Ira/tsp + er

[Joshua]

Hey, I wanted to bounce this off of you folks. It's mainly questions about how taxable vs. retirement accounts work for ER minded people.

I want to accumulate assets over the next 17 years and start withdrawing some of my profits at the age of 45 as a supplement ($20k) to my military pension. Does it really make sense for me to be looking at stuff like TSP and IRA accounts? They are designed for people to start withdrawing money at traditional retirement ages. I know that a ROTH allows you to withdraw your contributions at any time without penalty, but at the same time, the ROTH contribution limits mean that not much of that amount (relatively) would be in a ROTH anyway ($75k maybe?). I could put more than that in a TSP ($240k +/-) and just take my $20k supplement from the profits of the $585k left in taxable accounts, I suppose.

Some of these numbers look high for the time period, but I’m saying that if I averaged 7% return compounded over an accumulation period of 15 years, I’d wind up with just shy of $900k in total investment assets. One problem is, I’m not even sure where I came up with that 7% figure. It has just been in one of my spreadsheets for a while now. Oops. I think I got it from this board somehow, but I have this odd habit of deciding things and then forgetting the reasoning behind them. Is it possible/reasonable/safe as an aim? Or should I be figuring more conservatively?

Aside from that, though… what are some general thoughts about retirement accounts vs. normal taxable accounts for someone in my situation with this ER strategy? Is there an example somewhere of how much advantage it would be for me to have a couple hundred thousand in ROTH/TSP rather than placing it all in normal investment accounts?

I’d also like to do some conservative real estate stuff in the coming years (purchase some rentals, etc.), so I can’t afford to have capital completely tied up if I get involved with that. Just more thoughts.

Joshua

 

[Aeowyn]

As someone who is 45 and getting ready to ER (will have military pension too - but from the reserves so it won't kick in until I'm 60), my strategy has always been to put as much as possible into Roth accounts and then as much as possible into Traditional retirement accounts (like the TSP/401K).

As you mentioned, you can take out your Roth contributions prior to age 60. You can also take out the amount of any Traditional -> Roth conversions after 5 years from the conversion. So if at the time you ER you need $20K/year, I would convert $20K/year from your TSP savings to a Roth IRA - and then take $20K/year first from non-retirement accounts first and then from the Roth to use as you're supplement.

I would probably want a chunk of money in non-retirement accounts of ~3 years worth of cash flow (in you're case 3*20 = $60K) to get the ball rolling.

 

[samclem]

Does it really make sense for me to be looking at stuff like TSP and IRA accounts?

Yes, I think it does. Nobody knows how Congress is going to change the tax laws in the coming years. Rates could go up considerably, investment income (in your taxable accounts) might receive much worse treatment than it gets today, etc. It makes sense to have money in these tax-favored accounts to allow you, when the time comes, to manage withdrawals in a way that reduces your tax liability. In addition, if your do really well in your investments, a Roth is a great vehicle for passing resources to your kids as it can keep growing tax-free. Remember, if need be you can withdraw funds from IRAs by using the 72(t) rule.

The TSP has special significance--you will not find a lower cost way to invest in equities. Nothing fancy, but the kinds of solid investment vehicles they offer can easily form the backbone of your entire portfolio and at a very low expense ratio. And nothing like the G fund is available elsewhere.

Some of these numbers look high for the time period, but I’m saying that if I averaged 7% return compounded over an accumulation period of 15 years, I’d wind up with just shy of $900k in total investment assets.

Do you mean 7% real growth (after inflation) or 7% before inflation? I think 7% real growth is not likely given today's valuations. Sorry, I know that's not what you want to hear. I'm hoping for 4-5% real growth over the long term. Also, don't forget to budget for the taxes you'll pay, especially if you keep a lot of this money in non-tax-favored accounts. If you are lucky enough to accumulate that $900K in 15 years and it keeps earning 7%, and you earn $50K in military pay that year, you'll owe about $16K in federal taxes (married, standard deduction). Basically, as you accumulate more, it becomes harder and harder to pay the taxes using your military pay AND keep saving a big chunk of your paycheck. That's another reason to put a large slice of this money into tax-favored accounts.

 

[Joshua]

The TSP has special significance--you will not find a lower cost way to invest in equities.

That's true enough. I guess it just gives me the creeps to give my money to a place that won't let me have it back without jumping through hoops. That's not really a solid basis to plan an investment strategy on, though.

Do you mean 7% real growth (after inflation) or 7% before inflation? I think 7% real growth is not likely given today's valuations.

You're probably right that 7% real growth would be hard to hit. And as for what I want to hear... I'd rather hear something that realistic that makes sense now than get caught with my pants down later! If it honestly turns out that I can't get what I need with the likely rates of return, then I'll have to make plans to either lower expenses, raise capital, or get other income streams coming in.

Maybe the 7% was before inflation (I haven't looked at this calculation set in afew months ), which makes the whole thing slightly skewed and lower in terms of "real" future dollars. Government paychecks tend to increase at least a bit each year in partial compensation for inflation, so my contributions can scale up a little each year to help offset that, but yeah, it may be that my "real" growth from investment returns, as you stated, will only be about 4-5%, in which case I'd be looking at something closer to $740 or less in total investments by the time I clocked out.

If you are lucky enough to accumulate that $900K in 15 years and it keeps earning 7%, and you earn $50K in military pay that year, you'll owe about $16K in federal taxes

Mmm, a few thousand more than I had guessed off the top of my head, but I don't doubt it's a reasonable estimate. And yeah, you're right. The way taxes increase with each jump in income is annoying. If I raise my tax calcs by a few thousand and drop the growth estimate down to 4-5% to account for inflation, it slows things down to the point where return from investment holdings only comes out to a little bit more than your taxes.

Hmm.

Maybe I need to rearrange a few assumptions. Thanks for the food for thought.

Joshua

 

[pb4uski]

What is TSP? Military version of a 401k?

I think 401k/IRAs are the way to go in that the tax benefits are good since your marginal tax rates and therefore the tax deferral advantage, is higest during your working years and even witht eh uncertainty with respect to tax rates I still expect my tax rate to be much lower in retirement. I also have my tax defered accounts all in fixed income, which extends that advantage.

7% nominal long term return isn't an unreasonable assumption; I think I'm using 6% but if I look at the long-term average return given my AA of 60 equities/40 fixed it is 8.7% and I've lopped off 2.7% to be conservative (probably too conservative).

It would seem that if you have $585k in taxable accounts at age 45 that you could plan to take out $20k annually adjusted for inflation without breaking a sweat since it is only a 3.4% withdrawal rate.

 

[samclem]

What is TSP? Military version of a 401k?

Yes, it's a 401K-like program open to US Government employees and military members.

. . . if I look at the long-term average return given my AA of 60 equities/40 fixed it[-] is[/-] was 8.7% . . .

(my edit in bold) Like they say, "past performance is no guarantee of future returns." The US has had a very good run over the last 90 years, incredible by historical standards and helped by some fairly unique events. Maybe that will continue, but it seems a lot to bet on. One could bet on various foreign stock markets to be the "new US", but you'd be in uncharted territory.

 

[pb4uski]

<snip> Like they say, "past performance is no guarantee of future returns." The US has had a very good run over the last 90 years, incredible by historical standards and helped by some fairly unique events. Maybe that will continue, but it seems a lot to bet on. One could bet on various foreign stock markets to be the "new US", but you'd be in uncharted territory.

Agree - that's why I've scaled it down to 6% in my planning projections - I'm skeptical that the future will be that good.

 

[Joshua]

What is TSP? Military version of a 401k?

That is pretty much what it is. If you are a civilian employee, the government makes some matching contributions to your TSP, but Military users of the program don't get that benefit. That is kind of disappointing, but it still has the benefits of a normal tax deferred account, plus the fact that the funds available to hold in it, while limited to only a few different types, have almost untouchably low expense ratios compared to other, similar types of offerings.

I think 401k/IRAs are the way to go in that the tax benefits are good since your marginal tax rates and therefore the tax deferral advantage, is higest during your working years

Yes. Military pay is kind of a weird mix between normal, taxable income and non-taxable allowances and other forms of compensation, so the difference isn't quite as dramatic as otherwise, but it's still an issue.

7% nominal long term return isn't an unreasonable assumption; I think I'm using 6% but if I look at the long-term average return given my AA of 60 equities/40 fixed it is 8.7% and I've lopped off 2.7% to be conservative (probably too conservative).

Ok, I'm not that far off, then - based, as some wisely point out, on PAST performance, which is not always the same as future performance.

It would seem that if you have $585k in taxable accounts at age 45 that you could plan to take out $20k annually adjusted for inflation without breaking a sweat since it is only a 3.4% withdrawal rate.

Yes, I probably could, at that. I guess it's just a question of whether I could grow that much in a taxable account. That is, if the return rate would support it and if the taxes would slow it down too much. Does anyone know if there is a spreadsheet or calculator somewhere that will help me to compare the performance? Or do I just need to go look up tax tables and rough out the figures to see what the difference in growth would be? (I guess I need to do a little reading on capital gains taxes.)

Joshua

 

[Nords]

While maxing your TSP & Roths may seem to be vacuuming your entire paycheck for now, in a few more years you'll have enough pay to be able to max them all and still have cash left over for taxable accounts.

And of course when you start shoveling up those those big officer bucks, why then you'll just be wallowin' in the dough.

Seriously, though, maxing the TSP & Roths at the beginning of your career gives you the compounding advantage later in your career. Your spreadsheet for future savings could include some reasonable predictions for pay & promotions, and I can confidently predict that both will rise faster than the IRS will raise the TSP/Roth contribution limits. Once you exceed those limits, then that's when you'll start putting money into taxable accounts (or into real estate) and living off taxable accounts (and rent) until you either reach 59.5 or do a 72(t).

Look at it from the other direction. If you can't save more money than the TSP/Roth limits for at least the back half of your military career, then by the time you retire you won't have enough assets or income to ER and you'll be getting a real job (with or without the haircut).

Here's some rough numbers on savings rates vs years to financial independence:
How many years does it take to become financially independent? | Military Retirement & Financial Independence
and on Wed 16 March I'll put up one on saving the pay raises, promotion raises, and longevity raises. (Thanks to SamClem for suggesting the topic!)

So either way you want to ensure that you max your TSP/Roth contributions while the maxing opportunity is there.

Or do I just need to go look up tax tables and rough out the figures to see what the difference in growth would be? (I guess I need to do a little reading on capital gains taxes.)

You might already be aware of this: it's cap gains or dividends from taxable accounts, but TSPs & Roths are considered to be all income.

One more piece of anecdotal advice: Many of the military members on this board who have started saving for ER early in their careers have found that they have more than enough when they ER. The reasons for this pleasant surprise seem to be that they plan pessimistically and have very cheap thresholds for entertainment. But I don't have any long-term data to back up that assertion. Yet.