Author Topic: Where does FI stache come from?  (Read 5226 times)

lwhorton

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Where does FI stache come from?
« on: January 10, 2015, 07:18:02 PM »
I cheated, I actually have two questions in this post...

1) I have read through a large chunk of the blog, asked a few questions on the forum, done a lot of math, but something pretty important is still not clear to me; where does the money come from to gain Financial IndependenceŽ before reaching into retirement accounts?

I am a very lucky person to have the fortune of making $103500 a year (if you go to college today for anything but a CS degree you are missing out). After taxes I gross 70k. My current spending is about 31k a year. My savings rate is therefore ~56% of my gross income at 39k a year. But obviously the first 18k of this income goes to my 401k Trad. The next 5500 to a Roth IRA (not married, so no point in Trad IRA due to income limits on deductibility). That leaves me with 15.5k of 'raw cash' that I am putting into a fairly risk-tolerant Betterment fund.

All the examples in the blog post say something along the lines of "save 25x of annual spending and you are good to become FI". This figure surely can't include 401k/IRA accounts, right? You obviously can't draw on those until much later in life. That means the only real 'lump sum' of cash from which to withdraw is the 15.5k saved per year. Say I worked 15 years (more than I want to work) and was able to maintain the same salary with the same 'raw cash' savings, I wouldn't get anywhere near my "25x annual spending". Perhaps I'm misinterpreting the strategy, or I got lost in the details, but I thought the goal was to gain FI as soon as your RoI became higher than your annual spending. How can I possibly get a 232.5k (15.5k * 15yr) investment to throw back the 31k in annual spending? The dividends at 5% off that lump would offer ~12k, leaving a 19k gap to cover during 'FI', which to me seems more like a full-time job than an 'on the weekends, for fun' income.

2) Related to the concerns above, can anyone show me some math between Roth and Trad 401k? I know the whole point is to reduce your tax burden now while earning high now, and pay a much lower rate when drawing out relatively little money... but if we are aiming to live entirely off returns (especially after 59 1/2 when we have a much larger lump sum generating returns), is it not smarter mathematically to pay $0 on the growth of that investment? Or does the tax savings now outweigh the tax savings on the gains?


Many thanks for anyone who takes the time to read or respond.

deborah

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Re: Where does FI stache come from?
« Reply #1 on: January 10, 2015, 07:34:08 PM »
There are so many posts on this topic that even I (an Australian with no interest in the complexities/stupidities of the US system) know the answers. You CAN access all of your 401ks and IRAs... early if you do something called the Roth pipeline. This is explained here - http://www.madfientist.com/retire-even-earlier/

shuffler

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Re: Where does FI stache come from?
« Reply #2 on: January 10, 2015, 08:15:21 PM »
I thought the goal was to gain FI as soon as your RoI became higher than your annual spending.
I can't tell if you're talking about the ROI on your entire portfolio (including 401k/IRAs), or just the taxable/raw portion of your portfolio.
But no, if you retire "as soon as your ROI became hire than your annual spending", then you'd be setting yourself up for failure in a bear market.  Your ROI would be lower, and you'd reduce your stache, leaving it unable to support the level of withdrawal you started at when you retired.

The point is that you need a buffer between your ROI and your spending.  How much buffer is up to the individual, but we commonly talk about a 4% withdrawal rate, while at the same time assuming a 7 or 8% real-return from the market.

... if we are aiming to live entirely off returns (especially after 59 1/2 when we have a much larger lump sum generating returns), is it not smarter mathematically to pay $0 on the growth of that investment?
The Mad Fientist post is great and you should read it first.
Then you should think about the structure of capital-gains taxes.  If you're intending to live on $31k/year (to use your current expenses), and you sold $31k of long-term qualified stock to fund your life, then you'd owe $0 in taxes.  This is because at $31k of income you'd be in the 15% bracket (without even considering any deductions, just to make this easy), and the cap-gain tax rate would be 0%.

So in that situation, you could contribute to a t.IRA and get the tax break now, as well as paying no tax later when you sell the stock during your retirement.  Best of both worlds.

lwhorton

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Re: Where does FI stache come from?
« Reply #3 on: January 10, 2015, 08:41:55 PM »
The point is that you need a buffer between your ROI and your spending.  How much buffer is up to the individual, but we commonly talk about a 4% withdrawal rate, while at the same time assuming a 7 or 8% real-return from the market.

I was referring to the 401k/IRA. Is this 4% the rate at which you use the Roth conversion ladder, so that the original 401k/IRA can continue to grow (assuming 7/8% real returns) while still funding a withdraw-able account off returns?

So in that situation, you could contribute to a t.IRA and get the tax break now, as well as paying no tax later when you sell the stock during your retirement.  Best of both worlds.

I am beyond the Traditional IRA income limits to deduct contributions. That aside, I feel like I still have to use a no-longer-deductible tIRA so that I can setup the conversions at a later point, no? Nevermind, it seems to be too late at night to think clearly. I can simply open a tIRA when rolling over the 401k, then start the pipeline from that tIRA. The rIRA I currently have just becomes 'extra'.

Once again, your discussion is much appreciated.
« Last Edit: January 10, 2015, 08:48:25 PM by lwhorton »

CopperTex

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Re: Where does FI stache come from?
« Reply #4 on: January 10, 2015, 09:04:33 PM »
On the blog MMM suggests using your 401k as your "old person money" to get you through 59.5 --->RIP. Then have a separate stash that will last from the time you RE until 59.5.

lwhorton

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Re: Where does FI stache come from?
« Reply #5 on: January 10, 2015, 09:19:40 PM »
On the blog MMM suggests using your 401k as your "old person money" to get you through 59.5 --->RIP. Then have a separate stash that will last from the time you RE until 59.5.

That is how I interpreted the blog too, rather than the 401k->Roth pipeline described above. I just don't understand how to get such a large stash that isn't 401k/IRA if I'm already socking away such a large amount into "old person money". I suppose reduce spending... somehow. My current 31k spending a year is already pretty darn slim around the Baltimore/DC area. Even so, assuming I could chop off another 10k in spending, that would put me at 382.5k after 15 years, still not nearly enough to provide 'gains only' living. MMM seems to  not even touch the principal on his taxable accounts or his retirement accounts (the blogpost on a treadmill pushing forward, versus a debt-mill pulling you back), I just don't see how.

MDM

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Re: Where does FI stache come from?
« Reply #6 on: January 10, 2015, 09:52:32 PM »
2) Related to the concerns above, can anyone show me some math between Roth and Trad 401k? I know the whole point is to reduce your tax burden now while earning high now, and pay a much lower rate when drawing out relatively little money... but if we are aiming to live entirely off returns (especially after 59 1/2 when we have a much larger lump sum generating returns), is it not smarter mathematically to pay $0 on the growth of that investment? Or does the tax savings now outweigh the tax savings on the gains?
One of the more math-heavy posts I've seen is this: http://www.bogleheads.org/forum/viewtopic.php?f=10&t=140758.  It ignores some of the IRS-imposed limits on when one is allowed to contribute to what, but otherwise it looks correct.

I think I understand what's being said there - if there are parts that don't make sense, let us know. 

Of course the math is one thing, but the assumptions one makes about current vs. post-retirement tax brackets and overall tax rates are critical.  Much of the disagreement about "which is better?" has more to do with assumptions than with math.

shuffler

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Re: Where does FI stache come from?
« Reply #7 on: January 10, 2015, 10:17:13 PM »
On the blog MMM suggests using your 401k as your "old person money" to get you through 59.5 --->RIP. Then have a separate stash that will last from the time you RE until 59.5.
I just don't understand how to get such a large stash that isn't 401k/IRA if I'm already socking away such a large amount into "old person money".
I think you guys are referring to this post:  http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/
... in which he lists that as one of 3 strategies.  The second strategy happens to be the "Roth Pipeline".  So it doesn't seem to me that MMM has a preference of one over the other.  (Not that it really matters what he thinks, of course.)

Maxing out your tax-advantaged accounts and using the Roth Pipeline is a good thing, because, well, it's tax-advantaged.  You don't have to use the Roth Pipeline of course, but you're likely to have to work harder/longer to achieve the same result in a tax-disadvantaged account.

Assuming I could chop off another 10k in spending, that would put me at 382.5k after 15 years, still not nearly enough to provide 'gains only' living.
I wouldn't focus overly much on 'gains only living'.  The market will have up years and down years.  It's kind of hard to live on gains during the years in which you lose money.  So accept that sometimes your investments will make more than your cost of living, and other times your investments will make less than your cost of living.  No big deal.  What you want is for your portfolio to survive the long term.  Look at planning tools like http://www.cfiresim.com to get a feeling for whether your stache is likely to support your cost of living.  IMO, running scenarios there provides a much deeper understanding than simply adhering to ballpark rules like "4%" or "Gains Only".

bigalsmith101

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Re: Where does FI stache come from?
« Reply #8 on: January 11, 2015, 02:28:25 AM »
As we seem to be in agreement that the 401k and IRA are "old person" money. The question at hand is to determine HOW much is enough to invest in your 401k and IRA.

SCENARIO #1:
If you're 25 now, and you put 23.5k in your 401k/IRA every year for 10 years at 7% growth, you'd have $347k in the accounts by the age of 35. If you stopped investing in your 401k/IRA at age 35, by the time you hit 57.5, you'd have $1.88million in those investments, not included Social Security.

Meanwhile with $15.5k invested annually in your other accounts, you've amassed $229k in your short term accounts. Or roughly 7.5 years expenses.

Obviously 1.88m in your old person account is too much. You've invested too long into your 401k and IRA accounts.

So, SCENARIO #2: A more short term Example.
You only invest in the 401k/IRA at $23.5k for 4 years, and your investments reach $111k. You stop investing in your 401k/IRA at age 29 and by the age of 57.5, the investment reaches $844k. A safe withdrawal of 4% is $33,760.  You've secured your old person fund in 4 short years or working. Compounding interest does the rest.

Meanwhile you've invested $15.5k for 4 years, and 39k for the following 6 years. After ten years of investment in your "young person" investments, you've amassed $410k. 13 years of expenses, and your 35yrs old.

Option #1: At this point, with a return of 7%, you could begin withdrawing $32,880 from your young person investments, each year until age 58, when your 401k and IRA become available. You're young person investment balance would drop each year, but you'd run out just in time for old age retirement to kick in. RISKY

Option #2: You now find yourself with an income stream of 16k annually, and expenses of 31k. You only have to earn $15k a year to maintain your current standard of living in your part time retirement. And your investment balance would remain stable. Of course, with a current annual net income of $70k, this represents only 2.5 months of full time work. Or 400hrs of work. Or 8 hours of work a week. 1.6 hours a day... Annually. And when you hit 59.5, you'll never have to work again. Less RISKY

Option #3: You stop working full time at 35, and work 5 years longer at part time instead. You now net $35k instead of $70k. Enough to  cover your full annual expenses while letting your young person 'stache' continue compounding. 5 years later and your young person stache grows from 405k to 568k. Essentially 20 years of expenses if you cut back a bit, and you retire. You're now 40 and 20 years later your 58. At which point you start withdrawing from your 401k/IRA. LEAST RISKY. You'd have to forgo earning any money (hard to believe).

That represents 10 years of full time work and 5 years of part time work to bring yourself to full retirement. And you'll be rich!

Of course, you're a single individual. MMM was working for many years from with the Dual Income No Kids arena, often times contributing over $100k annually into his investments, not including his compound growth. His joint income near the end of his career approached $200k. All while sharing expenses with his wife. You're along in your boat and you have to power the oars yourself. It's a longer battle.

Also, this assumes your earnings don't ever increase, you never marry, you never have children, your savings don't increase, inflation is nullified, and your investment returns remain stable. You could easily earn more in the future, meet a partner, etc and be further along than anticipated, or invest poorly and have to work longer.

The main thing is to find the break even point with your investment portfolios so as to ensure the earliest possible comfortable retirement date.

« Last Edit: January 11, 2015, 03:19:01 AM by bigalsmith101 »

MDM

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Re: Where does FI stache come from?
« Reply #9 on: January 11, 2015, 03:56:31 AM »
As we seem to be in agreement that the 401k and IRA are "old person" money. The question at hand is to determine HOW much is enough to invest in your 401k and IRA.

SCENARIO #1:
If you're 25 now, and you put 23.5k in your 401k/IRA every year for 10 years at 7% growth, you'd have $347k in the accounts by the age of 35. If you stopped investing in your 401k/IRA at age 35, by the time you hit 57.5, you'd have $1.88million in those investments, not included Social Security.

Meanwhile with $15.5k invested annually in your other accounts, you've amassed $229k in your short term accounts. Or roughly 7.5 years expenses.

Obviously 1.88m in your old person account is too much. You've invested too long into your 401k and IRA accounts.
...
The main thing is to find the break even point with your investment portfolios so as to ensure the earliest possible comfortable retirement date.
Assigning labels of "old person" and "young person" to investment money can lead one down incorrect paths.

E.g., why ignore a Roth IRA Conversion Ladder in the above scenario? See http://www.madfientist.com/retire-even-earlier/.  With that option, it is not at all obvious that you have put too much in your 401k and tIRA accounts.

The last sentence quoted above does make good sense.  For a given income and living expense, however, minimizing the tax bite is the way to maximize available funds and "ensure the earliest possible comfortable retirement date."

morning owl

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Re: Where does FI stache come from?
« Reply #10 on: January 11, 2015, 04:33:18 AM »
Does anyone know, or can you point me in the direction of a post that answers this in canadian terms?

I'm currently maxing out my TFSA, and putting very little into my RRSP, because I can't access ithe RSP until I'm 71. I'm also curious how to calculate the SWR when my savings are divided into these separate accounts? Do Canadians here who invest heavily in their RRSPs plan to convert them early to RRIFs? Or is it best to save into tiers based on age... I.e. Using TFSA and taxable accounts to fund the first stage of ER, and the RSP to fund the second stage?

KMMK

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Re: Where does FI stache come from?
« Reply #11 on: January 11, 2015, 06:38:23 AM »
Does anyone know, or can you point me in the direction of a post that answers this in canadian terms?

I'm currently maxing out my TFSA, and putting very little into my RRSP, because I can't access ithe RSP until I'm 71. I'm also curious how to calculate the SWR when my savings are divided into these separate accounts? Do Canadians here who invest heavily in their RRSPs plan to convert them early to RRIFs? Or is it best to save into tiers based on age... I.e. Using TFSA and taxable accounts to fund the first stage of ER, and the RSP to fund the second stage?

It's quite different in Canada. We can withdraw from our RRSPs at any age; you just have to pay the taxes and you lose the contribution room forever.  My understanding is the forced converting to RRIF is only because the government wants those taxes. There's no reason to convert early, other than to equalize your tax burden over multiple years. I think converting RRSP to TFSA will be more what I'm doing. Since you'll have new TFSA room every year. My strategy will be based on what income I need, current tax rate and percentages of the account types. There are lower taxes when you are older (65?) so I'll use taxable first, then TFSA then RRSP with more TFSA younger and more RRSP older.

boarder42

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Re: Where does FI stache come from?
« Reply #12 on: January 11, 2015, 07:02:14 AM »
just use the roth pipeline or SEPP 72t.  not using the tax advantaged accounts can lead to many years of extra work before you acheive FI.  at 56% savings rate you should be building a solid taxable account right now anyways.  Also you should look into an HSA if you dont have one already.  i max 2 401k's 2 Roth IRAs and an HSA then we have about 15k we put into taxable annually.  this is 2 engineers salaries.  but the more you save in taxes the more you can sock away. 

morning owl

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Re: Where does FI stache come from?
« Reply #13 on: January 11, 2015, 07:30:31 AM »
We can withdraw from our RRSPs at any age; you just have to pay the taxes and you lose the contribution room forever.  My understanding is the forced converting to RRIF is only because the government wants those taxes. There's no reason to convert early, other than to equalize your tax burden over multiple years. I think converting RRSP to TFSA will be more what I'm doing. Since you'll have new TFSA room every year. My strategy will be based on what income I need, current tax rate and percentages of the account types. There are lower taxes when you are older (65?) so I'll use taxable first, then TFSA then RRSP with more TFSA younger and more RRSP older.

Do you mean that you'll withdraw from your rrsp early every year to move money into your TFSA? If you do this, you'd have to pay 10% tax on any amount withdrawn that's $5000 or less, and 20 or 30 percent over $5000, PLUS whatever taxes you would owe by adding this to your income. That's a pretty hefty penalty. I haven't worked out the math but wonder if it would be worth doing that vs. contributing to a taxable account instead, and minimizing RSP contributions? (In my case my income is relatively low so I don't really get the benefits of the contribution, plus my RSP is sizeable enough that it would be enough to live on in my 71+ years when I'm forced to convert it to RRIF, especially if I just let it grow and compound for 30 yrs.)

I'm also curious how you would calculate FIRE possibility, if one account is pretty hard to access until old age. I personally would avoid dipping into the RSP at all, unless it's an emergency, and hopefully wouldn't need to reach that point. I guess you'd just ignore the retirement account and calculate 4% of what's in the taxable and TFSA accounts?


KMMK

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Re: Where does FI stache come from?
« Reply #14 on: January 11, 2015, 08:59:11 AM »
We can withdraw from our RRSPs at any age; you just have to pay the taxes and you lose the contribution room forever.  My understanding is the forced converting to RRIF is only because the government wants those taxes. There's no reason to convert early, other than to equalize your tax burden over multiple years. I think converting RRSP to TFSA will be more what I'm doing. Since you'll have new TFSA room every year. My strategy will be based on what income I need, current tax rate and percentages of the account types. There are lower taxes when you are older (65?) so I'll use taxable first, then TFSA then RRSP with more TFSA younger and more RRSP older.

Do you mean that you'll withdraw from your rrsp early every year to move money into your TFSA? If you do this, you'd have to pay 10% tax on any amount withdrawn that's $5000 or less, and 20 or 30 percent over $5000, PLUS whatever taxes you would owe by adding this to your income. That's a pretty hefty penalty. I haven't worked out the math but wonder if it would be worth doing that vs. contributing to a taxable account instead, and minimizing RSP contributions? (In my case my income is relatively low so I don't really get the benefits of the contribution, plus my RSP is sizeable enough that it would be enough to live on in my 71+ years when I'm forced to convert it to RRIF, especially if I just let it grow and compound for 30 yrs.)

I'm also curious how you would calculate FIRE possibility, if one account is pretty hard to access until old age. I personally would avoid dipping into the RSP at all, unless it's an emergency, and hopefully wouldn't need to reach that point. I guess you'd just ignore the retirement account and calculate 4% of what's in the taxable and TFSA accounts?

That's a common misconception, but there is no extra tax on withdrawals. That is just what the bank must withhold for you, same as your employer does. You do a tax return like normal, figure out what actually owe and may get some or all of your withheld taxes back. So if you can live really cheaply on like 10,000 that won't even be taxable. The bank will probably give you 8000 when you withdraw 10000 but you'll get that 2000 back as a tax refund.
Again, other than GICs and pensions you can use any of your RRSPs and TFSA at any time.

wtjbatman

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Re: Where does FI stache come from?
« Reply #15 on: January 11, 2015, 09:38:12 AM »
I don't think enough emphasis has been put on how easy it is to access tax advantaged accounts once you retire. The two big methods are Roth Pipeline and SEPP/72(t). Roth Pipeline is big around here and with the Mad FIentist, let me talk about SEPP (substantially equal periodic payments) quickly.

It could be as simple as, you retire @ 45yo, roll your 401k over to an IRA, then tap the IRA with SEPP. Once begun you must continue those payments for 5 years or until you're 59 1/2, whichever is longer. The withdrawal rate depends on life expectancy and an interest rate that you can find at the IRS website, but in today's rate environment around 3% is realistic. Assuming you're following a 4% SWR, that means you would only need to withdraw 1% from your taxable accounts until 59 1/2 when you could then switch to withdrawing entirely from tax advantaged accounts.

The biggest "risk" to SEPP is you don't control the payments. Once you begin accessing an account with SEPP, you must continue withdrawing from that account until you reach the above milestones. Drawing down your account because the market tanked a year after you started SEPP? Too bad, gotta keep withdrawing from it. That said, with SEPP you're not likely to exceed a 4% withdrawal rate anyway, so I'm not as concerned about that. I expect my investments to return much more than that over time. And any account I start SEPP with will be properly diversified into both stocks and bonds.

morning owl

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Re: Where does FI stache come from?
« Reply #16 on: January 11, 2015, 10:45:45 AM »
@Kestra -- good to know! I didn't understand it that way. This changes things a little. Thank you!