Author Topic: Please help me to understand the MMM's article "How to Retire on a Fixed Chunk "  (Read 3871 times)

juliette

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Hello,
Please help me to understand the MMM’s article “How to Retire Forever on a Fixed Chunk of Money ” (published in Nov 2018). I have very little experience with investments. I really need to understand this article since I would like to do something similar in near future.
1.   He mentioned the index fund VTI “Total Stock Market Exchange Traded Fund”. Here is the quote: “Right now, the VTI fund happens to pay a 1.89% annual dividend, which means that the $500,000 account in that green box above will pay $9000 in annual dividends straight to you.”
I am considering VTI or something similar as well, but I am confused about 1.89% annual dividend. Isn’t this very low? I thought this kind of fund (stocks only?) should pay more like 4% to 7% dividends per year. I thought that there are CDs that pay more than that.

2.   Then he writes: “if you’re shooting for $40,000 of annual spending, simply set up an automatic monthly withdrawal of an additional $31,000 per year ($2583 per month) to be sent to your checking account”.
My understanding is that he recommends to withdraw $9K+31K per year from that taxable account for a number of years.
If I understand correctly, the $9K in dividends will be considered as earned income, but $31K withdrawals are not earned income. Am I correct?

3.    This leads me to my next question about health insurance. He wrote this: “If I go to healthcare.gov right now (or in my case the Colorado-specific equivalent) and put in a hypothetical 4-person family with a $40,000 annual income in my zip code right now, I see this:…”
My question: Is it allowed to say that annual income is $40K if 31K is not earned income, but withdrawals from savings? This question is very important to me because if your income is more than 28K, you qualify for subsidies. If not, you are screwed, because you cannot get Medicaid without working. In general, I do not want Medicaid because I do not want to be labeled as a freeloader. Private health insurance is at least $700 per month for a family of 3 where I currently live.

Please help me to understand. Thanks in advance!
 

marty998

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Hey Juliette,

1) The dividend yield of an index fund will reflect the dividend yield of the stocks that comprise it. Some of the larger stocks in VTI (such as your big tech companies) have low dividend yields, and this influences the yield of VTI. This is because the companies have decided they could make more money by retaining profits and reinvesting it in the business.

Conversely in my market, the big stocks are banks which all pay big 5%+ annual dividends. The Banks are already at saturation point, so with not a lot to invest in they hand back higher dividends to shareholders. So our local index has an overall yield of about 4%.

2) When you sell $31k a year, it will partly comprise some of your own money (the cost base you purchased the shares at) and partly some gains (or losses as the case may be). You will only be taxed on the gains, which means you might for example pay tax on $1000 of profit, with $30k simply being the return of your own money that you had originally invested.

3) In the above scenario, your income would be $9,000 + $1,000 = $10,000, not $40k. But I should leave that question to a US local to answer.

jim555

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3.    This leads me to my next question about health insurance. He wrote this: “If I go to healthcare.gov right now (or in my case the Colorado-specific equivalent) and put in a hypothetical 4-person family with a $40,000 annual income in my zip code right now, I see this:…”
My question: Is it allowed to say that annual income is $40K if 31K is not earned income, but withdrawals from savings? This question is very important to me because if your income is more than 28K, you qualify for subsidies. If not, you are screwed, because you cannot get Medicaid without working. In general, I do not want Medicaid because I do not want to be labeled as a freeloader. Private health insurance is at least $700 per month for a family of 3 where I currently live.

Please help me to understand. Thanks in advance!
Medicaid does not require work.  Some states have requested work requirements but these requests have been stuck down in the courts so far.  Colorado has not made any such request.

TomTX

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1.   He mentioned the index fund VTI “Total Stock Market Exchange Traded Fund”. Here is the quote: “Right now, the VTI fund happens to pay a 1.89% annual dividend, which means that the $500,000 account in that green box above will pay $9000 in annual dividends straight to you.”
I am considering VTI or something similar as well, but I am confused about 1.89% annual dividend. Isn’t this very low? I thought this kind of fund (stocks only?) should pay more like 4% to 7% dividends per year. I thought that there are CDs that pay more than that.

You are confusing dividend with potential growth (value/price increase) of stocks.

Do you know exactly what stocks are? Partial ownership of a company.

As a company owner, you receive value either by having the company give you a payment for part of the profits (dividend) or by having the value of the company itself go up.

Dividends are typically more regular/consistent. Stock price varies all the time depending on all sorts of factors.


juliette

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Thank you very much for your responses!
I misunderstood the concept of dividends, and the difference between VTI YTD return and dividend yield. Thank you, Tom, for making this more clear.
Here is my main question. Suppose my $500K in VTI grows to $520K in one year. If I sell $20K worth of VTI stocks and move it to my checking account, will this be considered as earned income? This is all about getting subsidies for health insurance. If I can report projected annual income of $28k or more, I get subsidies. If it is only 9K dividends, there are no subsidies. 


chasesfish

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@juliette - You'll report both the dividends received as income plus you'll have capital gains in the sale.

I'm newly retired and the ACA Cliff becomes an issue for me next year. 

There's $13,000 or so in dividends coming off my account (and then a deferred comp payout that most don't have).  What is going to make the final determination in my income is how much of my 401k I want to realize as income through a Roth IRA conversion.  Most of the early retirees out there who don't make a fortune on their blog(s) are controlling their income through a Roth IRA conversion process.  That'll get them over the medicaid hurdle but below the ACA subsidy cliff.

justchristine

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In regards to #2, dividends and capital gains from a taxable account are considered income for tax and ACA purposes and taxed at reduced rates.  If you are withdrawing from a 401k or IRA, then your entire withdrawal is considered income and taxed at regular rates like money you would earn from a job.

jim555

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If you need to create income you can always do a Roth conversion.

bacchi

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First, to be more precise, earned income is from a job. You'll never get earned income from dividends or selling stocks unless you're a professional trader (i.e., a mutual or hedge fund operator).

The ACA does depend on total income, including dividends and capital gains.

So what marty998 wrote is correct. SOME of what you sell is income and SOME is return of capital (what you put in). When you sell, some brokers (including Vanguard) allow you to designate what "lots" you want to sell. You'll know ahead of time what your cost basis is and what your income is. This applies only for brokerage accounts though.

The rules are different depending on other account types (401k, traditional IRA, Roth, 403b, 457).

Question to you: What kind of account(s) will this money come from?

« Last Edit: April 19, 2019, 08:54:16 AM by bacchi »

Maenad

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In regards to #2, dividends and capital gains from a taxable account are considered income for tax and ACA purposes and taxed at reduced rates.

That's not entirely true. For Federal taxes, capital gains aren't strictly speaking "income", and they're not taxed the same. However, states vary. My state taxes capital gains the same as income. So for me, dividends + SEPP* withdrawals + capital gains will be my "income" for the state of Minnesota.



*For the OP - Substantially Equal Periodic Payments - an alternative to doing a Roth conversion, under IRS rule 72t.

Caroline PF

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Everyone has given good answers, and corrected your misunderstandings, but I want to put it all in one response to make it clear.

1. Stocks earn money in 2 ways:
   a: dividends, which are payments made to you as a shareholder
   b: capital gains, which is when you sell the stock for more than you paid for it. Only the amount of growth is income, and it is not realized as income until it is sold.

Overall, considering both sources, stocks grow/make on average 10-11% per year (with a whole lot of variability). Dividends usually make up a smaller portion than capital gains.

2. Earned income is a specific definition, meaning income from a job that FICA taxes are paid on. Dividends and capital gains are considered income, but not earned income. The withdrawal from a taxable investment account will be a combination of basis (amount paid initially) and growth (capital gains). Only the capital gains will be considered income. So in your example, you would have $9000 of dividend income, and some portion of the $31,000 would be capital gains.

The other point is that spending money and realizing income are completely different. You could withdraw $40,000 for spending, and the realized income on that amount would be much less. Alternately, you could sell hundreds of thousands of dollars in order to realize $40,000 of income, and then reinvest all of it, spending nothing.

3. ACA subsidies are not based on earned income. They are based on MAGI, which is all sources of income minus specific deductions. If living off of investments, you can control your income by selling enough investments to realize the amount of income you want. You may run into trouble if your investments do not grow enough, or lose value. Then you may not have enough capital gains in order to realize the income level that you want.

A lot of early retirees realize income by making Roth conversions. This method is more stable than relying solely on capital gains. If you have money in an IRA or a 401k, you can use this method. You simply move the amount of income you want to realize from the traditional IRA to the Roth IRA, and that will show up as income on your taxes.

For example, let's say that you have $500,000 in a taxable account, and $500,000 in retirement accounts. You want to spend $40,000 this year, and want to have at least $28,000 in income in order to stay off of medicaid. You get $9,000 in dividends, and withdraw $31,000 out of your taxable account to make up the rest of the $40,000. Let's say that only $6,000 of that $31,000 is capital gains. So you have your $40,000 of spending money, but only $15,000 of income. You need $13,000 more in income, but don't need more spending money. You can either:
   a: sell more from your taxable account, and then reinvest it in order to realize an additional $13,000 of capital gains, or,
   b: move $13,000 from your traditional IRA to a Roth IRA in order to realize $13,000 of additional income.



Extra info on ACA subsidies for those not in your exact situation:

There are 3 subsidy cliffs to watch out for.
1. 400% FPL: go over this, and you lose all subsidies
2. 250% FPL: go over this, and you lose the cost-sharing subsidies, which pay a portion of your deductible if you get a silver plan. You still get the subsidy on your monthly premium.
3. The medicaid cliff.
   a. if you are in a state that expanded medicaid, 138% FPL is the cut-off. Go UNDER that, and you will be covered by medicaid. In some places, it's hard to find physicians who take medicaid, but in other places, medicaid is an excellent plan.
   b. if you are in a state that did NOT expand medicaid, 100% FPL is the cut-off. Go UNDER that, and you lose all subsidies for ACA, and probably won't qualify for medicaid at all, as there is usually some combination of work requirements, income limits, and asset limits.

One

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When you sell a stock in a taxable account you can choose to sell it first in first out or you can sell the stock by specific ID. If you want to have some control over your taxable income you can sell a small chunk of the stock that you purchased more recently which should have less gains. This is just another way that can help control your taxable income in some circumstances.
« Last Edit: April 19, 2019, 10:02:39 AM by One »

bacchi

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Everyone has given good answers, and corrected your misunderstandings, but I want to put it all in one response to make it clear.

Good summary. Thanks.

Eurotexan

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Trifele

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Everyone has given good answers, and corrected your misunderstandings, but I want to put it all in one response to make it clear.

Nice post @Caroline PF -- good job.

juliette

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Thank you very much for your responses! I am very grateful to Caroline for the excellent summary. Thank you for taking the time to share your wisdom and experience with us. This information is priceless.
I did not know about the method of realizing income by making Roth conversions. Unfortunately, I only have Roth IRA. I could open 403, 401, or 475 while I am still employed. My employer does not offer matching contributions. I feel it is too late to start an account like this. My employment could end in a year or two. Not sure. Everything I have is in a taxable account. I should be able to apply for pension at 55 or older.

BuildingFrugalHabits

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So regarding health care logistics, when does the decision need to be made for medicaid vs. ACA if they aren't sure what next year's income will look like? 

Also, let's say a person decides to retire Jan 1, 2020.  Their 2019's salary/income does not qualify for either medicaid or the ACA subsidies.  Must they wait another year before becoming eligible or can they sign up immediately upon retiring? 
« Last Edit: April 20, 2019, 08:18:16 AM by BuildingFrugalHabits »

MonkeyJenga

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So regarding health care logistics, when does the decision need to be made for medicaid vs. ACA if they aren't sure what next year's income will look like? 

Also, let's say a person decides to retire Jan 1, 2020.  Their 2019's salary/income does not qualify for either medicaid or the ACA subsidies.  Must they wait another year before becoming eligible or can they sign up immediately upon retiring? 

You do not need to wait a year. The decision needs to be made by the time you quit, unless you elect COBRA coverage.

Medicaid eligibility is based on monthly income - if you can provide proof that your job ended and documentation that your other sources of income (like investments) are below the threshold, you can sign up immediately. Even if you wait a few months, you may be able to get retroactive coverage.

ACA subsidies - I believe you can enter your projected income for 2020. I'm not as familiar with the process, but you'll probably also need to demonstrate that your job ended. The time to sign up is during open enrollment or after a qualifying event (ex: losing your job, moving to a new zip code).

https://www.healthcare.gov/quick-guide/dates-and-deadlines/

Trifele

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So regarding health care logistics, when does the decision need to be made for medicaid vs. ACA if they aren't sure what next year's income will look like? 

Also, let's say a person decides to retire Jan 1, 2020.  Their 2019's salary/income does not qualify for either medicaid or the ACA subsidies.  Must they wait another year before becoming eligible or can they sign up immediately upon retiring?

You can sign up immediately, using an estimate of what your income will be for 2020.  When I retired in January of this year and went on the Exchange, they accepted a letter from me that explained how I was estimating income for the rest of the year.

Then it's up to you to hit that income estimate for the year.  If your income is higher than predicted, I believe you will owe money to the insurer if the income difference was enough to impact/eliminate your subsidy.  And if your income is lower than predicted, I believe you could be put onto Medicaid (or potentially kicked out altogether?) for the following year.     
« Last Edit: April 20, 2019, 11:11:28 AM by Trifele »

bacchi

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Thank you very much for your responses! I am very grateful to Caroline for the excellent summary. Thank you for taking the time to share your wisdom and experience with us. This information is priceless.
I did not know about the method of realizing income by making Roth conversions. Unfortunately, I only have Roth IRA. I could open 403, 401, or 475 while I am still employed. My employer does not offer matching contributions. I feel it is too late to start an account like this. My employment could end in a year or two. Not sure. Everything I have is in a taxable account. I should be able to apply for pension at 55 or older.

If your employer offers a 457, that's probably the best plan available for early retirees as long as the investment options aren't annuities. Even with 1-2 years left at an employer and no matching, you should max it.

Caroline PF

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Thank you very much for your responses! I am very grateful to Caroline for the excellent summary. Thank you for taking the time to share your wisdom and experience with us. This information is priceless.
I did not know about the method of realizing income by making Roth conversions. Unfortunately, I only have Roth IRA. I could open 403, 401, or 475 while I am still employed. My employer does not offer matching contributions. I feel it is too late to start an account like this. My employment could end in a year or two. Not sure. Everything I have is in a taxable account. I should be able to apply for pension at 55 or older.

With no match, and 1-2 years until retirement, I can still think of one reason to open and contribute to a traditional retirement account (401k, 403b, IRA, etc.). And that is if you will save more in taxes now than you will pay at retirement.

In your case, with you aiming for an income in retirement of just enough to keep you off of medicaid, your tax bill in retirement should be essentially zero.

So, if contributing to a traditional retirement account now would decrease your current tax bill, you should do so. In your case, you could make that money tax free forever.

You would do so by contributing in 2019 and 2020, and taking the tax deductions. Then in retirement, make the conversions from traditional to Roth, up to the standard deduction (or other amount that keeps you at a zero tax bill), and then that money will grow tax-free in a Roth, having never paid taxes on it.

But again, I don't know how much you make, or what your marginal tax rate is. And if opening a 403b or similar wouldn't make a dent in your tax bill, than this probably wouldn't be worthwhile.

juliette

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Thank you very much for your advice! This is very helpful.
I am seriously considering starting contributions into 457 to the max even though I probably have only  one or two years with this employer. I was wondering what happens when I leave this employer. If I understand correctly, I will have to move this money to either IRA or to 401K or to 403b. Should I open one right now? Which one is best for the method of realizing income by making Roth conversions (for ACA purposes)? I was wondering if there are any penalties or any other caveats to know about?
I should be eligible for a pension at 55 or older, about $3.5K per month. At that time I should have enough income to qualify for subsidies. This is 10 years from now. Until that time, I need to figure out health insurance for myself and for my two children (3 and 7 y.o). I am trying to avoid Medicaid. Thanks in advance!

Trifele

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Rollovers of 457s are more complex than other types of plan, and your options depend on whether it's a government or non-government plan.  Government plans can be rolled over to other types of plans (like IRAs), but you lose the early withdrawal benefit of the 457:   https://www.bogleheads.org/wiki/457(b)#Rollovers

Non-government 457s can only be rolled over to another non-government 457; nothing else. 


Caroline PF

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I am seriously considering starting contributions into 457 to the max even though I probably have only  one or two years with this employer. I was wondering what happens when I leave this employer. If I understand correctly, I will have to move this money to either IRA or to 401K or to 403b. Should I open one right now? Which one is best for the method of realizing income by making Roth conversions (for ACA purposes)? I was wondering if there are any penalties or any other caveats to know about?

457b's are a unique retirement plan with unique benefits and risks. They are technically deferred income. You are telling your company "don't pay me now, pay me later." The money is owed to you, and you can direct how it is invested in the meantime, but unlike the other retirement plans, it is not fully yours until they pay it out. That means that in the event of your company going bankrupt, you would lose the money in the 457b to creditors. Anyone who puts money into a 457b needs to assess the risk of their company going bankrupt before they retire.

The money in a 457b is paid to you when you leave employment with that specific employer, regardless of what age you are. If you leave this job, and start another job that also has a 457 plan, you could roll that money over into the new plan. Or, if you have a governmental 457b, you are allowed to roll the money into an IRA.

If neither of those 2 situations apply, then the money is paid out to you. When you sign up for the plan, you choose over what timeline the money will be paid. Options like paid all in one year, spread out over 3 years, etc.

There is also a 457f, which is much more risky than a 457b, so make sure it's not that one.


As to the Roth conversions and realizing income:

A 457b would be paid out on the schedule you choose, and it would be counted as income when it is paid. As far as I know, you can't change the schedule after retiring, so there is some loss of flexibility, but it's simpler, as there are no need for conversions.

The standard method for Roth conversions is a 2-step process. First, roll over money from a 401k or 403b to an IRA. Then do a conversion on the amount of income you want to realize, moving it from the traditional IRA to a Roth IRA.