Author Topic: Do you account for pot. growth in converted Roths during 5-year holding period?  (Read 823 times)

Nick_Miller

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My wife and I have a target of $800K in our nest egg before pulling the trigger, with plans to convert $40K/year for living expenses. We would have an additional $200K in a "transitional fund" that would we draw down at $40K/year for the 5 years the Roth conversions "simmer" or whatever verb you want to use.

But do we really need $800K then? The nest egg, whether we're talking about the funds that are converted or the funds that are untouched over the 5 period, would still be projected (based on previous performance) to grow untouched for 5 years. Even with fairly conservative Target Date-type funds that will probably be about 60/40 stocks/bonds at that point, assuming 6% earnings/year, we'd be at almost $1.1M by the time we actually spend the first Roth conversion.

Do people view this growth as "icing" such it's obviously not guaranteed when you pull the trigger?

Given this scenario, would anyone be comfortable retiring with say $650K, which would be $870K in 5 years, again assuming 6% year earnings?

« Last Edit: September 24, 2021, 12:54:00 PM by Nick_Miller »

secondcor521

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Well, it depends.  When to FIRE and how much to FIRE with are pretty individual decisions, even though there are a lot of math and numbers out there.

If you have $1M today ($800K + $200K side fund) and spend $40K per year, that's a standard 4% rule.  If you buy into the 4% rule, have health care taken care of, know what your expenses are, etc., etc., then that's fine.

The future growth (at 6% or whatever) is already baked into the 4% rule.  In other words, the 4% rule assumes / counts on / includes investment returns.  The 6% is not somehow "extra" that the 4% rule is ignoring.

The 4% rule also includes inflation, by the way.

If I bought into the 4% rule (I do), and if I had $650K now, I'd only FIRE now if I thought I could live on 4% * $650K = $26K per year.

(Yeah, I know it's not a rule.  Whatever.)

bacchi

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Any earnings from your Roth are also taxed, unlike the conversions.

boarder42

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I'm comfortable with a 5-6% swr and given your stated age in other posts and proximity to ssa I'd be ok with it in your shoes with an all VTI/bond AA at no lower than 80/20. I'm much younger and will have a much more aggressive but at the same time safer historically at preservation and recovery of down year capital losses. Which is why I'm comfortable at 5-6%. But due to me working the rest of this year we'll probably be closer to sub 4%

Nick_Miller

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Any earnings from your Roth are also taxed, unlike the conversions.

How would Roth earnings be taxed?

Nick_Miller

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Well, it depends.  When to FIRE and how much to FIRE with are pretty individual decisions, even though there are a lot of math and numbers out there.

If you have $1M today ($800K + $200K side fund) and spend $40K per year, that's a standard 4% rule.  If you buy into the 4% rule, have health care taken care of, know what your expenses are, etc., etc., then that's fine.

The future growth (at 6% or whatever) is already baked into the 4% rule.  In other words, the 4% rule assumes / counts on / includes investment returns.  The 6% is not somehow "extra" that the 4% rule is ignoring.

The 4% rule also includes inflation, by the way.

If I bought into the 4% rule (I do), and if I had $650K now, I'd only FIRE now if I thought I could live on 4% * $650K = $26K per year.

(Yeah, I know it's not a rule.  Whatever.)

I agree that it's "baked into the rule" after you start withdrawing funds, but is it really baked into the rule during period where you aren't drawing down on it at all? I was making that distinction. I mean, what if someone in my situation had a $400K transitional fund and planned to let the nest egg ride for 5 years, and then was going to start making conversions, meaning that all of that money would be growing for 10 years (hopefully) until the first converted funds were finally withdrawn? Wouldn't it be a safe practice to anticipate that the nest egg would be higher after all of that time untouched and wouldn't that affect your initial estimated SWR?

Just trying to figure this stuff out better! I appreciate the feedback.
« Last Edit: September 24, 2021, 01:47:34 PM by Nick_Miller »

secondcor521

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Well, it depends.  When to FIRE and how much to FIRE with are pretty individual decisions, even though there are a lot of math and numbers out there.

If you have $1M today ($800K + $200K side fund) and spend $40K per year, that's a standard 4% rule.  If you buy into the 4% rule, have health care taken care of, know what your expenses are, etc., etc., then that's fine.

The future growth (at 6% or whatever) is already baked into the 4% rule.  In other words, the 4% rule assumes / counts on / includes investment returns.  The 6% is not somehow "extra" that the 4% rule is ignoring.

The 4% rule also includes inflation, by the way.

If I bought into the 4% rule (I do), and if I had $650K now, I'd only FIRE now if I thought I could live on 4% * $650K = $26K per year.

(Yeah, I know it's not a rule.  Whatever.)

I agree that it's "baked into the rule" after you start withdrawing funds, but is it really baked into the rule during period where you aren't drawing down on it at all? I was making that distinction. I mean, what if someone in my situation had a $400K transitional fund and planned to let the nest egg ride for 5 years, and then was going to start making conversions, meaning that all of that money would be growing for 10 years (hopefully) until the first converted funds were finally withdrawn? Wouldn't it be a safe practice to anticipate that the nest egg would be higher after all of that time untouched and wouldn't that affect your initial estimated SWR?

Just trying to figure this stuff out better! I appreciate the feedback.

I understand what you're saying (and I think I understand why).

You're trying to separate and segregate your FIRE stash into two piles:  your "nest egg" pile and your "transitional fund" pile.  I would not do that.  I would combine both into one large pile, and calculate your SWR on that (like I did in my earlier post).  So if you want $40K in spending, and want to do a 4% WR, you need $1M, regardless of how you split/combine/separate/side fund it.

The 4% rule starts whenever you start drawing from the nest egg, regardless of how many piles it's divided in to and regardless of which pile you choose to take from in any given year.  (Before you start withdrawing, you can certainly expect/plan/hope for your portfolio to grow, and it probably will.)

Yes, if you leave a portion of your pile untouched and invested, it'll probably grow *in the future*.  Including that *future* growth to support a *initial* SWR is really not following the 4% rule:  "I've got $650K now in one fund and $200K now in another fund, and I'm spending $40K so ... <waves hands> ... I really have $1M and am following the 4% rule."  Nope.  You've got $850K and spending $40K, which is a 4.7% withdrawal rate.  Yes, it might work.  No, you're not "complying" with the 4% rule.

It seems you want to FIRE as early as possible.  I wanted to as well.  Just make sure you understand how the 4% rule works and is calculated and the studies it is based on, and then be honest about how you're counting things.  At times I was including the proverbial change under the sofa cushions in my FIRE stash just to get it here sooner.  If you want to stretch and take a risk, you certainly can.  But be honest with yourself and your partner if that is what you're doing, because they need to understand and accept whatever risks are involved in the options being discussed.

boarder42

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The good news here is you clearly lean more creative thru asking this question this way so your book writing will hopefully be a hit. One can only hope it's as good as the pepperwood chronicles

bacchi

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Any earnings from your Roth are also taxed, unlike the conversions.

How would Roth earnings be taxed?

Roth earnings are always taxed and penalized if taken out before 59.5, with a few exceptions. ??

In this case, your $650k conversion would grow to $870k. The earnings -- $220k -- would be taxed and penalized at 10%.

$40k = X - (X * .10)

Withdrawals would need to be $44444 instead of $40,000 if income taxes are $0.

secondcor521

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Any earnings from your Roth are also taxed, unlike the conversions.

How would Roth earnings be taxed?

Roth earnings are always taxed and penalized if taken out before 59.5, with a few exceptions. ??

In this case, your $650k conversion would grow to $870k. The earnings -- $220k -- would be taxed and penalized at 10%.

$40k = X - (X * .10)

Withdrawals would need to be $44444 instead of $40,000 if income taxes are $0.

One exception is if the conversion is left in for 5 tax years, which it sounds like OP intends to do, since they mentioned simmering.

If so, withdrawals from Roth of both contributions then conversions are tax and penalty free.  That's the whole idea behind the Roth conversion ladder.

I think you are right about earnings being taxed and penalized if withdrawn before 59.5.  But earnings come out last, after contributions and conversions.  As long as OP only withdraws contributions and conversions until age 59.5, then they're OK (and neither taxed nor penalized).

ETA:  And that tax/penalty on earnings is especially heinous.  It'd be better to just make an early withdrawal from a traditional IRA instead (if one had one with any money left), since the taxation is the same on the withdrawal but the money would be better off left in the Roth.  And those Roth dollars, if waiting until 59.5, are zero tax in almost every situation (assuming first Roth > 5 years ago).
« Last Edit: September 24, 2021, 04:05:44 PM by secondcor521 »

Nick_Miller

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Any earnings from your Roth are also taxed, unlike the conversions.

How would Roth earnings be taxed?

Roth earnings are always taxed and penalized if taken out before 59.5, with a few exceptions. ??

In this case, your $650k conversion would grow to $870k. The earnings -- $220k -- would be taxed and penalized at 10%.

$40k = X - (X * .10)

Withdrawals would need to be $44444 instead of $40,000 if income taxes are $0.

One exception is if the conversion is left in for 5 tax years, which it sounds like OP intends to do, since they mentioned simmering.

If so, withdrawals from Roth of both contributions then conversions are tax and penalty free.  That's the whole idea behind the Roth conversion ladder.

I think you are right about earnings being taxed and penalized if withdrawn before 59.5.  But earnings come out last, after contributions and conversions.  As long as OP only withdraws contributions and conversions until age 59.5, then they're OK (and neither taxed nor penalized).

ETA:  And that tax/penalty on earnings is especially heinous.  It'd be better to just make an early withdrawal from a traditional IRA instead (if one had one with any money left), since the taxation is the same on the withdrawal but the money would be better off left in the Roth.  And those Roth dollars, if waiting until 59.5, are zero tax in almost every situation (assuming first Roth > 5 years ago).

Yeah I'm just doing the normal Roth conversion ladder thing that I learned from Mad Fientist.

The reason I'm treating the "transitional funds" as separate is for that very reason: you need to account for those first five years of living expenses. Well, that's what the transitional funds are. I mean, it doesn't really matter how you fund those first five years, whether it's through PT work or getting an inheritance, or setting aside a pot of money to live on, which is our approach. And it's not part of our Stache because we fully anticipate burning through the $200K. And that's fine. Because it gives our stache 5 more years to grow.

Our transitional funds include a mix of 1) cash, 2) taxable brokerage, and 3) our Roth contributions. We're pumping money into all 3 of those in the coming years, but once we pull the trigger, obviously only #2 has growth potential at that point.

I sort of figured this is how lots of people do it.

This way, our entire Stache will be tax/penalty free come withdraw time, other than the taxes we'll pay for the yearly conversions, and those are years that I only anticipate us earning about $10K in income, plus whatever measly interest we get from our cash accounts, so I wouldn't think we would owe any taxes at all.

Nick_Miller

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The good news here is you clearly lean more creative thru asking this question this way so your book writing will hopefully be a hit. One can only hope it's as good as the pepperwood chronicles

That's a high bar indeed! And some of my favorite episodes too.

Retire-Canada

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Given this scenario, would anyone be comfortable retiring with say $650K, which would be $870K in 5 years, again assuming 6% year earnings?

$40K/Yr spend out of $650K + $250K = $850K is ~4.7%WR. That's not crazy talk and you should be fine. Just don't fool yourself into thinking it's the same thing as retiring with $1M because most likely your portfolio will grow after retirement. You are eating into your safety margin a bit at ~4.7%WR.

Using cFIREsim all default settings unless noted:

- 4.0%WR [$40K/$1M] = ~96% success rate
- 4.7%WR [$40K/$850K] = ~79% success rate

So against historical data both options were highly likely to succeed over 30 years, but 4%WR was 17% better in that regard.


Nick_Miller

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Given this scenario, would anyone be comfortable retiring with say $650K, which would be $870K in 5 years, again assuming 6% year earnings?

$40K/Yr spend out of $650K + $250K = $850K is ~4.7%WR. That's not crazy talk and you should be fine. Just don't fool yourself into thinking it's the same thing as retiring with $1M because most likely your portfolio will grow after retirement. You are eating into your safety margin a bit at ~4.7%WR.

Using cFIREsim all default settings unless noted:

- 4.0%WR [$40K/$1M] = ~96% success rate
- 4.7%WR [$40K/$850K] = ~79% success rate

So against historical data both options were highly likely to succeed over 30 years, but 4%WR was 17% better in that regard.

Thanks for the info! I'll run some cFIREsims myself, which is something I haven't done yet. Does it account for social security at all? We likely won't be able to pull the trigger until I'm 52 at the earliest, and then we'd be living off the Transitional Funds for the next 5 years, so we'd really only be withdrawing from the nest egg for the next 5 years before I'd be eligible to take early SS benefits at age 62.

Or do all of these calculators always ignore SS? That would seem odd.

boarder42

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https://www.cfiresim.com/

you can add in your estimated SSA at the time you expect to earn it.

bacchi

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Or do all of these calculators always ignore SS? That would seem odd.

They usually do. Add an income source It now has its own section at the bottom of cfiresim.
« Last Edit: September 28, 2021, 08:36:38 AM by bacchi »

boarder42

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Or do all of these calculators always ignore SS? That would seem odd.

They usually do. Add an income source It now has its own section at the bottom of cfiresim.

you can also run it with a fixed mortgage payment that doesnt index to inflation using the adjustment section.

MustacheAndaHalf

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We likely won't be able to pull the trigger until I'm 52 at the earliest, and then we'd be living off the Transitional Funds for the next 5 years, so we'd really only be withdrawing from the nest egg for the next 5 years before I'd be eligible to take early SS benefits at age 62.
I'd urge you to view social security as an insurance policy, and let it build up value as long as you can stand it.  My information might be out of date, but I think social security increases by 8% per year you wait.  The stock market might give you an 8% return, but it won't be guaranteed by the U.S. government.

The most flexible approach is just to plan for both possibilities, and make a decision near age 62.

Nick_Miller

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So I ran it and got this:

100.00% - Failed 0 of 108 total cycles.   $982,559

I plugged in $800K nest egg, $40K/year inflation-adjusted withdraws, early retirement for each of us kicking in at age 62 and assumed very conservative SS monthly payments of $1500/month (me) and $1400/month (wife). I kept nest egg at 60/40 equities/bonds and had us both living to be 90 years old and the numbers assume the mortgage is paid off before retirement.

Lowest ending portfolio was $584K. Average ending portfolio was $3.2M. And this was with me plugging in that we'd be taking $40K withdraws in year 1 of retirement, which is decidedly not the plan, as has been discussed above. Let me run it with a 5-year delay on taking withdraws.

EDITED TO ADD:

So I ran it with a 5-year delay in taking withdraws, all other info the same as above.

100.00% - Failed 0 of 108 total cycles.   $982,559

Lowest ending portfolio was $1.4M and highest was $12.9M. Surely I am missing something here. I must be plugging in something wrong to make this look this optimistic. The numbers get even better if I plug in $900,000 in as the starting nest egg, which is more realistic if we do indeed stop with $800K nest egg but let it grow untouched for 5 years. I have to be underestimating health care costs.
« Last Edit: September 28, 2021, 09:01:37 AM by Nick_Miller »

boarder42

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its performing properly.  your SSA supplements your annual spend and there is no reason that plan would fail.  You're so close to SSA that it works well for you

Nick_Miller

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Nah I was running it wrong! I was plugging the $ I thought we'd have in retirement, not the amount of the nest egg we have now. Big difference!

Still, I have to adjust the nest egg down to $440K at "trigger time" (meaning it would still have 5 years to grow) to get any failure rate, and even then it's 1%. But obviously, SS is doing a lot of the heavy lifting in these scenarios, which I'm not comfortable with. But it does show we likely have some wiggle room.


ericrugiero

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I like to view it in two steps. 
Step 1: Do you have enough money to retire?  This would be your total invested assets ($800K+$200K) multiplied by your desired withdraw rate (3.5%, 4.0%, 4.5% etc).  If this covers your expenses you could retire.  You shouldn't count on growth in that five years to bring you within the 4% rule.  That rule is based on the total invested money.  Pulling 20% per year from the transitional fund will deplete that fund.  At the same time, the other fund will grow.  That's fine because you are looking at total invested money for this part not focusing on a small portion. 
Step 2: Do you have a plan to access the money before "normal" retirement age where you can access the money penalty free.  This is where the $200K transitional fund comes in.  Having that makes it easy.  After tax savings, Roth contributions, side gig income, etc are all ways to fund the first five years while starting the Roth conversion ladder. 

It sounds like cFIREsims is showing you that you are safe at a larger than 4% withdraw because it's just until you reach SSA eligibility and then that covers a significant portion of your spending and your withdraw rate drops significantly.  That makes sense. 

boarder42

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Nah I was running it wrong! I was plugging the $ I thought we'd have in retirement, not the amount of the nest egg we have now. Big difference!

Still, I have to adjust the nest egg down to $440K at "trigger time" (meaning it would still have 5 years to grow) to get any failure rate, and even then it's 1%. But obviously, SS is doing a lot of the heavy lifting in these scenarios, which I'm not comfortable with. But it does show we likely have some wiggle room.

i mean thats the only way i run it I have my own calculator for the speculation of my NW and i run it as if i'm retiring today with those numbers in there.  Of course my speculation on my NW is getting closer to correct as we'll FIRE in a few months but still i find it a much better way to use the tool but i also have some investments that it doesnt estimate returns on well that will divest when i leave my job.

secondcor521

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Nah I was running it wrong! I was plugging the $ I thought we'd have in retirement, not the amount of the nest egg we have now. Big difference!

Still, I have to adjust the nest egg down to $440K at "trigger time" (meaning it would still have 5 years to grow) to get any failure rate, and even then it's 1%. But obviously, SS is doing a lot of the heavy lifting in these scenarios, which I'm not comfortable with. But it does show we likely have some wiggle room.

You'll probably like https://www.firecalc.com/ and the "Not retired?" tab at the top (the other tabs have places for other inputs - SS goes in the Other Income/Spending tab).  I think it does what you're trying to get after by letting you plug in all the numbers *as they exist right now* but also including future growth and contributions between now and your trigger date.