Author Topic: 4% rule with two staches (ER stache & old money stache)? How to do it?  (Read 7374 times)

bigote2032

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Hello all Mustachians!

My first post! I spent 3 months reading all the blog posts and finished last week.  I have a ton of questions and trying to find answers in this forum.  Forgive me if these has been covered before (I am sure many times but either I am not good with the search feature or those posts are buried somewhere).  Feel free to point me to posts that cover this.

Small intro: 39 year old living in the Pacific Northwest, married, no children (and no plans to have) with a good job in tech in one of the top tech companies & side consulting gigs; looking to FIRE between 50 to 55 years old depending on how the market treats me (I might post a case study someday). I am not going to lie to you, I don't hate my job but I don't really like it, it's just a job and I'd rather be playing rock music (my hobby). Only planning of FIRE with index funds and 401k since don't have interest or knowledge about real estate.

Question 1: I am maxing out my 401K.  The rest of my savings about 55% to 60% of my after-tax salary is going to index funds.  I will probably have to live from my index funds investments until I am 59.5. How do you do this? If I take 4% of my index funds and they account for 50% of my stache, I run the risk of depleting my funds.  Taking 2% won't be enough to live.

Question 2: I don't see too much information on the blog on how to actually live on FIRE.  It focuses on preparing and saving for FIRE.  There is only a post where MMM discuses how to get your money.  It's basically by setting all your funds to send you a check for the dividends & capital gains and selling some funds.  Selling your funds is scary, you are selling your capital and this is what provides you your dividends and gains, am I missing something here?

I have more related questions but want to keep this short so I don't overwhelm you.

I will be glad to receive punches in the face, recommendations, feedback, jokes, kicks in the butt, etc.  But please, I don't want to waste your time so if there are posts addressing this specific questions that you think are worth the read, send them my way instead of elaborating answers.

This is such a great community and you guys rock helping each other out.  I REALLY appreciate your time and willingness to help and provide insight from your own experiences.

Best regards!

Bigote2032

JLee

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #1 on: November 09, 2017, 01:22:26 AM »
4% is from your entire portfolio. It doesn't matter if you'd run out of taxable accounts at 62 if you have a huge 401k.

Also, regarding accessing retirement accounts early: https://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

boarder42

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #2 on: November 09, 2017, 03:35:12 AM »
Are you just starting to save now ?  Bc based on your percentages you should be done way before 50-55 if you have any current invested assets.

I'd suggest posting an investment focused case study based on what you have and let some others help you with when you can be FI. When you retire is then up to you

Laura33

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #3 on: November 09, 2017, 08:24:45 AM »
First, the 4% is the figure you need to live on basically forever.  So having enough to draw 4% from you post-tax and then enough to draw 4% from your 401(k) means you have saved twice as much as you need.  All you need is enough pre-tax to draw down until you can access your 401(k) and IRA.

Second, that period is really only 5 years.  Look up "Roth pipeline" -- there are a bunch of posts here and elsewhere on that.  Basically, you roll your 401(k) over into an IRA, and then every year you convert part of your IRA into a Roth.  After 5 years, you can then draw from that Roth tax-free with no penalties.  So all you need post-tax is enough to get you through that first 5 years.

On post-FIRE, there is an entire section of the forum on that, so I'd suggest you start lurking there and see what you can learn.

Good luck!

ZiziPB

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #4 on: November 09, 2017, 09:29:59 AM »
Stop thinking about your money as two separate pots: ER stache and old money stache.  It's all one, money is fungible.  4% applies across the board, so effectively you may be withdrawing from your taxable at a higher rate, but at the same time, your tax advantaged accounts will be reinvesting dividends and distributions so they will be growing to compensate for the higher withdrawal rate from taxable.  Thinking about your money in separate bucket categories doesn't work well - it's much better to look at it as one bucket for purposes of asset allocation purposes, withdrawals, etc.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #5 on: November 09, 2017, 10:40:21 PM »
Thanks JLee, boarder, ZiziPB & Laura for your quick replies! :)

@JLee: Yes, I know all about the ROTH IRA ladder but would rather not go through that if I can avoid it.  Thank you anyway :)

@Boarder: No, I am not starting to save now, I have about 250K split around 50/50 401K/Index funds.  Yes, will work on a case study whenever I get some time, thanks!

@Laura: I am aware and have learned good stuff in post-FIRE forum but did not find specific answers to my questions.  Also aware about the ladder but not too excited about it if I can have other sources for early retirement like the index funds.  I have figured out the pre-FIRE stuff, most of my doubts and questions are about post-FIRE.  I have not found people that FIRED only with dividend/capital gains *only*.  It seems most of the folks have either a rental house or still work so there are no clear examples for my case.  I work in tech but my tech skills won't keep up for me to work on that field when I am older.  Really need extra assurance about living only from index fund returns.  Also will try to find more info about selling stock to cover expenses since for me is a very risky approach.  Thanks for your help!

@ZiziPB: You are right, that should be the way to look at it, I just think too much :) Great points about the 401K growing more while I withdraw from my other investments.  Thanks for your help!

MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #6 on: November 09, 2017, 10:59:54 PM »
Question 1: I am maxing out my 401K.  The rest of my savings about 55% to 60% of my after-tax salary is going to index funds.
Great plan.   Icing on the cake would be $5500/yr into a Roth IRA (I'm assuming you exceed the tIRA deductibility limit).  Might as well take advantage of tax-free growth of that amount in the Roth IRA instead of the tax drag it would incur in a taxable account.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #7 on: November 10, 2017, 08:24:12 AM »
Hi MDM - Yes, I have been thinking about ROTH IRA, I make too much money to contribute but conversion is an option.  I am planning on ER with about 40K  a year so I will be in much lower tax bracket so thinking that traditional 401k/IRA is best way to go for me.  What do you think?

boarder42

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #8 on: November 10, 2017, 09:06:39 AM »
Thanks JLee, boarder, ZiziPB & Laura for your quick replies! :)

@JLee: Yes, I know all about the ROTH IRA ladder but would rather not go through that if I can avoid it.  Thank you anyway :)

@Boarder: No, I am not starting to save now, I have about 250K split around 50/50 401K/Index funds.  Yes, will work on a case study whenever I get some time, thanks!



this bolded reply to me doesnt make sense.  a 401k is an account type index funds are an investment type.  you can invest in index funds in a 401k so whats your real breakdown in your 401k. 

1. you should use the roth ladder due to the cost efficiency in saving in a trad account vs taxable or roth.  i'd strongly reconsider that

2. so you've got 250k and you have a savings rate of 60% so lets assume you're saving 60k on top of that and you want to spend 40k in fire.  so when will you hit a million thats the question.  Using a simple compound interest calculator at money chimp - http://www.moneychimp.com/calculator/compound_interest_calculator.htm

7% returns - 250k - 60k annual addition - tells us you can retire in about 7.5 years.  so you really only need to work til your 46-47 -  now if you want to continue working i guess thats a different story but by 50 you'll have 1.5MM and by 55 you'll have2.5MM - my numbers i'm using could be off but you'll likely be able to retire easily by 50

MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #9 on: November 10, 2017, 10:48:07 AM »
Hi MDM - Yes, I have been thinking about ROTH IRA, I make too much money to contribute but conversion is an option.  I am planning on ER with about 40K  a year so I will be in much lower tax bracket so thinking that traditional 401k/IRA is best way to go for me.  What do you think?
Given the difference in tax rates, traditional will be better if it is deductible.  No problem deducting the 401k.  There are, however, income limits to deducting a tIRA: IRA Deduction Limits | Internal Revenue Service.

If you exceed the Roth contribution limit (Retirement Topics IRA Contribution Limits | Internal Revenue Service), there is the Backdoor Roth IRA.  If you have no money in pre-tax tIRAs now, and exceed the straightforward Roth contribution income limit, the backdoor Roth method is perfect for you.

boarder42

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #10 on: November 10, 2017, 10:58:50 AM »
i need to revise my post.  if you make to much to contribute to a roth and are saving 55-60% on top of maxing a 401k youre actually saving more like 100k a year at 55-60% of after tax plus the 18k to 401k .  so with that revision you will be FI by about 44-45

Catbert

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #11 on: November 10, 2017, 01:29:44 PM »
In terms of how to take the money out, there are several ways. For starters, have all capital gains and dividends paid out rather than reinvested.  As necessary sell stocks/bonds/mutual funds to generate cash.  Once FIRE and living on your stash pay attention to your tax rates.  For example, capture enough capital gains to fill your 15% tax bracket - they will be Federal tax free.  If you are using ACA for health insurance that will also provide limits to how much you want showing on your tax return.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #12 on: November 10, 2017, 06:45:31 PM »
@boarder -  In my 401K I have allocated diversified index funds + target date plan with mix of stock/bonds.  About the estimations you made, you are right, is more like about 90K a year (thanks for doing that by the way).  However, that's savings currently, I have a mortgage to pay and will start paying extra for the principal starting next year (about $20K extra payments a year).  I won't retire unless I am done with that mortgage (makes me nervous).  I think that either way I will be all set when I am closing in 50 years.  At least FI would be great, it's hard to say if I will be willing to retire when I get there, who knows what kind of job I would have in the future.  It's likely that if I get a job that gets me excited about waking up every morning, I will continue to work.  Right now, I just want to stay in bed all day :(
@MDM - I have to look into the deductions, to be honest I am not to knowledgeable with taxes, it is so complicated on purpose to screw us over.  The general consensus I get from this blog and others is that if you plan to be in lower tax bracket when you retire, just contribute to traditional 401K & IRA.  I would like to see the real dollar amounts that I will save going the backdoor Roth IRA as opposed keeping all money in traditional accounts taxed in the future.
@Catbert - Hello and thanks for your reply! I have a few follow up questions:
- Aren't you worried of selling stocks/funds to get money? That's my main argument when people say that they would sell their capital.  Assuming you don't ever work, you won't be able to replace that capital you sell, hence, your dividends and gains will be less and less.  What's your take? Risky?
- The tax rate thing really worries me, what if my dividends and capital gains are so high that they get me into the higher brackets? How can I control that? I guess by simply changing my investment setup not to send me a check and reinvest once my income is getting close to the bracket limit?
- Ahh, health insurance, that's a monster I need to tackle, who knows if ACA would be around when I retire.  I was curious and I went to ehealthinsurance.com to get a quote for me and my wife (very healthy, no smokers, no pre-existing conditions, etc) and it gave me a monthly premium of $650! And that's a bare bones bronze plans with high deductible and no coverage for doctor visits (no copays so I can't even image how expensive it's to go to a doctor to check for a bad cold case).  For some reason, the plans in that website says that there are no subsides in WA state, MMM always said that if your income is lower, you will get subsides and it will be way cheaper, I will keep looking, maybe there are other websites that might offer plans with subsides.  The situation right now is messed up, hoping things get better in terms of health insurance.

Thanks again folks, I wish I could invite you all home to have some beers with me this weekend and keep talking :)
« Last Edit: November 10, 2017, 06:50:38 PM by bigote2032 »

MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #13 on: November 10, 2017, 07:24:42 PM »
@MDM - I have to look into the deductions, to be honest I am not to knowledgeable with taxes, it is so complicated on purpose to screw us over.  The general consensus I get from this blog and others is that if you plan to be in lower tax bracket when you retire, just contribute to traditional 401K & IRA.
You may have missed the Investment Order suggestions.

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I would like to see the real dollar amounts that I will save going the backdoor Roth IRA as opposed keeping all money in traditional accounts taxed in the future.
Assuming you will pay 15% tax on annual dividends, and 15% on LTCG when you sell, with 8% total return (2%/yr from dividends, 6%/yr from appreciation), and investing $11K/yr after tax, after 15 years you would have
  $292,085 if using taxable
  $317,202 if using Roth

Up to you whether the $25K difference is worth the hour or so per year to handle the online transfers and extra tax forms.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #14 on: November 13, 2017, 10:18:43 PM »
Hey MDM, thank you.  I would work for 1 full extra month to get that extra 25K!

However, I am pretty lost in terms of the actual "how to do it", I found several IRA backdoor ROTH ladder articles.  They make it seem so simple but none of them explain how to actually do it. The execution part is not clear to me.  Sometimes taxes really discourage me to reach FIRE.

If you have an article that would actually explain you in depth how to do it that would be great, even better, somebody that is actually doing this would be a great resource.

MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #15 on: November 13, 2017, 11:09:29 PM »
Hey MDM, thank you.  I would work for 1 full extra month to get that extra 25K!

However, I am pretty lost in terms of the actual "how to do it", I found several IRA backdoor ROTH ladder articles.  They make it seem so simple but none of them explain how to actually do it. The execution part is not clear to me.  Sometimes taxes really discourage me to reach FIRE.

If you have an article that would actually explain you in depth how to do it that would be great, even better, somebody that is actually doing this would be a great resource.
Did you read the Bogleheads wiki article linked earlier, including the "comprehensive tutorial: Backdoor Roth: A Complete How-To, by forum member tfb"?

If so, what parts are not clear? 

Taxes in general, and backdoor Roths in particular, are like many things: easy once you've done them a few times, but somewhat incomprehensible until then. ;)

Dpwyatt91

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #16 on: November 14, 2017, 12:15:09 AM »
Also The Finance Buff has a lot of good info on tax subjects and other stuff that might help you. You should check out his blog. I cant figure out how to link his website from my phone...https://thefinancebuff.com/

Laura33

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #17 on: November 14, 2017, 08:29:24 AM »
So, first, the reason you don't see a lot of people living solely on dividends and CGs is because that would be like a 2% withdrawal rate.  Most folks here don't want to work long enough to support a 2% withdrawal rate.  The 4% rule does, in fact, assume that you sell assets as needed every year to achieve your 4% target.  Even with that assumption built in, it still succeeds far, far more often than it fails.

I have also personally done the back door Roth, as I make too much to do a deductible tIRA.  Here is what I did:

Called the fund company that I have my EF with (money market account that had gotten too high).  Had them walk me through setting up electronic access to my account, because I am a fucking idiot with this sort of thing.  Logged in with my spanky new credentials.  The guy then pointed me to the button that said "Open an IRA." I clicked the button and followed the instructions, and transferred money from my existing money market account, so it funded right away.  Boom, step one done, thanks very much, hang up the phone.

Next day:  log in with my fancy new online access.  Go to the account.  Find the "roll over to a Roth" button.  Click that, follow the instructions.  Boom, step 2 done.  Whole thing took maybe 15 minutes, and the first 5-10 of that was putzing around to see if I could figure out electronic access myself and then looking for the phone number to call for help.

The Roth Pipeline is the same thing over five years.  First, you would just first roll over your 401(k) into an IRA once you quit your job.  The company you want to open the IRA with will help walk you through this.*  Then every year you would convert up to 20% of the IRA into a Roth**, following the exact same steps above.  If you have a pulse and can talk on the phone or follow instructions on a website, you have what it takes to set up a Roth or execute the pipeline.

The two slightly more complex things to remember:  Yes, when you roll over your IRA to a Roth, you will then need to pay taxes (for the immediate rollover, it's just on the gains, which should be practically nothing if you do it the next day; with the 401(k) rollover, I believe it is on the entire amount; the tax calculations also get more complicated if you have other tIRAs out there that you are not rolling over).  The good news is that you don't actually need to figure any of this out, because the fund company will send you a statement every year that tells you the amount of money that is taxable, and then you put that amount into the proper line on your tax form.   

The second hitch is that when you do the Roth pipeline, you have to wait 5 years before you can take anything out of the account.  Which is why I said above you really only need post-tax money to cover the first five years:  because you will need some other source of $$ to cover your living expenses until you can access your Roth.

* I am not going to bullshit you on this, some companies make this unnecessarily painful, because they don't want to lose your money to some other account.  But you are likely going to want to do this anyway when you retire, whether you do the Roth pipeline or not, so don't let that stop you.

**You want to convert enough to cover one year's anticipated living expenses every year.  A lot of people will roll over just enough to stay in a low tax bracket. 

boarder42

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #18 on: November 14, 2017, 09:17:51 AM »
would be nice if they changed the roth pipeline to be a year or 2.

marty998

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #19 on: November 14, 2017, 01:44:30 PM »
would be nice if they changed the roth pipeline to be a year or 2.

This is called "having a loophole you could drive a truck through"

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #20 on: November 14, 2017, 11:23:59 PM »
@MDM - Thanks, I actually missed reading the links.  That example article on how to do it is great!  And now I feel better about the taxes and forms thingie. I have doubts in a couple of items:

Step 2 Make a non-deductible contribution to a traditional IRA - confused in this one due to the "non-deductible" contribution, how do I ensure that it's non-deductible? I plan to move some money from 401K (the amount I need to survive a year) to the traditional IRA, is this 401K money non-deductible?

No Rollover to Traditional IRA states part: "When you are repeating steps 2 to 5 every year, remember not to roll over from an employer-sponsored plan to a traditional IRA in the same year, either before or after you do the Roth conversion. You can leave the money in the original plan, roll over from one plan to another plan, or roll over to your own solo 401k, just not roll over to a traditional IRA."
Isn't this contradicting Step 2? I thought that in step 2 I was rolling over some money from my 401K to the IRA.  I am sure I am missing something or confused with the terms: rolling over, converting and making a non-deductible contribution.

Last but not least, to be clear, I will be moving from my 401K every year to my IRA and then to my ROTH IRA (leave 401K open) or do I need to move all the money from 401K to IRA at once (close 401K)?

@Dpwyatt91: Thanks, I added it to my favorites, it seems to be great resource, so much to read :)

@Laura33: Many thanks for your great explanation! I have all my accounts in Fidelity and Vanguard and both support IRAs and ROTHs transaction online or via phone.  I have a few doubts about your reply:

"Called the fund company that I have my EF with (money market account that had gotten too high)." A bit confused by EF, what does this acronym stands for? So it's a money market account.  Would the process be different if instead of a money market account I use my 401K? Asking since that's what I will do when I quit my job and seems that it's one of the most common ways to do the ROTH ladder conversion thing.  And do I need to move all the 401K money at once or just the annual amount I need every year? I want to make sure I don't mess up in the "moving money" part.

Last question to Laura: I never paid taxes for 401K, I thought once you take it out, you paid taxes, but it seems that if it's moved to an IRA it does not apply? I know it's a loophole but man, that is a huge loophole! From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0.

For me this will be the best approach with the 5 year ladder.  I will probably live from my index fund investments or cash the first five years.

And thanks marty998 & boarder42: Cheers for loopholes!


MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #21 on: November 14, 2017, 11:48:58 PM »
Step 2 Make a non-deductible contribution to a traditional IRA - confused in this one due to the "non-deductible" contribution, how do I ensure that it's non-deductible? I plan to move some money from 401K (the amount I need to survive a year) to the traditional IRA, is this 401K money non-deductible?
Two words, "contribute" (or contribution) and "convert" (or conversion), that sound similar but are very different in terms of 401ks and IRAs.

A backdoor Roth is done when one wants to contribute newly earned income (e.g., from this year's W-2 income) to a Roth IRA, but has an AGI too high to do so directly.  There is a $5500/yr ($6500/yr if age 50 or older) limit on total contributions to IRAs.

A traditional to Roth conversion is done when one has money in a traditional (either 401k or IRA) account and wants to move it a Roth.  There is no dollar limit on conversions.

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No Rollover to Traditional IRA states part: "When you are repeating steps 2 to 5 every year, remember not to roll over from an employer-sponsored plan to a traditional IRA in the same year, either before or after you do the Roth conversion. You can leave the money in the original plan, roll over from one plan to another plan, or roll over to your own solo 401k, just not roll over to a traditional IRA."
Isn't this contradicting Step 2? I thought that in step 2 I was rolling over some money from my 401K to the IRA.  I am sure I am missing something or confused with the terms: rolling over, converting and making a non-deductible contribution.
This gets back to the difference between contribution and conversion.

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Last but not least, to be clear, I will be moving from my 401K every year to my IRA and then to my ROTH IRA (leave 401K open) or do I need to move all the money from 401K to IRA at once (close 401K)?
Do you also want to contribute new money to a Roth IRA (via the backdoor method if necessary)?

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A bit confused by EF, what does this acronym stands for?
Emergency Fund.

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I never paid taxes for 401K, I thought once you take it out, you paid taxes, but it seems that if it's moved to an IRA it does not apply?
No tax on 401k to tIRA.

Converting from tIRA to Roth IRA is when the taxman takes a cut, and the entire amount converted (to the extent it was pre-tax contribution and gains) is taxed as ordinary income.

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From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0.
This is not correct.  See above.

Laura33

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #22 on: November 15, 2017, 08:01:26 AM »
@Laura33: Many thanks for your great explanation! I have all my accounts in Fidelity and Vanguard and both support IRAs and ROTHs transaction online or via phone.  I have a few doubts about your reply:

"Called the fund company that I have my EF with (money market account that had gotten too high)." A bit confused by EF, what does this acronym stands for? So it's a money market account.  Would the process be different if instead of a money market account I use my 401K? Asking since that's what I will do when I quit my job and seems that it's one of the most common ways to do the ROTH ladder conversion thing.  And do I need to move all the 401K money at once or just the annual amount I need every year? I want to make sure I don't mess up in the "moving money" part.

Last question to Laura: I never paid taxes for 401K, I thought once you take it out, you paid taxes, but it seems that if it's moved to an IRA it does not apply? I know it's a loophole but man, that is a huge loophole! From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0.

Yeah, sorry, emergency fund.

I think MDM has pretty much covered it, but in case:  I would roll your entire 401(k) over to a tIRA at once.  This is NOT a taxable event.  This allows you to put your money in whatever low-expense funds you want, vs. being stuck in your 401(k)'s fund choices (which likely have higher expenses).* 

Then every year you convert a part of that tIRA to a Roth.  Because you have not been taxed on the money you put into your 401(k), the entire amount you convert is treated as taxable income.  This is why people usually split the conversions across multiple years (because if your 401(k) rollover gives you a $1M tIRA, and you convert the whole thing to a Roth in one year, Uncle Sam will treat you as if you made $1M that year.  And that means you will pay far, far more taxes on that money than if you converted, say, $40K/yr). 

The reason the article says not to roll over from your 401(k) to an IRA in the same year you do a conversion is because they are talking about minimizing taxes associated with doing a Backdoor Roth every year.  That is not what you are doing.

-- Backdoor Roth:  You do this when you are in the "amassing assets" mode; the goals are (a) to give yourself a way to put new savings into a tax-sheltered investment that you cannot contribute to directly, and (b) to minimize the taxes you pay in getting your money into that vehicle.  Every year, you set up nondeductible tIRA**, then convert it to a Roth.  Because you have already paid taxes on the money you used to fund the tIRA, when you convert it to a Roth, you pay taxes only on the gains in the account since you first opened it.  But the big caveat here is that the IRS looks at all of your tIRAs as one big pot, no matter how many individual accounts you have.  And if you have a deductible tIRA out there, and you convert it to a Roth, you have to pay taxes on the entire amount of money you convert (because you never paid taxes on that money when you set it up).  So if you have say $95K in an existing deductible tIRA, and you start a new nondeductible tIRA with $5K, and then convert $5K of your tIRA money into a Roth, the government will assume that you took 95% of that money from your deductible account and 5% from your nondeductible account -- meaning that you will pay taxes on 95% of the amount you convert!  Look at step 1 of the article again:  the first thing they want you to do is "hide" all of your other deductible tIRAs (by, say, rolling them into your 401(k)), so every year when you open a nondeductible tIRA, that is the only tIRA you have (i.e., you don't have any other deductible tIRAs hanging around)***, and so all of the money you are converting into the Roth comes from the nondeductible tIRA, which means you pay taxes only on the gains between when you started that account and when you converted it (which should be minimal).

-- 401(k) rollover to tIRA:  The 401(k) rollover, OTOH, is typically what you do at the end of your working career -- now, instead of putting more money into tax-sheltered accounts, you are figuring out how to withdraw that money (a) at an earlier age than allowed for a direct withdrawal from an IRA/401(k), and (b) in a way that minimizes the taxes you owe.  So here, you roll over your 401(k) into a tIRA, and you then convert that tIRA over time into a Roth (because a Roth lets you withdraw the money you put into it after 5 years, even if you're not 59.5).  In this case, all of the $ you are rolling over is pretax $$, and so you are going to have to pay taxes on 100% of what you convert to a Roth -- the conversion from a rollover IRA to a Roth is treated exactly the same for tax purposes as the conversion from a deductible tIRA to a Roth (because your new IRA "inherits" the deduction you got when you initially made the contributions to the 401(k)).  In this case, what you are doing is stringing out the conversion from the rollover tIRA to the Roth so you pay a lower tax rate than if you did it all at once (because, per the example above, someone with $40K in taxable income pays a much lower marginal tax rate than someone with $1M in taxable income!). 

-- The problem is when you combine those two very different things in the same year.  Remember that the first step for the Backdoor Roth (to make it the most "tax-friendly") is to get rid of any existing deductible or rollover tIRAs.  But if you are doing the Roth pipeline, the first thing you are doing is creating another rollover tIRA that is going to trigger taxes when you convert it to a Roth!  Which is exactly the opposite of what you want to do to take advantage of the Backdoor Roth.  So what they are saying is, hey, don't try to do both of these things in the same year, or else you won't get the full tax benefit that you'd get from the standard Backdoor Roth option.

-- But again, if you are in the withdrawal stage, you are very likely only doing the Roth pipeline -- taking existing tax-sheltered investments and moving them around to be able to withdraw them earlier and with the lowest overall taxes.  So you don't have to worry at all about that warning, because you are just moving existing investments around and are going to need to pay taxes on those conversions anyway.

*The exception to this is if you retire between 55-59, most plans allow you to begin taking withdrawals from your 401(k) immediately, without waiting until you are 59.5  So if you wait until 55 to retire completely, you don't even need to worry about the Roth pipeline, since that is primarily useful for accessing 401(k)/IRA funds before you turn 59.5.

**Implementing deductible vs. nondeductible:  see the same article:  "You do not specify to the custodian whether the IRA is deductible or not; it is just treated as an IRA. Non-deductible simply means that you do not deduct the IRA contribution on your 1040 tax form (the transaction is recorded on form 8606 and submitted with your tax return)."

*** Money from any other nondeductible tIRA is not a problem here -- again, see the article.  Just trying to simplify the explanation rather than get caught up in all the caveats.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #23 on: November 15, 2017, 02:58:45 PM »
@MDM- Ok, that makes more sense now, so to summarize and make sure I understand, two very different things:

Backdoor IRA ROTH - contributions to IRA then converting to ROTH IRA when you can't make regular contributions due to high income (usually before retirement)
IRA ROTH Ladder - a conversion of a 401K to IRA in order to contribute to the ROTH IRA once a year and get money before 59.5 years old

Question about IRA ROTH Ladder - When I convert my 401K to IRA, it is the totally of the money right effectively closing my account?

About  your comment: "Do you also want to contribute new money to a Roth IRA (via the backdoor method if necessary)?".  You did convince me to do this instead of investment in index funds.  In order to do this I just need to open an IRA account? How do I tell my employer to get money there on every paycheck after tax? My employer uses Fidelity and I have options for PRE-TAX (401K), ROTH (not sure if 401K or IRA) AND AFTER-TAX, the attached screen shot shows this.  Or is this something that I do myself after I get paid?

Regarding " "From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0."
This is not correct.  See above."

Got confused since Laura said that "Yes, when you roll over your IRA to a Roth, you will then need to pay taxes (for the immediate rollover, it's just on the gains, which should be practically nothing if you do it the next day; with the 401(k) rollover, I believe it is on the entire amount", so are you saying this is not the case, I pay taxes for more stuff other than gains?

@Laura - thanks for elaborating more about this, it was all Greek to me but getting better now.  I figure the whys and now trying to figure out the how.

So about that Backdoor ROTH explanation, some doubts:

 - Do you manually transfer money once a month to the tIRA and then move it to ROTH IRA (assume my employer does not have anything to do with this since is money that was already taxed?) I uploaded a screen shot of Fidelity with all the things they offer via my employer, I only use 401K there, so not sure if I need to open IRA and ROTH or just use one of those options they have there?
- If previous question answer is Yes, by end of year I just close the tIRA and open new one the next year, why I cannot leave it open (it's empty anyway)

I won't have trouble mixing the two items in a year since I will be retired when I get to the 401k rollover / ladder and won't be doing the backdoor anymore.

Thank you!!

MDM

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #24 on: November 15, 2017, 03:13:22 PM »
@MDM- Ok, that makes more sense now, so to summarize and make sure I understand, two very different things:

Backdoor IRA ROTH - contributions to IRA then converting to ROTH IRA when you can't make regular contributions due to high income (usually before retirement) Yes.
IRA ROTH Ladder - a conversion of a 401K to IRA in order to contribute convert to the ROTH IRA once a year and get money before 59.5 years old Yes, as edited.

Question about IRA ROTH Ladder - When I convert my 401K to IRA, it is the totally of the money right effectively closing my account? Assuming you mean your 401k account, if you withdraw all the money after leaving employment, that account is closed to you.

About  your comment: "Do you also want to contribute new money to a Roth IRA (via the backdoor method if necessary)?".  You did convince me to do this instead of investment in index funds.  In order to do this I just need to open an IRA account? Follow the procedure in https://www.bogleheads.org/wiki/Backdoor_Roth_IRA
How do I tell my employer to get money there on every paycheck after tax? You don't.  An IRA is up to you, separate from your employer.
My employer uses Fidelity and I have options for PRE-TAX (401K), ROTH (not sure if 401K or IRA) AND AFTER-TAX, the attached screen shot shows this.  Or is this something that I do myself after I get paid? Correct.

Regarding " "From your explanation, only capital gains from the day I move the money to IRA to day I move to ROTH IRA will be taxes which will probably be close to 0."
This is not correct.  See above."

Got confused since Laura said that "Yes, when you roll over your IRA to a Roth, you will then need to pay taxes (for the immediate rollover, it's just on the gains, which should be practically nothing if you do it the next day; True for a backdoor Roth.
with the 401(k) rollover, I believe it is on the entire amount", True for the Roth ladder.so are you saying this is not the case, I pay taxes for more stuff other than gains?

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #25 on: November 16, 2017, 07:49:48 PM »
Thanks MDM & Laura for clearing the last doubts for me!  I figured the backdoor is done once a year and it seems you can choose to use the same tIRA account every year or open new one, I will probably keep same one.

I have learned so much from you guys.   I started the post asking a question and I ended up asking like 20.  I will try to have my next posts more focused, being so new to all of this is a bit overwhelming when you don't understand the terms, acronyms, etc.

I have to keep doing my research and learning but wanted to ask you where are you guys in your life journey? Are you FIREd or still in accumulation phase?

I will see you in other posts, regards.




Laura33

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #26 on: November 17, 2017, 08:51:33 AM »
Thanks MDM & Laura for clearing the last doubts for me!  I figured the backdoor is done once a year and it seems you can choose to use the same tIRA account every year or open new one, I will probably keep same one.

I have learned so much from you guys.   I started the post asking a question and I ended up asking like 20.  I will try to have my next posts more focused, being so new to all of this is a bit overwhelming when you don't understand the terms, acronyms, etc.

I have to keep doing my research and learning but wanted to ask you where are you guys in your life journey? Are you FIREd or still in accumulation phase?

Happy to help!  I think I fall in the category of SWAMI (look up the acronyms thread), though not quite full "S" and pretty light on the "M" -- early 50s, could FIRE if I wanted, but DH is more spendy than I am and in no rush to quit, and my job generally doesn't suck and pays me far more than I'm worth, so why not keep working for a while?  But always re-evaluating and may go part-time next year, just because.  Was never hard-core MMM, more like save @20% for @20 years and have only gotten closer to 45-50% recently; definitely suffering from lifestyle inflation, so I hang here a lot to get a totally different perspective than I get literally everywhere else in my life, and I'm working on figuring out what kind of spending really matters and makes me happy and improves my life vs. what kind of spending just facilitates laziness and sloth and is a waste (basically, I want to figure out how to use my money as efficiently as possible, as measured on a "life satisfaction per $" basis).

TomTX

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #27 on: November 19, 2017, 12:07:41 PM »
I have a few follow up questions:
- Aren't you worried of selling stocks/funds to get money? That's my main argument when people say that they would sell their capital.  Assuming you don't ever work, you won't be able to replace that capital you sell, hence, your dividends and gains will be less and less.  What's your take? Risky?

Do you live under the market conditions of a Jane Austen novel where everyone responsible is living off the equivalent of the interest on bonds?

I should hope not. But that's where that financial maxim dates from. It is entire inappropriate to apply it to a portfolio with a large fraction of stocks under current market conditions.

Selling shares of stock is equivalent to not reinvesting dividends. Follow the 4% rule overall, and it's NBD.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #28 on: November 19, 2017, 08:41:35 PM »
@Laura - thanks for sharing your story. Yeah, I found out about SWAMI reading MMM blog.  If I FIRE would be about 10 years from now, I would def be worried if I had to retire now due to the healthcare debacle.  Health care is just a business and is not about the people, I do hope some day it changes for the good, you cant' afford to get sick in this country :( 

@TomTX - Yeah, big risk tolerance for me.  Like many people here, almost all of it is stock for me in index funds, firecalc always gives you 100% chance of success the more stock you have anyways.  I will introduce some bonds as I reach FIRE date.  Asset allocation is a complicated subject, we can discuss it for years as some of the posts here show :) Don't get your argument about not being worried about selling funds, you are decreasing your capital.  Sorry, I have not read novels in a long time. Thanks.

Laura33

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #29 on: November 20, 2017, 11:12:52 AM »
@TomTX - . . . .  Don't get your argument about not being worried about selling funds, you are decreasing your capital.  Sorry, I have not read novels in a long time. Thanks.

So in the "novels," you'd hear things like XX had L20,000 "in the four percents" -- that meant his capital was invested in bonds that were paying 4%, so he could live off the interest.  The idea of "living off the interest" was very, very common until just about a generation ago, because (1) for most of that history, there was no reliable, well-regulated stock market; (2) even once that market developed, "normal" people like us couldn't afford to play in it due to minimum investments and trading fees (e.g., must buy 100 shares at a time and pay $695 for the privilege); and (3) interest rates were a shit-ton higher, so who really cares anyway (e.g., if you have a CD paying 12% and you only need 4% to get by, what's the problem)? 

The problem is that this advice no longer applies, because (a) there currently aren't high-quality bonds throwing off 4%, (b) even if there were, they wouldn't throw off enough to allow your withdrawals to keep up with inflation (i.e., 4% + rate of inflation), and (c) even if you could find something that met those first two criteria, your principal would remain unchanged and thus lose buying power to inflation every year -- so you're still losing money, it's just invisible (because you have the same number of dollar bills, they just buy you a lot less stuff than they used to).

The current iteration of the 4% rule was developed under these more modern circumstances.  It assumes a mix of stocks and bonds -- because, yay, normal people like us do have access to the stock market.  And under that rule, you don't need to worry about "dipping into the principal," -- in fact, the 4% rule  assumes that you will be selling more than you make in dividends/distributions.  And yet even with those periodic sales, your 'stache will still (likely) continue to grow even bigger, because when you measure market performance by decades, the returns historically have been well above 4%. 

Example:  Year 1 you have $500K.  You withdraw 4% ($20K) at the end of the year, but the market returns 10%.  So you now have $530K invested ($500K + $50K - $20K). 

Year 2:  You start with $530K.  Market is completely flat -- returns 0%.  Oh no!  You have to "dip into the principal" (a/k/a sell assets)!  So you sell $20K worth of stock.  But look:  you still have $510K!  So despite withdrawing $40K over two years, and despite having been forced to sell stock in only the second year, you still have more money than you did when you started.*  Multiply this times a 30+ year retirement, and take a look at the ratio of "up" to "down" years in the market, and you will see how the 4% rule is very likely to leave you with more money than you started with -- even assuming you do periodically "dip into the principal" when the market is down.

Conceptually, it also makes no difference how you take that money (and I think this is what TomTx was saying).  Assume both years your funds returned 2% in capital gains/dividends/etc.  So year 1, your various distributions would net you $10K.  You can either have those paid to you directly, and then sell $10K worth of stocks, or you can have your dividends reinvested in your accounts and then just sell $20K worth of stock at the end of the year.  How you take the money makes no difference to the amount of money you have left.

*Note also that if you were invested in bonds paying 4%, you'd still have exactly $500K in those bonds, because the principal you invest in bonds does not compound over time like reinvested stock gains do, and your 4% returns aren't throwing off enough cash for you to take any excess and buy more bonds with it.

Telecaster

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #30 on: November 20, 2017, 12:16:58 PM »

Question 1: I am maxing out my 401K.  The rest of my savings about 55% to 60% of my after-tax salary is going to index funds.  I will probably have to live from my index funds investments until I am 59.5. How do you do this? If I take 4% of my index funds and they account for 50% of my stache, I run the risk of depleting my funds.  Taking 2% won't be enough to live.


In addition to what everyone else said, the IRA does allow penalty-free withdrawals (with some conditions) prior to age 59.5.   

https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-substantially-equal-periodic-payments

Yes. If distributions are made as part of a series of substantially equal periodic payments over your life expectancy or the life expectancies of you and your designated beneficiary, the 72(t) tax does not apply. If these distributions are from a qualified plan, not an IRA, you must separate from service with the employer maintaining the plan before the payments begin for this exception to apply. If the series of substantially equal periodic payments is subsequently modified (other than by reason of death or disability) within 5 years of the date of the first payment, or, if later, age 59, the exception to the 10% tax does not apply. In that case, your tax for the modification year is increased by the amount that would have been imposed (but for the exception), plus interest for the deferral period.

TomTX

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #31 on: November 20, 2017, 06:10:14 PM »
@TomTX - Yeah, big risk tolerance for me.  Like many people here, almost all of it is stock for me in index funds, firecalc always gives you 100% chance of success the more stock you have anyways.  I will introduce some bonds as I reach FIRE date.  Asset allocation is a complicated subject, we can discuss it for years as some of the posts here show :) Don't get your argument about not being worried about selling funds, you are decreasing your capital.  Sorry, I have not read novels in a long time. Thanks.

Lets try a different tactic.

Why is a gain in stock price "capital" but a dividend payment is not?

You are using a 150+ year old attitude that is completely inapplicable to the modern investor.

To wit: In the time this was developed, there was essentially no inflation. You could safely spend the gains/interest from bonds, but not the principal.  Stocks were wildly risky compared to today.

bigote2032

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Re: 4% rule with two staches (ER stache & old money stache)? How to do it?
« Reply #32 on: November 20, 2017, 11:59:33 PM »
Thanks Laura and TomTx for elaborating more about this.  Now it's clear to me and I actually agree with you, not too worried about selling stock anymore to cover any shortage.

Thanks Telecaster about the IRA link, I will def. keep it in mind and see if would be good in my scenario.

 

Wow, a phone plan for fifteen bucks!