I Don't Understand Drawdown

[nessa]

Hey there - I'm happily chugging away through my Boring Middle. Now that I feel secure in what I am doing (saving, monitoring my spending) I'm trying to wrap my head around what will happen when I leave paid employment.

I don't understand how I will get get the money out of my retirement accounts - I thought it would be like taking money out of my checking, but I don't think that's right.

I currently have a 401k with my employer, and a separate Vanguard account that's a Traditional IRA. I max my IRA every year, and contribute 25% per pay check to my 401k. This will get me to my FI number by the time I "retire".

When I leave my job I will roll my 401k over into my Traditional IRA, and leave it there until I'm ready to use it as my "income".

So, folks, how do I do that? Do I just transfer money from the IRA to my credit union account? And, how do I know what I'll be taxed on (let's assume I don't have any other income and I'm not drawing SS)?

I know  its a ways off, but I figure I'd better start understanding this part of my plan.

[Sandi_k]

Assuming all of your retirement savings is pre-tax, yes, you'll withdraw the funds from your IRA and 401(k), and ALL of it will be taxed as income.

So, to keep it simple, and assume you have $1M saved, and you need $40k in Year One.

Year One: Withdraw $40k in a lump sum, transfer to your savings account, and then transfer 1/12th of that each month to your checking/billpay account. Note that taxes NEED to be an expense, tracked on your budget line items.

Year Two: Add inflationary dollar amount, rinse and repeat.

The assumptions for such action are:

- The 4% Rule of Thumb + COLA each year for withdrawal rates.
- The portfolio is at least 50% stocks.
- You have a 30 year retirement.
- You pay taxes out of the $40k.

What else did you need to know? What are your obstacles?

[bacchi]

If you're in the US, you can build a Roth ladder. You'll need 5+ year of expenses in post-tax accounts like Roth IRA contributions, brokerage accounts, and savings accounts.

[reeshau]

If you're in the US, you can build a Roth ladder. You'll need 5+ year of expenses in post-tax accounts like Roth IRA contributions, brokerage accounts, and savings accounts.

Yeah, once you get the basics down of how it would work purely with traditional / pre-tax accounts, you can start to examine alternate / optimal scenarios for you.

And if you are really going to FIRE, don't discount the utility of taxable investments, too.  With no income except dividends and interest, you can take advantage of the $85k (MFJ) of capital gains taxed at 0%,  but still generate income to stqy eligible for ACA.  (particularly in a State that did not expand Medicaid) If you need to rely on it, ACA subsidies become a big part of the "tax" problem, because they are reconciled through your federal taxes.

As I stand right now, age 52, I live off taxable investments and cash.  I expect to pay no tax out of pocket.  At the end of the year, when the tax software first comes out, I do a pro format return to see how much of my trad IRA I can roll over to Roth, and even out with my standard deduction + tax credits + ACA subsidy, to get as close to $0 as I can.

[nessa]

@Sandi_k Thank you! I think you answered my basic questions - so I can treat my IRA like a 'regular' account when I get to the drawdown phase (I was wondering if the money is literally divided into 'interest'/principal and I would have to tell Vanguard which dollars in which bucket I was choosing [silly, I know]), and that I will treat it as regular income, file taxes "as normal". That makes so much more sense now!

@reeshau I'm following the investment strategy laid out here on the MMM forum: 401k to get the match, max IRA, throw everything 'extra' at my 401k (to max each year, but I think that's more of a dream). Once I max both the retirement accounts, that's when I'd be looking at opening a taxable account - with Vanguard, I guess? And so that's where dividends come into play (there aren't any 'dividends' to draw from on my IRA? Its all just one lump of money?) << This is where I start getting confused!

[EvenSteven]

@Sandi_k Thank you! I think you answered my basic questions - so I can treat my IRA like a 'regular' account when I get to the drawdown phase (I was wondering if the money is literally divided into 'interest'/principal and I would have to tell Vanguard which dollars in which bucket I was choosing [silly, I know]), and that I will treat it as regular income, file taxes "as normal". That makes so much more sense now!

@reeshau I'm following the investment strategy laid out here on the MMM forum: 401k to get the match, max IRA, throw everything 'extra' at my 401k (to max each year, but I think that's more of a dream). Once I max both the retirement accounts, that's when I'd be looking at opening a taxable account - with Vanguard, I guess? And so that's where dividends come into play (there aren't any 'dividends' to draw from on my IRA? Its all just one lump of money?) << This is where I start getting confused!

Dividends and capital gains within either Roth accounts or tax deferred traditional accounts don't matter, they only have an effect on your taxes in a regular taxable brokerage account.

I might have missed it, but are you planning on retiring and needing to withdraw this money before or after age 59.5? There will be a difference in the steps you take to access this money depending on your age.

[zolotiyeruki]

@Sandi_k Thank you! I think you answered my basic questions - so I can treat my IRA like a 'regular' account when I get to the drawdown phase (I was wondering if the money is literally divided into 'interest'/principal and I would have to tell Vanguard which dollars in which bucket I was choosing [silly, I know]), and that I will treat it as regular income, file taxes "as normal". That makes so much more sense now!

@reeshau I'm following the investment strategy laid out here on the MMM forum: 401k to get the match, max IRA, throw everything 'extra' at my 401k (to max each year, but I think that's more of a dream). Once I max both the retirement accounts, that's when I'd be looking at opening a taxable account - with Vanguard, I guess? And so that's where dividends come into play (there aren't any 'dividends' to draw from on my IRA? Its all just one lump of money?) << This is where I start getting confused!

Everything you withdraw from a traditional IRA is taxed as income.  There's no distinction between original contributions, capital gains, or dividends.  I think the idea is to make it sort of comparable to a brokerage account from a tax perspective.  When you contribute to a brokerage account, you're doing so with already-taxed dollars, dividends are taxed as they come in, and capital gains are taxed when you sell shares.  Thus, each component (contribution, dividends, gains) gets taxed once, and only once, but at various times. For a tIRA, none of it gets taxed taxed until you withdraw them, and they all get taxed at the same time.  As a result, there aren't any "buckets" in a traditional IRA

Nothing you withdraw from a Roth IRA is taxed at all.* It doesn't even show up as income on your 1040 form.

* - All of this, of course, assumes you wait to withdraw until the year in which you turn 59.5.  If you withdraw earlier, you pay penalties.

To get money out of your retirement accounts, you'll just initiate a transfer by either calling Vanguard or doing it through their website.  At the end of the year, they'll send you a 1099-R (if I recall correctly) with the numbers to use when filing your taxes.

Now, if you plan to retire earlier than age 59.5, and have most of your savings tied up in retirement accounts, it gets a bit more tricky, because you can't access those funds directly without incurring penalties and extra taxes.  That's where the Roth Conversion Pipeline aka Roth Ladder comes in.  It requires you to have five years of spending money in accessible locations (usually some combination of brokerage account, Roth contributions, cash, etc).  If such early retirement is in your plans, you'll need to make sure you fund those buckets sufficiently.

[yachi]

When you contribute to a brokerage account, you're doing so with already-taxed dollars, so you are only taxed on the gains when you withdraw.

Woah, hold up.  When your investment is owned in a regular taxable brokerage account (i.e.. outside of an IRA, or 401(k), or other tax advantaged account) you are taxed on dividends as soon as they are received, and gains as soon as they are realized.  This is true whether you withdraw the money from the account, reinvest it into a different security, or leave it in cash.

edit: gains are realized when an investment is sold for more than it was purchased, before the sale they are known as unrealized gains.

[zolotiyeruki]

When you contribute to a brokerage account, you're doing so with already-taxed dollars, so you are only taxed on the gains when you withdraw.

Woah, hold up.  When your investment is owned in a regular taxable brokerage account (i.e.. outside of an IRA, or 401(k), or other tax advantaged account) you are taxed on dividends as soon as they are received, and gains as soon as they are realized.  This is true whether you withdraw the money from the account, reinvest it into a different security, or leave it in cash.

edit: gains are realized when an investment is sold for more than it was purchased, before the sale they are known as unrealized gains.

Good catch--I'll update my post.

[secondcor521]

So, folks, how do I do that? Do I just transfer money from the IRA to my credit union account? And, how do I know what I'll be taxed on (let's assume I don't have any other income and I'm not drawing SS)?

It's pretty simple.  I have a Vanguard IRA and a checking account at USAA.  I can go on to Vanguard's website, go into my IRA account, sell $X of whichever investment I want, and tell them to ACH the proceeds to my USAA checking account.  It takes a few days for the sale and ACH to occur and the money to end up in my checking account.

All withdrawals (with limited exceptions) are taxed as ordinary income.  In January of the year following the withdrawal, you'll receive a 1099-R from your custodian with the total of all of your withdrawals from the previous year in box 1, and the taxable amount in box 2a (which will almost certainly be the same as the box 1 amount).  That box 2a amount will end up on your 1040 line 4b and then flow through the rest of your tax return.

(As others have mentioned, if you take money out of your IRA before 59.5, you will generally owe a 10% penalty in addition to the regular income tax unless you qualify for one or more of the several exceptions to the penalty.  Those exceptions will be listed in the instructions for Form 5329.)

[FIRE 20/20]

@nessa , how old are you (actually, how old will you be when you FIRE)?  As people have mentioned this changes things significantly. 

[nessa]

This community is so awesome! Thank you everyone for chiming in, I have a much better understanding now!

For those who asked (and those who didn't LOL) I'll be transitioning to Recreational Employment in five years (at age 55), and won't touch/need to touch my investments until I'm 67, so there's no worry on my part needing to access the monies before then.

[yachi]

This community is so awesome! Thank you everyone for chiming in, I have a much better understanding now!

For those who asked (and those who didn't LOL) I'll be transitioning to Recreational Employment in five years (at age 55), and won't touch/need to touch my investments until I'm 67, so there's no worry on my part needing to access the monies before then.

Just keep in mind it becomes taxable income when it's withdrawn.  So if you're planning to travel the country in a $150K RV, and need another $50K for living expenses, then you'll be taxed as if you have $200K income that year.  Some people (in real life, not this board generally) get hit by big tax surprises because they don't account for that fact.  It could be better to finance the RV so you can spread the costs among a number of years (and save yourself from a higher tax bracket).

[mistymoney]

If you're in the US, you can build a Roth ladder. You'll need 5+ year of expenses in post-tax accounts like Roth IRA contributions, brokerage accounts, and savings accounts.

Yeah, once you get the basics down of how it would work purely with traditional / pre-tax accounts, you can start to examine alternate / optimal scenarios for you.

And if you are really going to FIRE, don't discount the utility of taxable investments, too.  With no income except dividends and interest, you can take advantage of the $85k (MFJ) of capital gains taxed at 0%,  but still generate income to stqy eligible for ACA.  (particularly in a State that did not expand Medicaid) If you need to rely on it, ACA subsidies become a big part of the "tax" problem, because they are reconciled through your federal taxes.

As I stand right now, age 52, I live off taxable investments and cash.  I expect to pay no tax out of pocket.  At the end of the year, when the tax software first comes out, I do a pro format return to see how much of my trad IRA I can roll over to Roth, and even out with my standard deduction + tax credits + ACA subsidy, to get as close to $0 as I can.

this is a new concept for me! Can you explain a little how this would work? I would be filing single, google says it is 44,625 for that.

So capital gains are only in the taxable account. Are the capital gain inclusive or exclusive of the "income" limit?

So as a singleton - if you withdraw 40k from IRA, have 2k in taxable dividendends, then you can sell in the taxable account for 2.625k of gains and not pay taxes on it? Is that how it works? for a total of 44,625 in income....

Or is it withdraw 44625 from 401k which is "income" and then your dividends are taxed as dividends, and you get capital gains for free on top of that? Seems it can't be that because then you could have like 100k dividends, and 100k capital gains and still have free cap gains.....but I've been surprised before on how it all works!!

Thanks for any info!

[reeshau]

So capital gains are only in the taxable account. Are the capital gain inclusive or exclusive of the "income" limit?

So as a singleton - if you withdraw 40k from IRA, have 2k in taxable dividendends, then you can sell in the taxable account for 2.625k of gains and not pay taxes on it? Is that how it works? for a total of 44,625 in income....

Unfortunately, it's your first scenario that is correct.  The income limit for 0% capital gains is eaten up by ordinary income.  That's why it is especially powerful for those who are FIRE'd, but not withdrawing from IRA's.

My FIL and I had a brief argument about it some time ago.  He didn't believe it existed, because his tax guy never mentioned it.  But he retired well after 59 1/2, and lives well, so he's never been in a position of ordinary income under the limit where the 0% rate would be exposed.

[jim555]

Roll over.  Start a 5 year Roth conversion ladder or a 72t withdrawal to avoid the 10% penalty prior to 59.5 (assumes you are under 59.5)

[mistymoney]

So capital gains are only in the taxable account. Are the capital gain inclusive or exclusive of the "income" limit?

So as a singleton - if you withdraw 40k from IRA, have 2k in taxable dividendends, then you can sell in the taxable account for 2.625k of gains and not pay taxes on it? Is that how it works? for a total of 44,625 in income....

Unfortunately, it's your first scenario that is correct.  The income limit for 0% capital gains is eaten up by ordinary income.  That's why it is especially powerful for those who are FIRE'd, but not withdrawing from IRA's.

My FIL and I had a brief argument about it some time ago.  He didn't believe it existed, because his tax guy never mentioned it.  But he retired well after 59 1/2, and lives well, so he's never been in a position of ordinary income under the limit where the 0% rate would be exposed.

Thank you! There is so much to know!

[mistymoney]

So capital gains are only in the taxable account. Are the capital gain inclusive or exclusive of the "income" limit?

So as a singleton - if you withdraw 40k from IRA, have 2k in taxable dividendends, then you can sell in the taxable account for 2.625k of gains and not pay taxes on it? Is that how it works? for a total of 44,625 in income....

Unfortunately, it's your first scenario that is correct.  The income limit for 0% capital gains is eaten up by ordinary income.  That's why it is especially powerful for those who are FIRE'd, but not withdrawing from IRA's.

My FIL and I had a brief argument about it some time ago.  He didn't believe it existed, because his tax guy never mentioned it.  But he retired well after 59 1/2, and lives well, so he's never been in a position of ordinary income under the limit where the 0% rate would be exposed.

also - I looked up taxation of qualified dividends and it is the same limit. So 0% taxes on dividends and capital gains up to 44.625k! Wild! That is just wild that this exists......

[BicycleB]

So capital gains are only in the taxable account. Are the capital gain inclusive or exclusive of the "income" limit?

So as a singleton - if you withdraw 40k from IRA, have 2k in taxable dividendends, then you can sell in the taxable account for 2.625k of gains and not pay taxes on it? Is that how it works? for a total of 44,625 in income....

Unfortunately, it's your first scenario that is correct.  The income limit for 0% capital gains is eaten up by ordinary income.  That's why it is especially powerful for those who are FIRE'd, but not withdrawing from IRA's.

My FIL and I had a brief argument about it some time ago.  He didn't believe it existed, because his tax guy never mentioned it.  But he retired well after 59 1/2, and lives well, so he's never been in a position of ordinary income under the limit where the 0% rate would be exposed.

also - I looked up taxation of qualified dividends and it is the same limit. So 0% taxes on dividends and capital gains up to 44.625k! Wild! That is just wild that this exists......

Hi, @mistymoney! Yes, it is. It's almost like the tax system has a hidden boost to make living on 44k or less a superpower. :)

[reeshau]

Shh--If we keep talking about it, somebody in Washington is going to realize the mistake, and take it away!!