Optimizing the Double Shark Fin of Early Retirement

[chutneyohio]

Fellow Mustachians,

I've searched around the forums and elsewhere online as well as constructed a few spreadsheet to figure this out, but I’m still struggling to come to a conclusive answer.  I am trying to figure out how to allocate my investments to optimize what I call the Double Shark Fin of Early Retirement.  Obviously with the goal of moving the start of early retirement as soon as possible, while ensure the money will last until my wife and I die.

If you read the normal FIRE guidelines the advice is to save as much as you can, maximize tax sheltered accounts first, then pad after-tax account with what is left.  But that advice is counter to our ability to live off of those savings in early retirement.  In order to pull the “eff you! card” on your boss you’d need accessible savings in taxable accounts to live off of until you can access tax sheltered savings like 401k, TSP and IRAs (I understand there are tricks like the Roth IRA ladder, but let's keep this is simple and conservative for now).

That scenario might look like this:



Like most people who are aspiring to financial independence I’ve been saving 50-70% of my income.  I started by putting everything I could into my 401k.  As I got promoted at work and my income grew, I started to max those vehicles (both the 401k and a Roth IRA) so I dumped the excess into vanguard index funds.
 
My situation looks more like this:



You can see that as of today I have ~75% of my savings in tax sheltered accounts, and ~25% in my vanguard fund.  Calculating our net worth, my wife and I have almost half of our goal (25x our annual spending rate) in our ‘stache.  We are starting to see light at the end of the tunnel!

The question for the group is:

In these final couple years of savings, how to we determine where to put our money to optimize its value towards early retirement?  If we retired today, we wouldn’t have enough money accessible to live off of until we could start drawing from our traditional retirement accounts.  But if we shoveled more into our vanguard fund, we’d be missing the tax savings the 401k offers.

Thanks in advance for any help!

[kpd905]

There are a few ways to access your tax advantaged accounts before you turn 59.5.  There is either the Roth IRA conversion ladder or the 72t method.

Here is a good article describing the Roth IRA Conversion ladder: http://rootofgood.com/roth-ira-conversion-ladder-early-retirement/

[seattlecyclone]

You're planning to spend upwards of 20 years in the blue "shark fin." That's plenty of time to make many Roth conversions to transfer money from the green "old person money" shark fin to the blue "early retirement" shark fin. When you max out your retirement accounts, you defer income from your working years (when you're earning way more than you spend) until your retirement years (when your income will likely be no more than your spending). That's a win. Instead of being "conservative" and pretending that options to access this money sooner don't exist, use all the tools in the toolbox and retire earlier.

[kendallf]

Mathematically, the optimal is probably to have 5 years of living expenses in taxable accounts, and start ROTH laddering as soon as you retire.  You can't optimize and ignore your conversion options.

The Mad Fientist has written extensively about this and done test cases and the calculations to back them up; this one comes to mind:

http://www.madfientist.com/how-to-access-retirement-funds-early/

[ekimatuan]

All the responses so far have gone back to accessing the tax sheltered money before 59.5. While there are the strategies mentioned TODAY to do this, and some great articles mentioned, things change dramatically if there is a change to the laws that govern these retirement vehicles.

If I had to guess, maybe chutneyohio is worried that some future administration is going to close these "loopholes". Looking at is this way, that these are no longer options in 10 years, what would you do differently?

[onlykelsey]

All the responses so far have gone back to accessing the tax sheltered money before 59.5. While there are the strategies mentioned TODAY to do this, and some great articles mentioned, things change dramatically if there is a change to the laws that govern these retirement vehicles.

If I had to guess, maybe chutneyohio is worried that some future administration is going to close these "loopholes". Looking at is this way, that these are no longer options in 10 years, what would you do differently?

Agreed.  People always point out the ladder option, but that's far from guaranteed and has become the subject of congressional scrutiny.  I'd like to have more than 5 years in taxable savings if I was quitting for good, just in case.

[Proud Foot]

The question for the group is:

In these final couple years of savings, how to we determine where to put our money to optimize its value towards early retirement?  If we retired today, we wouldn’t have enough money accessible to live off of until we could start drawing from our traditional retirement accounts.  But if we shoveled more into our vanguard fund, we’d be missing the tax savings the 401k offers.

Thanks in advance for any help!

If you are worried about the current rules for early withdrawal changing then the only thing you could do is to max out your taxable accounts.  Unfortunately that means potentially losing out on 401k tax savings.  I'd save at least enough to the 401k to max out your match (if any) and then figure your your plan for your early retirement money.  In my option the biggest part of this equation is the balance of the taxable funds at the time you are able to start drawing on your retirement money. Is your goal to have 50% remaining, 10% remaining, some other percentage? Once you have figured that out you can work backwards to figure the amount you need to start with.

[sol]

If I had to guess, maybe chutneyohio is worried that some future administration is going to close these "loopholes". Looking at is this way, that these are no longer options in 10 years, what would you do differently?

Everyone places WAY too much emphasis on how hard it is to access "tax sheltered" investments.  The truth is that you can access these funds AT ANY POINT without using a Roth IRA conversion ladder or 72t, by just accepting the extra 10% tax "penalty" on withdrawals. 

If the difference in your marginal tax rate between working and retirement is more than 10% then you actually save money by maximizing the tax sheltered accounts first and then deliberately paying the extra 10% tax upon early withdrawal.  You're already saving more than 10% by putting the money into the tax shelter!  Don't be afraid to give 10% back on some portion of it in order to bypass all of the age restrictions.

And unless you're a super spendypants retiree, your tax rate in retirement should be zero, meaning that any income you earn now in the 10% bracket or above should go into tax shelters.  Why will it be zero?  Because you get personal exemptions and deductions, and maybe child tax credits and college credits, that should wipe out the tax burden on nearly all of your income, and the rest can be funded by selling assets and spending your returned capital, which isn't taxed as income.  Plus your Roth IRA principal comes out tax free at any age for any reason, so you can supplement your income that way too. 

There are LOTS of way to pay zero income tax in retirement.  A family of five (like mine) can have about $50k/year of taxable income without paying any income taxes, without ever resorting to any of the more complicated means of reducing taxable income.  And you can spend much more than that, if you're spending down returned capital or Roth contributions that aren't taxed as income.

So everyone just relax.  Your money isn't nearly as tied up in retirement accounts as you think it is.

[Dicey]

What sol says. Also, Jeremy at Go Curry Cracker has posted extensively on how to avoid paying taxes in retirement.

[chutneyohio]

Wow, I really appreciate all the responses!

I wouldn't say I am worried about the Roth IRA ladder 'loophole' getting closed up, like ekimatuan suggested.  Although it does make me a little uneasy planning to use that method if it could be subject to change.

So I'll add a couple more details about my situation to see if I have this down correctly:

Currently my wife and I are both US federal employees.  We both invest in our Thrift Savings Plans (TSP), I max it out and she puts in enough to get the full match plus a little more.  We both max out Roth IRAs and then put what ever is left in to Vanguard Index funds.  Using the 25x rule, we are about half way to hitting our magic number and pulling the trigger.  At our current savings rate we should be there in 5-6 more years. 

Between now and then, I gather (from your comments and the referenced posts by the Madfientist, rootofgood and others) that we should be maxing out her contributions to her TSP to realize the tax savings now.  Then keep growing our Vanguard fund until we have at least 5 years of expenses saved up.  Once we quit our jobs we can live off the Vanguard savings while we start a Roth conversion ladder.  Then ride that until we start using the TSP and Roth IRA earnings in 'full retirement'.

Does anyone here know if the TSP has different rules about converting funds using the Roth conversion ladder than a traditional IRA?  Or would we have to convert our TSPs into an IRA to execute the conversion ladder correctly?

Thanks again!

[seattlecyclone]

I've heard some things about the TSP not allowing for multiple withdrawals over the years; you may need to roll over to an IRA. A federal employee should have more insight on this.

[kendallf]

I've heard some things about the TSP not allowing for multiple withdrawals over the years; you may need to roll over to an IRA. A federal employee should have more insight on this.

This is currently true.  However, the TSP is planning changes to add options for multiple withdrawals, as reported here:

http://www.fedsmith.com/2015/07/28/expanding-withdrawal-options-in-the-tsp/

I'm also a federal employee.  In my case, I'm about 6 years out from my MRA (minimum retirement age) so I'm planning on staying for the immediate pension, supplemental pension, and ability to continue my health coverage.  At that point, those pensions will more than cover our basic expenses, so I'm essentially not worrying about taxable accounts at all. 

I could basically go out in the yard and light the rest of my paycheck on fire between now and then, and we'd still be comfortable in retirement.  I'm still saving because it will increase our options and those of our children, and because I don't like the smell of burning money.  :-)

If you plan on retiring early, you'll want to take the conversion route described above.  Keep the conversions going in those years before your deferred pension (and eventually Social Security) reduce your "low tax space".

[sol]

I've heard some things about the TSP not allowing for multiple withdrawals over the years; you may need to roll over to an IRA.

Currently you are correct.  The TSP only allows two lifetime withdrawals, the first of which can be for virtually any amount, and the second of which has to close out your account, removing all future access to the TSP system. 

To get around this problem, most people who separate from federal service early roll most or all of their money from the TSP into a traditional IRA, which is a tax-free conversion because they are both the same type of account.  Then they can roll over the smaller annual portions from the trad IRA to the Roth IRA to build the pipeline each year.

If you are both federal employees, then you technically have FOUR withdrawal events to work with.

[chutneyohio]

Thanks Kendallf and Sol,

Seeing at the government moves at a glacial pace, I won't hold my breath for updated TSP withdrawl options.

Sounds like the best plan for me (and most federal employees) is to max out the TSP to realize the immediate tax savings.  Then retire early, transfer from the TSP into a traditional IRA and live off post tax (Blue Shark Fin) savings for 5 years while we initiate a Roth conversion ladder.

If congress or the IRS change the rules on the Roth conversion ladder, we'll still be better off taking the 10% 'penalty' as Sol described.

The path forward is much more clear now.  Hopefully this discussion helps others as much as it's helped me!

[sol]

max out the TSP to realize the immediate tax savings.  Then retire early, transfer from the TSP into a traditional IRA and live off post tax (Blue Shark Fin) savings for 5 years while we initiate a Roth conversion ladder.

That's my plan.  And keep in mind that all of your traditional IRA (and thus TSP) funds can be immediately available to you by paying the extra 10%.  It's a nice safety buffer to put your mind at ease, knowing that money isn't really locked up until retirement age. 

They just call it a "penalty" to discourage people, but really it's just a different tax treatment that is still a better deal than investing in taxable accounts while working.