I approached the question:

Zeroth, I figured out my goals and priorities. For me it was (a) FIRE more or less as soon as I didn't like my job, (b) then have a safe WR, then a few other goals such as (c) legacy for my kids and (d) financial simplicity.

First, I figured out what lifestyle I wanted and what that would cost. I decided I'd be happy with my then current lifestyle and so I could pretty much just look at Quicken and adjust for things like lower taxes and OOP healthcare. It wasn't, but for argument's sake let's say $40K.

I then figured out what 25x that number was and aimed for that in my FIRE stash. So that was $1M.

I then ran FIREcalc sensitivity to figure out what I wanted my overall AA to be. For me that turned out to be about 90/10. 90/10 was the AA that had 100% historical safety given my assumed planning period of ~40 years (goal B) and had the largest average remaining balance (goal C).

I then looked at the Bogleheads' asset location article at Tax-efficient fund placement - Bogleheads. In my case it was easy - the 10% bonds goes in my traditional IRA, and everything else is stocks.

I then decided how to fund my 46 to 59.5 lifestyle. I chose to spend from taxable for regular expenses, and Roth convert to have a conversion ladder if I ran out of taxable before then. Because I ran into some unplanned extra income, I haven't and won't run out of taxable before then, but I still do Roth conversions for tax rate arbitrage between now and my 80s.

I didn't worry about SORR because I overshot my mark and retired with a 2.x% WR, which is historically safe by a wide margin. If SORR is playing Russian roulette, a 2.x% WR means there are no bullets in the gun. It sounds like your 3.5% has wiggle room, which means there are probably no bullets in your SORR gun either.

So:

1. If that assessment is correct, I wouldn't worry about the bond tent that all the cool kids are talking about these days.

2. I wouldn't bother with bonds in taxable at all. I would look at your allocation overall, then put whatever bonds you want in your 401(k)/IRAs. You can rebalance inside your IRAs with zero tax consequences as you adjust to retirement and see how things are working. This approach does have a side effect risk to be aware of - if your bonds are all in your IRAs and your taxable is all stocks, then you might risk depleting your taxable portfolio sooner if you have bad SORR luck in your pre-59.5 period. I considered this risk, and to me all it meant was I'd start on my Roth conversion ladder at that point which might be sooner than I wanted. But the allocation tax benefits were good enough that I decided that the risk wasn't very likely or very high. I retired in 2016 and as mentioned above, my taxable account still has a solid balance even after 8 years of spending from it, and my Roth IRA pipeline has 12 years of expenses available in it, or 46 years if you account for side income I can pretty reasonably expect.Just wondering

First, I think you have to decide what you think about historical calculators like FIREcalc in terms of how much you can or want to rely on the future being no worse than the past. My decision is to think that the historical calculators are the best approach we have (compared to Monte Carlo and fixed analyses). I also think that the future will be no worse than the past (and probably somewhat better - I'm an optimist).

Then I ran FIREcalc with my particulars. Note two things about FIREcalc that some folks miss at first glance: (1) There are extra tabs across the top, so I can put in my Social Security benefits, my portfolio expense ratio, my portfolio AA, my side gig, and some other things. (2) The last tab is an investigate tab, which enables me to do sensitivity analysis with things like spending rates and AA.

What is viewed as "acceptable" is mostly up to what a person thinks about the first paragraph of my response - whether a person likes historical or Monte Carlo or fixed analyses, and what they think about using the past as prologue. And I suppose withdrawal scheme comes into play also. There are plenty of arguments on all sides and plenty of withdrawal methods, and people regularly cycle through them.

To me, I think "acceptable" is whatever WR% one measures as bulletproof based on their assumptions about such things. For me, since I chose historical analysis, that the future wouldn't be any worse than the past, and the payout period reset withdrawal scheme, "acceptable"/"bulletproof" to me was 4%. I ended up working longer and a few other things happened where my initial rate was somewhere in the 2.x% area. But you have to go through the analysis yourself.

Oh, I also documented a bunch of backup plans in case things went south, which also helped me feel OK. Monitoring the situation and adjusting spending rapidly in response to worsening conditions is a pretty good backup plan - I think ERN in his series puts some numbers on that idea.

Very logical. Just wondering about an idea: what do you think of borrowing against the portfolio for living expense, especially in the down market? Would that be a reasonable approach to manage the market volatility?

 

[SecondCor521]

Very logical. Just wondering about an idea: what do you think of borrowing against the portfolio for living expense, especially in the down market? Would that be a reasonable approach to manage the market volatility?

I think some people here have an open HELOC and do manage things tactically to shift spending forward a tax year on a big item like a car or a roof replacement or something.

But for me and as a general rule, no, I wouldn't do that. Three reasons:

1. Even at relatively low rates (people tend to mention IBKR in this context), the guaranteed downside risk of the margin interest versus non-risk-free investment return shifts the risk/reward ratio too far out of whack for my taste.

2. If a person chooses to do this and borrows during a down year, it would seem to me that this increases the portfolio risk in a down market, which would seem to increase the person's stress level: not only do they have a down market, but now they have the stress of a loan to pay back and they're not sure when they're going to be able to do that. Maybe they need to roll the loan over another year. Maybe interest rates move against them. Maybe there's a margin call. Bleh, no thank you.

3. I haven't thought about it much, but it does seem to me that the tax consequences of doing this would be worse than just biting a small bullet and selling what one needs as one needs it.

But then again, I'm partial to my own logic and approach because it's what I view as best (for me) and it's been working mostly well. Others here might have good arguments for doing what you suggest. YMMV as they say.

 

[OldShooter]

I think some people here have an open HELOC and do manage things tactically to shift spending forward a tax year on a big item like a car or a roof replacement or something.

But for me and as a general rule, no, I wouldn't do that. <snip>

I did exactly that last tax year, finishing up paying for a new lake home. Your reasons are logical but based on the implicit premise that equity risk ("non-risk-free investment return") is involved. If the goal is simply tactical/tax there is no reason this has to be true. In our case, the money to pay the HELOC had long since been in very short term/near money market assets, so we took no market risk. Our only cost was the arbitrage between the MM and the HELOC, maybe 300 or 400 bps for two or three months.

 

[SecondCor521]

I did exactly that last tax year, finishing up paying for a new lake home. Your reasons are logical but based on the implicit premise that equity risk ("non-risk-free investment return") is involved. If the goal is simply tactical/tax there is no reason this has to be true. In our case, the money to pay the HELOC had long since been in very short term/near money market assets, so we took no market risk. Our only cost was the arbitrage between the MM and the HELOC, maybe 300 or 400 bps for two or three months.

I agree. On a short term basis like a few months, I can imagine that the tax benefit of deferring can outweigh the arbitrage cost. When I was listing my reasons, I mostly was responding to the notion of borrowing on a longer term basis of multiple years.