"Two pots of money" approach to determine withdrawal rates?

[halcyonmind]

I have what is likely a basic question: should I be thinking of "two pots of money" when determining a withdrawal rate, vs. looking at my assets as a single lump sum?

Let me explain:

1) Many books and sites I have read tend to think of retirement assets as a single entity from which you determine your SWR. However, present company excluded, most of these resources tend to think that retirement begins at 65 (or at least post 59 1/2) when tax-advantaged accounts can be accessed with no penalties.

2) I plan to (mostly) retire well before that, as does pretty much everyone else on this site. Yet we all are investing in tax-advantaged retirement accounts, because we all hope we will one day reach the penalty-free age and will put that money to use (or will have adopted all sorts of fancy footwork to access it sooner penalty-free).

3) When I see SWR calculations/estimates/guesstimates on this site, there appears to be a tendency to continue to think of all assets as a single entity, yet (aside from the fancy footwork), I really have two "pots of money": one pot that can be accessed without penalty at any time, and one pot that is age-restricted. By calculating a SWR on the aggregate but only tapping assets in the first pot, there is a more than decent chance I will be drawing that pot down faster than it is replenishing itself (though the overall portfolio will continue to grow, because neither I nor the taxman is touching the second pot for now).

4) So here's the real question: shouldn't I be determining a withdrawal rate based on the value of the first pot (non-restricted), accepting that the rate is likely higher than a traditional definition of SWR (e.g., one that does not draw down capital over time) for that pot but knowing that I will eventually have access to the age-restricted pot (at which point I would indeed shift to a perpetuity-oriented, SWR strategy for the second pot)?

To put it in the extreme: why shouldn't I opt to spend the entire value of the first pot between now and the penalty-free years, knowing that by the time that first pot runs out, I will be able to access the proceeds of the tax-advantaged accounts (that have been growing all the while)? I could go super conservative and place that first pot into a guaranteed return instrument (even as basic as CDs), essentially just dividing the pot (plus interest) over the years between now and penalty-free access to the second pot.

The main reason I think this is a basic question is that calculating SWR off of all assets may essentially accomplish that faster draw down of the first pot of money, depending on your circumstances (such as when the current value of your tax-advantaged accounts is substantially greater than the current value of your other assets). Therefore, others appear to be implicitly assuming a drawdown of the first pot, which could make their SWR calculations potentially more aggressive than they realize.

I am likely missing something major here, so please do share your thoughts.

[innkeeper77]

The main point that you are missing is that there are"backdoors" to get money out prior to 59 1/2. The most popular is the roth conversion pipeline, where you can roll money over from an IRA or 401k, pay minimal taxes, let it sit for 5 years, and take it out. Therefore, you can transfer a years worth of expenses over to a roth every year, and take it out 5 years later. Ideally, you would start this 5 years before quitting your job..

https://forum.mrmoneymustache.com/investor-alley/roth-conversion-ladder-question/
https://forum.mrmoneymustache.com/ask-a-mustachian/help-me-understand-the-roth-conversion-pipeline-idea-and-its-benefits/

[arebelspy]

Sure, that works fine.

That's strategy 1, here: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

You're making your retirement money your "old man/woman" money, then making a bucket to get you to that age.

It's fine, it's just suboptimal in terms of ERing as fast and efficiently as possible (because, presumably, you'll have to start funding taxable after awhile, and won't get the tax savings you could if you Roth Pipelined or 72t'd).

[mozar]

Ok, I don't understand this. Where would I put all my money then? I can only put so much in my 401k.

[nereo]

Ok, I don't understand this. Where would I put all my money then? I can only put so much in my 401k.

Well, most people choose to use a combination of their 401(k), IRA, HSA, and then taxed savings accounts (usually index funds, sometimes with some bonds) and/or paying down mortgages .  You are allowed $17.5k in a 401(k), $5,500 in a tIRA or ROTH IRA, and $3300 in an HSA under most circumstances.  That's $26,300 in tax advantaged accounts for 2014.  If you are maxing those out you're already on a short-track to FIRE.  There's no limit to how much you can contribute to taxed savings accounts or how fast you can pay down a mortgage.

[arebelspy]

Ok, I don't understand this. Where would I put all my money then? I can only put so much in my 401k.

Generally you put as much as you can into tax advantaged, then start looking at other vehicles.  The advice is for those people who decide not to max tax advantaged because they fear (or are unsure of how) accessing it early without penalty.

If you're maxing all your eligible 401ks, 403bs, 457bs, IRAs, HSAs, yadda yaddas, then by all means start on your taxable investments next.

[Exflyboy]

The only disadvantage I see with the 401k to Roth say is the fact that even though the conversion will be taxed at zero percent (if you stay in the 15% tax bracket) , the net effect on your income will mean that you will get less on the ACA heathcare subsidies.

If I am correct in how that works.

Like you I am taking the "two pot approach".. I.e draw down the after tax savings first based on about 3% of the total of the two pots.. This would be roughly a 5% drawdown of the after tax stuff.

but then.. the pretaxed savings wont be touched at all so the net effect is the same as if it was in one large pot at a 3% WR.

Frank

[Emilyngh]

The only disadvantage I see with the 401k to Roth say is the fact that even though the conversion will be taxed at zero percent (if you stay in the 15% tax bracket) , the net effect on your income will mean that you will get less on the ACA heathcare subsidies.


Frank

Unless you live in a state that hasn't expanded medicaid (and doesn't by the time you retire).   Then, it actually may enable you to qualify for any subsidy at all.   Eg, if your income is below the poverty level when one retires, if in a non-medicaid expanded state, you fall between the cracks and qualify for $0 in subsidies.    In this case, conversion money could bring your income up to qualifying for a subsidy.

[Silverwood]

So I thought this was an interesting topic. I was trying to figure my pension out at work as at 25 years I'll only be 47 and to reach early retirement I'll have to put in 39 years. Hell no. If I want to receive it earlier I lose 1/3. So my plan right now is to get my mortgage paid off and max out my tfsa/rrsp.  Then I'll have enough set aside so that any job I have is something I enjoy. So my first pot would have to have enough to last me till I access my second pot. 

[George_PA]

halcyonmind, I agree with you in that this is how I see it too, as two pots each with its own withdraw rate.  This makes more sense to me because it matches with how investments actually work in the real world.

Please keep in mind, that among mustachians there is basic two basic schools of thought: 

(1) treat the 401k-type investments (age restricted funds) as old man/old woman money; thus, you have 2 pots, regular investment funds are used to bridge the gap until you reach 59.5 years of age

(2) utilize a IRA roth laddering scheme; this is a type of hack or loophole to exploit the tax code rules to tap into 401k type investments before age 59.5

ARS points out a good MMM article about this where he covers the different strategies.

For strategy (2), right now it will get you to FI sooner, however I would not be surprised if congress changes the rules to shut down this option in the future.  The US government, in general, probably does not like their retirement programs being used for withdraws before 59.5 and plus they don't like people retiring early in general (the less you work, the less income taxes and payroll tax they can collect from you).  Tax rules are often changed and adjusted to maximize government income.

For my situation, I plan on using strategy (1) with 2 pots (here is a diagram of how it works): 


I am 33 years old now and planning FIRE for age 40.  IMO, with Pot 1 (Regular investments), you can get a bit more aggressive with the withdraw rate.  If you look at the trinity study data, you could possibly go up to 7% reasonably with your withdraw rate for pot 1 money only (under some scenarios you may run pot 1 into the ground right when you can access pot 2 to live off of).   I made a forum posting about this called "Anybody else ok using an aggressive 7% withdraw rate?" (https://forum.mrmoneymustache.com/investor-alley/anybody-else-ok-using-an-aggressive-7-withdraw-rate/)
Personally, I found it frustrating when mustachians talk about retirement money as a single entity.  I think they probably do this either because they are oversimpliying things, or they are using the roth laddering strategy.