If you have already been planning for early retirement, you are probably well versed in strategies to accumulate wealth on a tax advantageous basis. As you move further along this accumulation path successfully, the desire to exit the workforce can become overwhelming. Once one is used to saving a large percentage of their income, it becomes imperative that they transition to a withdrawal strategy as they plan on pulling the plug on full-time employment. This article will detail the what, when and why of our unique draw-down strategy.
Skipping the Roth ladder
Some of you already reading this may be familiar with the Roth conversion ladder. Under this strategy, one converts traditional IRA’s into Roth IRA’s, pays taxes in full on the conversion in the current year, and withdraws the principal tax-free in year six (after a five-year waiting period). While this is a popular method, we have determined that it’s not one we are going to use for our early retirement.
In addition to current taxes paid on a Roth conversion, I would need to estimate the taxes I will owe in five years and make additional conversions to meet that liability.
Consequently, the withdrawals needed to pay current and future Federal taxes under this strategy are somewhat substantial. All of the first five-year living expenses, in a Roth conversion scenario, would need to be withdrawn from our taxable investments, which I view as our most valuable wealth. There is 0% tax, along with no age based restrictions, for locking in gains and withdrawing cash from a taxable investment account.
Embracing the 10% early withdrawal penalty
What if we simply skipped the Roth ladder strategy altogether? Assuming we had enough cash in taxable investments, we could live off the investment income those taxable investments produced for the next 14 years (age 41-55). Alas, we don’t have that much money in taxable investment accounts. Therefore, we are going to implement a hybrid penalty/taxable investment withdrawal strategy.
The hybrid approach works like this. Figure out what our 0% Federal tax bracket is for our filing status, and make IRA withdrawals (with 10% penalty) up to the top of this allotment. Above this allotment, make withdrawals, taxed at 0%, from our taxable investments.
Let’s take a look at what our 2018 strategy might be under this scenario. We are married filing jointly, with two children. Therefore, our 0% tax allotment looks like this next year:
Standard Deduction: 13,000
Personal Exemptions (4) 16,600 (4150 X 4)
Tax loss carry forward 3,000
2018 tax-free allotment: 32,600
10% penalty tax owed on traditional IRA withdrawals (32,600 X 10%) = $3,260
Less Child tax credits (2) (2,000) (calculated as $1,000 X 2)
Net Federal tax owed $1,260
Since we aren’t doing any conversions in the next 14 years, we also don’t need to plan to pay future conversion taxes, either. Consequently, the only tax we owe for 2018 is $1,260.
Based on this information, let’s estimate how much we would need to withdraw from our investment portfolio in 2018.
Living expenses: 60,000
Federal taxes owed: 1,260
Total withdrawals: 61,260
An additional benefit of this strategy is that we will be able to preserve our taxable investments for a longer period of time. In year one of the hybrid strategy, we will only sell/withdraw $31,360 from our taxable investment accounts. This is significantly less than the Roth conversion ladder, which would have us withdraw a whopping $66,373 from our (most valuable) taxable investments.
Benefits to the hybrid penalty-taxable draw-down strategy
- Withdrawals tend to be lower in early retirement, resulting in the possibility for a higher net worth later on due to overall lower taxation levels.
- We have lower withdrawals from our taxable investments. Consequently, this should elongate the life of those assets. If we were to do a Roth ladder, all of our taxable assets would be needed for living expenses in years 0-5. Thus, our taxable assets likely wouldn’t last longer than five years.
- If our taxable investments decline in value, we have the flexibility to withdraw more funds from our penalty accounts. For example, the 10% Federal tax bracket is something we mostly won’t take advantage of right away (due to 10% tax plus 10% penalty = 20% on withdrawals). However, if our status should change, we have the flexibility to withdraw more at 20% Federal tax, and still come out ahead (most of our 401k/IRA deductions were at the 25% Federal taxation level). Employing such a strategy would certainly elongate the life of our taxable investments.
- Our children are only ages 6 & 8 as of today. By the time the oldest turns age 14, we will seriously need to consider financial aid eligibility for college. That’s only 6 years away. The advantage of using our taxable investments to fund our living expenses is only the capital gains (on sales) and dividends will count against us on the FASFA.
A word about tax reform and why I’m not sweating it
As of the time of this writing (October 2017), there is a lot of talk in Congress and the oval office about tax reform. The 0% tax on capital gains and dividends COULD BE at risk, or it’s not at risk. What I do know is this. Our income is low enough to qualify for free or reduced price lunches for our kids next year. The likelihood of our taxes significantly increasing is fairly low in the future. Even if a higher tax is implemented on cap gains and dividends for middle class income earners, we will probably have some offsets against this as well.
If tax law should change, our strategy will adjust to the law. We will plan accordingly for whatever happens. Retiring early is a risk to begin with, as is driving a motor vehicle.
Personally, I would rather rely on our strategy and investment income to support my family than putting all my eggs in employment at an “at will” employer that can fire me at anytime for any reason. Now THAT’s what I call risky.
What is your strategy for early retirement withdrawals? Do you plan on taking advantage of the Roth IRA ladder? If so, why? If not, why not. Please discuss further in the comments below. I’d be happy to answer any questions about our non traditional strategy.