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Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: homestead neohio on August 09, 2016, 02:25:03 PM
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I learned 2 things this week that may lead to shortening my time to FIRE, and I have a question for those who have thought about this.
Thing 1:
Good article by Brandon at MadFientist comparing different withdrawl strategies:
http://www.madfientist.com/how-to-access-retirement-funds-early/ (http://www.madfientist.com/how-to-access-retirement-funds-early/)
I have most of my assets in tax-deferred 401k and tIRA and I'd like to retire as soon as possible. I was thinking I'd do a Roth IRA conversion ladder, but that requires me having 5 years living expenses in prior Roth contributions ($0 currently) or taxable accounts (~1x expenses currently).
Saving in Roth or taxable now (to support having 5x in Roth contributions and taxable) means forgoing tax deductions now (I can max my 401k and tIRAs for DW and I, but savings dollars tend to run out after that). So I'd be saving fewer $ with Roth and/or taxable and getting to my 25x expenses slower. Now I'm thinking just go 401k and tIRA and then SEPP via 72t and take a penalty when needed.
Thing 2:
I have 13 years remaining on 15 year mortgage. In choosing between paying down mortgage to reduce retirement expenses and saving enough to afford the mortgage payment as part of FIRE budget, I had always assumed I would pay down that mortgage first, then FIRE. Now I'm not so sure.
Running the numbers looks like this (timeframes based on 7% steady returns which won't happen, but is a useful comparison):
Option 1: I could FIRE in late 2022 with no mortgage and a stash to cover non-mortgage expenses at 4% WR OR
Option 2: I could FIRE in early 2021 with a mortgage and a stash to cover all expenses (including mortgage) at 4% WR
Keeping the mortgage I can FIRE maybe 18 months sooner and have an extra $1k/mo to use however I wish after 2030 when mortgage is paid. Bonus. So I'm strongly considering Option 2 now.
The question I have is this:
How can I mitigate sequence of return risk if I take the fastest path to FI (using 401k/tIRA and keeping mortgage)?
Maxing tax deferred savings, then retiring while still paying a mortgage (in order to FIRE sooner) means I have to take larger distributions from my larger stash, and using a 72t is the most tax efficient way to get this money out. I won't turn 59.5 until 2037. So a 72t would lock in my withdrawls for 16 consecutive years. Larger withdrawls for 16 required consecutive years could really hurt in a prolonged downturn or stagnated period. I can set the 72t distributions to be "bare bones" expenses and take a 10% penalty for optional expenses, but "bare bones" is much larger and much less flexible if it includes a mortgage.
Seems like the mortgage and 72t are working against each other. I wish I could suspend mortgage payments until age 59.5 (when sequence of returns is known), then pick them back up until it is paid. I have no intention of moving, so eliminating the mortgage via a change in housing is not for me.
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Use Roth contributions and conversions to supplement the 72t?
1) Rollover over some of the tIRA to a new tIRA. This will be used for Roth conversions.
2) 72t the original tIRA.
3) Pull out the natural Roth contributions until the conversions mature.
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Am I correct in reading that you plan to start SEPP distributions and then take extra distributions out in some years when the SEPP payment isn't quite enough? Be careful with that. I've read that taking extra payments can be considered a "modification" of the SEPP arrangement, which would invalidate the whole thing and cause you to owe a 10% early withdrawal penalty on all previous SEPP distributions. To avoid this risk you probably could take SEPP distributions from your IRA only and leave your wife's IRA for ad hoc withdrawals (or vice versa), but then the SEPP withdrawals would be calculated based on a smaller account balance and so you would need to supplement quite a bit with the other account and pay a sizable amount of penalty in the process.
Based on the fact that you mention you're making deductible traditional IRA contributions, I'm guessing you're ending up in the 10-15% tax bracket. If that's true, you may want to consider switching some of your traditional contributions to Roth because you're probably not going to be in a significantly lower tax bracket during retirement anyway. In that case there's little difference tax-wise between Roth and traditional, so you may as well diversify and make the Roth pipeline easier in the process.
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Am I correct in reading that you plan to start SEPP distributions and then take extra distributions out in some years when the SEPP payment isn't quite enough? Be careful with that. I've read that taking extra payments can be considered a "modification" of the SEPP arrangement, which would invalidate the whole thing and cause you to owe a 10% early withdrawal penalty on all previous SEPP distributions. To avoid this risk you probably could take SEPP distributions from your IRA only and leave your wife's IRA for ad hoc withdrawals (or vice versa), but then the SEPP withdrawals would be calculated based on a smaller account balance and so you would need to supplement quite a bit with the other account and pay a sizable amount of penalty in the process.
I appreciate the note of caution. I was looking at the 3 best ways to access tax deferred funds in the article (traditional SEPP, traditional penalty, traditional to Roth ladder) as a menu to choose to from, not considering some options may be exclusive. Considering SEPP is new to me, so I'll have to research it. From your comment it sounds like one can combine SEPP and Roth ladder, but not SEPP and penalty. An unplanned 10% penalty on all prior SEPP distributions would be tragic. If I have to pay a penalty, I'd rather plan for it and adjust my target FIRE number higher, take what I want when I want without the hooplah of SEPP (within reason, monitoring for sequence of returns risk), and slightly extend time until FIRE.
The idea of splitting my tIRA in two to allow SEPP distributions from one and Roth conversions from the other is helpful in tailoring a target SEPP amount. And keeping my wife's tIRA with no SEPP to have the option to take distributions with the 10% penalty when needed sounds like a plausible work-around after taxable accounts are depleted, I'll have to research this further if attempting.
I look at killing the mortgage (or any way of significantly reducing recurring expenses) is a hedge on sequence of returns risk, though, and I'm not able to think of a way to reduce the additional risk I'd have if I carry the mortgage with me into FIRE. This may just be a trade-off I have to accept and make my choice based on my tolerance for accepting that risk, but I'm open to anything I might be missing that might help. Trading another 18 months of my life is no joke.
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Does anyone know if there is any tax code language preventing you from having more than one 72t going? Like maybe you start a small one with a small diverted new IRA while you initiate the Roth pipeline for the remaining, and then plans change and you start a second one on another IRA at a later point to up the income? My assumption is no, at least for couples who would have 2 separate sets of accounts, but I wonder if an individual can have more than one if they have more than one IRA...again, I assume so, but you know what they say...I've reviewed IRC section 72(t) (which has literally one line about SEPP with no details), IRS notice 89-25, and Revenue ruling 2002-62, and the language seems to refer specifically to account balances, etc., so different accounts, treated differently, right?. But we know that in some other instances the IRS treats all IRAs for one individual as pooled together, specifically when dealing with aftertax Roth conversions, so if the IRS were to take a similar mindset regarding SEPP, then that could blow a whole in the idea of "partial" 72ts entirely, but I can't find positive or negative confirmation about multiple IRAs under the same account owner.
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You're worried that having a large enough SEPP withdrawal to cover your mortgage will expose you to greater sequence of returns risk, and balancing that against wanting to retire 18 months earlier by keeping the loan versus paying it off. Try door 3: refinance to a 30 year mortgage to reduce your withdrawal and therefore your sequence of return risk. You can decide to make extra principal payments any time you choose, so you're not actually stuck with a loan for 30 years. If you do decide to keep the 15 year loan going, what will you do with all of the extra availability in your budget when that loan pays off in your early 50's? You are still stuck with your SEPP until 59.5, correct? which is quite a few years of extra mandatory payments. (Based on you being 40 now, having 13 years left on your loan, planning to retire at age 45, your loan would pay off at age 53).
Another thing to look at is social security and pensions. Planning to retire around age 45, you have ~20 years before SSI kicks in. If your planned social security payments will cover most or all of your expenses, or even just cover PART of them, it is a strong mitigant against the downside risk of a poor sequence of returns while locked in to SEPP.
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Does anyone know if there is any tax code language preventing you from having more than one 72t going? Like maybe you start a small one with a small diverted new IRA while you initiate the Roth pipeline for the remaining, and then plans change and you start a second one on another IRA at a later point to up the income? My assumption is no, at least for couples who would have 2 separate sets of accounts, but I wonder if an individual can have more than one if they have more than one IRA...again, I assume so, but you know what they say...I've reviewed IRC section 72(t) (which has literally one line about SEPP with no details), IRS notice 89-25, and Revenue ruling 2002-62, and the language seems to refer specifically to account balances, etc., so different accounts, treated differently, right?. But we know that in some other instances the IRS treats all IRAs for one individual as pooled together, specifically when dealing with aftertax Roth conversions, so if the IRS were to take a similar mindset regarding SEPP, then that could blow a whole in the idea of "partial" 72ts entirely, but I can't find positive or negative confirmation about multiple IRAs under the same account owner.
I found the below quote at the below link, put out by Morgan Stanley:
If I have several IRAs, do I hav to apply the 72(t) calculations to all of them? No. You can choose to take 72(t) distributions from one IRA account and leave the funds in your other IRAs untouched.
http://www.morganstanleyfa.com/public/projectfiles/a248f8a8-bec2-4944-b0fb-1f21e43af7ae.pdf (http://www.morganstanleyfa.com/public/projectfiles/a248f8a8-bec2-4944-b0fb-1f21e43af7ae.pdf)
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From your comment it sounds like one can combine SEPP and Roth ladder, but not SEPP and penalty.
I haven't researched the SEPP very extensively because I'm planning to use the Roth ladder, but my understanding is that once you start SEPP distributions from an IRA you have to take out exactly the amount determined by the formula every year, no more, no less. But it does look like you can split your IRA into separate accounts before starting SEPP. With this setup you'll take out exactly the required amount from the SEPP IRA, and do what you want with your other IRA. That could mean direct withdrawals (incurring a penalty), or Roth conversions.
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My understanding as well. Figure out how much you want to withdraw, use the formula to work backwards and determine what IRA balance you need to get that withdrawal amount, then transfer that amount to a new IRA and do your SEPP from that IRA only.
From your comment it sounds like one can combine SEPP and Roth ladder, but not SEPP and penalty.
I haven't researched the SEPP very extensively because I'm planning to use the Roth ladder, but my understanding is that once you start SEPP distributions from an IRA you have to take out exactly the amount determined by the formula every year, no more, no less. But it does look like you can split your IRA into separate accounts before starting SEPP. With this setup you'll take out exactly the required amount from the SEPP IRA, and do what you want with your other IRA. That could mean direct withdrawals (incurring a penalty), or Roth conversions.
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You're worried that having a large enough SEPP withdrawal to cover your mortgage will expose you to greater sequence of returns risk, and balancing that against wanting to retire 18 months earlier by keeping the loan versus paying it off. Try door 3: refinance to a 30 year mortgage to reduce your withdrawal and therefore your sequence of return risk. You can decide to make extra principal payments any time you choose, so you're not actually stuck with a loan for 30 years. If you do decide to keep the 15 year loan going, what will you do with all of the extra availability in your budget when that loan pays off in your early 50's? You are still stuck with your SEPP until 59.5, correct? which is quite a few years of extra mandatory payments. (Based on you being 40 now, having 13 years left on your loan, planning to retire at age 45, your loan would pay off at age 53).
Another thing to look at is social security and pensions. Planning to retire around age 45, you have ~20 years before SSI kicks in. If your planned social security payments will cover most or all of your expenses, or even just cover PART of them, it is a strong mitigant against the downside risk of a poor sequence of returns while locked in to SEPP.
If I keep the 15 year and pay it off in my early 50s, I am stuck with SEPP until 59.5, for sure. But if I increase my stash amount enough to cover that via 4% rule, AND I can accomplish that sooner than paying off mortgage and stashing for 25x non-retirement expenses, that's bonus money (see Thing 2, Option 2 in OP). By that time I'll know what the returns have been in the first years after FIRE. If they were low, I'd hold on to this money in a taxable account, I'm gonna need it. If they were fine, I'd give it to charity or help out my children who will be in their early 20s then and may have college loans.
I really like both suggestions you made, RobbyJ. I can keep the 15 year for now because it pays down more principle, but refi the remaining principle balance just before FI (while I still have a solid income) if the rates are reasonably low. This will require less monthly cash than current mortgage, reducing withdrawls and sequence of returns risk. If rates go up significantly between now and then, I can reconsider. My social security benefit, adjusted to 75% of what the current formula says I'm due, is enough to cover 50% of annual non-mortgage retirement budget. Each year working means this goes up more, so I'll probably be near 70% of budget by the time I FIRE. I tend to think of my stash as needing to cover all expenses until I die due to uncertainty with social security, but the reality is I have been paying in and I'll likely get something significant out. My other big safety is not counting home equity in net worth because I'm in my "forever home" and don't intend to tap that for living expenses.
I plan to calculate the actual tax dollars saved in each tax year before deciding if I contribute to Roth or tIRA, and if I picked wrong, recharacterize. Last year I chose Roth, but recharacterized to traditional based on knowing how many actual dollars would be lost to taxes and not be invested for the long haul. This year the tIRAs are fully funded.
Any other suggestions? Door 4? Door 5?
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You could go ahead and refinance to a 30 year loan now, while rates are very low. You will be able to make extra payments on your loan.. so if your loan payment is $500 less on a 30 year than a 15 year, put that extra $500/month towards principal, and you basically have a 15 year loan again! Except that you get the bonus option of stopping that extra $500/mo at any time, lowering your payment.
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Last year I chose Roth, but recharacterized to traditional based on knowing how many actual dollars would be lost to taxes and not be invested for the long haul.
Taxes are inevitable. The question is whether you'll pay them now or later.
Suppose you have N pre-tax dollars available to save for retirement, and suppose you expect any dollars you invest this year to grow by a factor of X by the time you withdraw them during retirement.
If you contribute that money to a traditional retirement account, you'll have NX dollars in the account immediately before withdrawing. If your tax rate at that time is TR, you'll pay NXTR in taxes when you withdraw, leaving NX(1-TR) left for you to spend.
If your tax rate right now is Tnow and you decide to make Roth contributions instead, you'll pay NTnow in taxes this year, leaving you with N(1-Tnow) to invest in the Roth account. You'll have NX(1-Tnow) dollars to withdraw during retirement. Your Roth withdrawals won't be taxed, so that's what you get to keep.
If Tnow is the same as TR, you get to keep the same amount either way! Don't fret over the taxes you might pay now to make Roth contributions if your tax rate will be about the same during retirement. Instead consider the other pros and cons of each account type. In your case, some money in Roth might make sense to give you some more flexibility in withdrawals and it might even allow you to use the Roth pipeline instead of messing around with the SEPP system.
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Last year I chose Roth, but recharacterized to traditional based on knowing how many actual dollars would be lost to taxes and not be invested for the long haul.
Taxes are inevitable. The question is whether you'll pay them now or later...
Taxes are inevitable now during accumulation, but not in retirement. I'm lowering my tax burden now and hoping for zero tax in retirement.
We live simply in a LCOL area. Our RE budget if the mortgage is INCLUDED is just over $30k. With no mortgage or a lower mortgage payment we could EASILY live off of the $28,800 we can earn with 0 tax (standard deduction + 4x personal exemption) until the kids are gone, the excess will support Roth conversions. This doesn't even count the child tax credits which reduce taxes dollar for dollar. This drops to $20,700 (standard deduction + 2x expenses) when we can no longer claim the kids as dependents, earliest is 2025. We can live a full life on that little without a mortgage and pay no taxes, or keep a mortgage and pay some small amount of taxes. Either way our marginal rate is currently higher than it will be in retirement. ;)
The trick is getting to that money if it is all tax deferred. Because paying marginal tax rate on Roth contributions now is less efficient when I can deduct tIRA contributions.
The goal is NX(1-TR) = NX
Because the size of stash required to hit FI is lower.
Which means RE is sooner.
Inspirations:
- I don't have quite as many tax-defferring options as Justin did in this post, so I can't get effectively to zero during accumulation. http://rootofgood.com/make-six-figure-income-pay-no-tax/ (http://rootofgood.com/make-six-figure-income-pay-no-tax/)
- http://www.gocurrycracker.com/never-pay-taxes-again/ (http://www.gocurrycracker.com/never-pay-taxes-again/)