Sanity Check - Withdrawal Strategy and Taxes with Roth Conversion Ladder

[tarheeldan]

Hi All!

Now that I'm getting closer to FI, I'm looking to hammer in the details. I could use some help optimizing withdrawal strategy, and also making sure my thinking is sound.

At retirement, I expect to have:

Taxable:           11 years of spending
Traditional IRA: 14 years of spending
Roth IRA:          3 years of spending

I will be using the Roth Conversion Ladder strategy

The first 5 years are my concern - I'll need to both a) pay for yearly expenses and b) convert one year's worth of expenses (plus projected 5-year inflation) to Roth

*Question 1*: During the first 5 years, should I use up my 3 years of Roth in order to reduce taxable income? Or should I do FIFO out of my Taxable so that there will be very little capital gains (excepting holdings <1year old, to avoid s-t cap gains)
I'm thinking pull out of taxable with lot identification to minimize capital gains tax

After the first 5 years, I could pull from Roth tax free and only then pay taxes on the conversion

*Question 2*: Should I pull from Roth (after the first 5 years), or continue drawing down from Taxable, or do a mix? I guess we're weighing current taxes against future taxes? How should I calculate this, assuming no changes to the tax code?

[yachi]

Question 1:
Only your contributions to your Roth IRA can be withdrawn without penalty during the first 5 years.  Withdrawals above that amount are penalized 10%.

Your taxable account would have capital gains tax, but only on the gains portion.  If you withdrawal 50k with a cost basis of 25K, and your tax rate is 15%, you only pay $3,750 to withdrawal that 50K.

You could borrow on margin for your first year of retirement, then you can wait for your short term capital gains to become long term capital gains.  Most sales are FIFO by default.

Question 2:
After the first 5 years, I would pull regular living expenses from the Roth IRA, and leave the taxable account for periodic things like a car replacement, or large house project.  I can see the case for spending from both the taxable and the Roth if you wanted more of your money in a tax advantaged account.

[tarheeldan]

Only your contributions to your Roth IRA can be withdrawn without penalty during the first 5 years.  Withdrawals above that amount are penalized 10%.

Your taxable account would have capital gains tax, but only on the gains portion.

I know :)

After the first 5 years, I would pull regular living expenses from the Roth IRA, and leave the taxable account for periodic things like a car replacement, or large house project.  I can see the case for spending from both the taxable and the Roth if you wanted more of your money in a tax advantaged account.

I'll be retiring at 40, so I'm trying to weigh tax-free growth in the Roth against paying zero in taxes by pulling the 5-year seasoned conversions rather than from taxable. I do lot identification with taxable, so I can find 1-year+ old holdings to sell, such that cap gains are minimized. But, so long as we have appreciation, tax would still be non-zero.

[secondcor521]

You're asking good questions.

I retired at 46 and have nominally been using the Roth conversion ladder as my strategy as well.  I say nominally because I've been doing Roth conversions every year but haven't yet needed to pull anything from my Roth.

On question 1, I have been living off dividends, side-gig income, and LTCG from my taxable.  There are a few reasons for this:

First, I realized that the sweet spot in the tax code is "some income", not "zero income".  As an example of this, there are nonrefundable credits that you might qualify for (AOTC for example if you have kids who will be in college at some point) but are wasted if there is no income (and thus no income tax liability) to offset.

Second, all else equal I'd rather have a larger Roth and a smaller taxable.  Spending down the taxable by living off of it helps achieve this goal.

Third, like everyone else I'll have Lake Wobegon life expectancy, so while I don't attempt to quantify it, the loss of decades of tax free compounding on money withdrawn from a Roth seems to outweigh a little bit of LTCG taxes now, especially since these LTCG taxes can be offset by credits (point 1 above).

Your second question really just comes down to your personal goals, situation, preferences, etc.  Having been retired 5 years now and with enough in taxable and Roth that I could pull from either, I've decided to continue to pull from taxable.
 Pretty much for the same three reasons above.  But it's not a very clear-cut decision.  If I ran out of taxable I'd probably start spending from my Roth ladder if pre-59.5, and my traditional IRA or some mix of traditional/Roth to target a specific AGI level if post-59.5.

[tarheeldan]

On question 1, I have been living off dividends, side-gig income, and LTCG from my taxable. 

Thank you! I'd forgotten about this, I'll have about 20% of my budget in dividends from my taxable account that I can't choose not to receive :) That just leaves 80% to cover with LTCG or Roth

First, I realized that the sweet spot in the tax code is "some income", not "zero income".

Good point!

Second, all else equal I'd rather have a larger Roth and a smaller taxable
...
 the loss of decades of tax free compounding on money withdrawn from a Roth seems to outweigh a little bit of LTCG taxes now, especially since these LTCG taxes can be offset by credits (point 1 above).

Makes sense to me, and I was thinking along these lines too. I guess I could model it out with some assumptions, but I think here's what I'll end up doing after year 5:

Live off of dividends and ltgc up to the top of the 12% bracket, pull from Roth if any shortfall (highly unlikely)


Thank you! @secondcor521

[secondcor521]

Happy to help :)