Taxable investing strategies for FIRE before 59.5

[pdxguy]

I have been putting money aside in my company's stock plan with the intent to capture the discount and sell as needed. I've been cashing out at regular intervals, but the stock has had a strong run, and now I am putting a plan together to retire at 55 (47 now) using taxable investments to fund from 55 to 59.5 and then I can start withdrawing from my 401k.

I will need to diversify out of my employer's stock and into other investments. I have put time and effort into my pre-tax retirement accounts and feel they are sorted, at least until I need to start withdrawals, but haven't put the research into taxable options yet.

I'd like good ideas from the group here on tax efficient investing with a relatively short time horizon, 7-12 years.

Edit: for clarity, I don't want to start withdrawals from my 401k...I need to manage my taxable investments to support FIRE

[clifp]

For the most part you can withdraw money your 401K if turn 55 in the year you leave.  Not all but the vast majority of medium to large firms support this.

With 8 years to go I'd really focus on the  very  tax efficient equity index funds. At the same time start shifting some of your 401K to bond funds. I think bonds are lousy  investments right now, so I would have a rather modest allocation. 3-5 years out I'd start setting up a CD ladder

[forummm]

http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

[pdxguy]

http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

I'd have to pay taxes now on the conversion, if I'm reading that right. I already have money in a taxable account...I'm in a higher tax bracket now than I'll be in retirement...I'd want to postpone paying any taxes after retirement when I'm in a much lower bracket.

[seattlecyclone]

For money you already have in taxable accounts, read http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement. Long story short, put any bonds and REITs in your retirement accounts, while your taxable accounts should be more stock-heavy.

If you do leave your job when you're 55, you can withdraw from your 401(k) without penalty at that time. If you don't foresee yourself being able to retire prior to 55, there's no reason not to keep maxing out your 401(k) until then. Even if you can retire before 55, if your current tax bracket is at least 10% higher than your retirement tax bracket, contributing to your 401(k) and paying early withdrawal penalties after retirement will be better than paying tax on that money now and putting it in a taxable account.

[forummm]

http://forum.mrmoneymustache.com/investor-alley/how-to-withdraw-funds-from-your-ira-and-401k-without-penalty-before-age-59-5/

I'd have to pay taxes now on the conversion, if I'm reading that right. I already have money in a taxable account...I'm in a higher tax bracket now than I'll be in retirement...I'd want to postpone paying any taxes after retirement when I'm in a much lower bracket.

No, you would do the conversion later--once you're in retirement--and pay the taxes at that time (i.e. at your lower retirement tax bracket rate). If you have a low enough spend, you could pay no tax, even while cashing out some of your taxable funds.

[seattlecyclone]

Given that the OP is planning to retire at 55, the Roth conversion ladder offers little benefit. By the time any post-retirement conversions have been in the account for five years, it would be possible to have simply withdrawn that money from the pre-tax account with no penalty. Conversions could still be a good idea to pre-pay some tax during the earlier years where they would otherwise only have capital gains income that is taxed at very low rates, but it's not the same strategy as many of us are planning to use in our even earlier retirement.

[forummm]

Given that the OP is planning to retire at 55, the Roth conversion ladder offers little benefit. By the time any post-retirement conversions have been in the account for five years, it would be possible to have simply withdrawn that money from the pre-tax account with no penalty. Conversions could still be a good idea to pre-pay some tax during the earlier years where they would otherwise only have capital gains income that is taxed at very low rates, but it's not the same strategy as many of us are planning to use in our even earlier retirement.

Yes, good point.

OP, Roth contributions (IRA or 401k) can be pulled out at any time, so that could help you during the first 5 years of retirement. Other than that, just investing in with your normal AA is good. Generally try to keep bonds and other tax inefficient holdings in a tax-advantaged account. But other than that there isn't anything too special about taxable investing--just buy and hold until you're ready to spend it in retirement.

[spud1987]

If you have a high-tax rate now, you may want to think about muni-bonds. They return about 3-5% tax-free, which is the equivalent of about a 4-7% taxable return (depending on your marginal rate). The bulk of my taxable account is in Cal muni-bonds whereas my retirement accounts are almost entirely stocks.

This works well for me since dividends from equities would be taxed at around 36.8% (23.8% federal + 13.3% CA).

Once I FIRE I'll move in to a more traditional stock/bond mix in my taxable account since my income should be low enough to avoid all federal dividend taxation and we will be moved out of CA.

[pdxguy]

For the most part you can withdraw money your 401K if turn 55 in the year you leave.  Not all but the vast majority of medium to large firms support this.

With 8 years to go I'd really focus on the  very  tax efficient equity index funds. At the same time start shifting some of your 401K to bond funds. I think bonds are lousy  investments right now, so I would have a rather modest allocation. 3-5 years out I'd start setting up a CD ladder

Not sure how I missed this, but the 55 exemption is a sweet option, thanks. The only catch is that the 401k account you withdraw from has to be the same employer at the time you leave? Below is the best I found, the IRS pub was no help. Looking for a clearer explanation if someone has it.

There is an exception to that rule, however, which allows an employee who retires, quits or is fired at age 55 to withdraw without penalty from their 401k (the "rule of 55"). There are three key points early retirees need to know.

First, this exception applies if you leave your job at any time during the calendar year in which you turn 55, or later, according to IRS Publication 575.

Second, if you still have money in the plan of a former employer and assuming you weren't at least age 55 when you left that employer, you'll have to wait until age 59½ to start taking withdrawals without penalty.

Agree with the allocation advice...

Still reading through the comments and advice, good stuff - keep 'em coming!

[seattlecyclone]

The only catch is that the 401k account you withdraw from has to be the same employer at the time you leave?

Yes. Roll over any previous 401(k) accounts and/or traditional IRAs into the 401(k) with your final employer to take full advantage of this. If your final employer only has crappy funds in the 401(k), don't roll over more than you need to last until 59½.

[mrpercentage]

Everyone is afraid of taxes but given your time line I would just invest it into something that you control the selling and won't sell. You should fair fine. Who cares if they tax some dividends. No prepayment penalty and dividends can actually help you out if you have a bad month.

[mrpercentage]

And actually I was thinking of replacing all my future income with dividends. This is how it would work.

Buy high yield reliable dividend grown company. Set it to pay out to me. Then go and increase my pretax deduction investing to match new dividend income. End result is Im investing more and paying the same or less taxes. I am trying to figure out what balance I would need of normal income invested vs pretaxed. That balance I haven't figured out yet but Im working on it. Maybe I will just do it with tax returns. Not sure yet but its a new strategy I am exploring.

[matchewed]

Everyone is afraid of taxes but given your time line I would just invest it into something that you control the selling and won't sell. You should fair fine. Who cares if they tax some dividends. No prepayment penalty and dividends can actually help you out if you have a bad month.

It's not fear, it's optimization. Why pay out more money to other people than you have to? There are few things you can control when investing; cost is numero uno, taxes is numero dos when you have all the different available tax treated accounts at your disposal.

[mrpercentage]

Everyone is afraid of taxes but given your time line I would just invest it into something that you control the selling and won't sell. You should fair fine. Who cares if they tax some dividends. No prepayment penalty and dividends can actually help you out if you have a bad month.

It's not fear, it's optimization. Why pay out more money to other people than you have to? There are few things you can control when investing; cost is numero uno, taxes is numero dos when you have all the different available tax treated accounts at your disposal.

Because you can optimize yourself into a corner. No strings attached and you setting your own rules is strength. I prefer a position of strength. You could do it with many ETFs for sure but if I picked up KMI, CVX, COP, O, BX and they were all yielding 5-9%, who cares if they take 15% of my 7% yield. Why would I put money into something with a bunch of strings attached? Flexibility is power.  Even SPY isn't that bad. Okay they will get 15% of your 2% yield. So what. You can take it anytime and pay the taxes. Now you need to put it in something you will hold not trade. Trading will put a huge drag on your account. But what is 15% of 2%? It's 0.003%. So what. Small price to pay.

[matchewed]

Everyone is afraid of taxes but given your time line I would just invest it into something that you control the selling and won't sell. You should fair fine. Who cares if they tax some dividends. No prepayment penalty and dividends can actually help you out if you have a bad month.

It's not fear, it's optimization. Why pay out more money to other people than you have to? There are few things you can control when investing; cost is numero uno, taxes is numero dos when you have all the different available tax treated accounts at your disposal.

Because you can optimize yourself into a corner. No strings attached and you setting your own rules is strength. I prefer a position of strength. You could do it with many ETFs for sure but if I picked up KMI, CVX, COP, O, BX and they were all yielding 5-9%, who cares if they take 15% of my 7% yield. Why would I put money into something with a bunch of strings attached? Flexibility is power.  Even SPY isn't that bad. Okay they will get 15% of your 2% yield. So what. You can take it anytime and pay the taxes. Now you need to put it in something you will hold not trade. Trading will put a huge drag on your account. But what is 15% of 2%? It's 0.003%. So what. Small price to pay.

What corner do you optimize yourself into with utilizing a variety of investment vehicles with different tax treatments?

And note you don't get to "set your own rules" in your scenario. You get to play by the rules outlined in that scenario you just painted as well. If you're looking to live off of taxable dividends as you seem to be outlining there, the "small price to pay" is needing a massive amount invested. Let's say you have expenses of $40k, you'd need a portfolio of $2.35 million dollars throwing a consistent dividend of 2% adjusting for inflation.

Or I could just go with tax efficiency and just save a stache of $1.12 million dollars in order to do a 4% SWR and have expenses of $40k. This is also going with the assumption that you'd have to pay income tax on all withdrawals. Which given the different tax treated investment vehicles will not be the case. Thereby still shrinking the amount your portfolio needs to be in order to FIRE.

So would I rather save at most $1.12 million dollars or least $2.35 million dollars?

[mrpercentage]

Okay I was under the impression I would need a massive amount to retire anyway. Being that dividends don't sell shares and DGI will actually increase your payout  in time I'm still missing your point.

Look you get a pretax 401k. That means you have to pay taxes. I buy SPY and have an additional annual drag of 0.003% for the dividend but can sell when I want and would pay taxes just like 401k.

Now DGI sure they get a bigger bite but I actually have close to zero annual rate anyway because I buy in chunks of a couple of thousand coming off the top of my emergency fund. So 2000 with a $7 fee is a one time fee of 0.035% with an annual tax fee of 0.0105% for a 7% dividend. I can shoot the dividends at me whenever I like with no penalty, and the compounding will make money when the market is going down too. My style is actually closer to buy a hold than an index with less fees and total control on withdrawals.

sorry changes made in bold

[matchewed]

Okay I was under the impression I would need a massive amount to retire anyway. Being that dividends don't sell shares and DGI will actually increase your payout  in time I'm still missing your point.

You can't guarantee that DGI will increase the payout in time. That's a pretty key and massive assumption. My point is that you have to save way more than necessary for a 2% dividend yield strategy. It is time taken from your life for a needlessly conservative and rigid strategy.

Look you get a pretax 401k. That means you have to pay taxes.

It's as if you didn't read what I wrote. I don't actually have to pay taxes if I optimize correctly. So again what corner have I "optimized myself into"? You haven't answered that question. You however do have to pay taxes guaranteed.

I buy SPY and have an additional annual drag of 0.003% for the dividend but can sell when I want and would pay taxes just like 401k.

No you don't get to pay taxes just like a 401k. You pay taxes on the dividend and when/if you do sell because the dividend is not a guaranteed amount you have to pay income taxes because you don't have other tax treated accounts. So in effect you are not actually more flexible by using less variety of tax treated accounts, you've rigidly set yourself in one particular place.

Now DGI sure they get a bigger bite but I actually have close to zero annual rate anyway because I buy in chunks of a couple of thousand coming off the top of my emergency fund. So 2000 with a $7 fee is a one time fee of 0.035% with an annual fee of 0.0105% for a 7% dividend. I can shoot the dividends at me whenever I like with no penalty, and the compounding will make money when the market is going down too. My style is actually closer to buy a hold than an index with less fees and total control on withdrawals.

What are you saying?

Regardless of all of this your advice has nothing to do with what the person is asking in this thread. You've basically come in here shouting ORANGES when people were talking about APPLES.

[mrpercentage]

Chevron has increased its dividend the last 26 years strait.

Yes if you sell you have to pay taxes. Don't sell. We aren't supposed to trade are we?

A lot of vanguards funds are 0.08%. You can easily get that in a taxable account DGI. Easy. 2000 is a lowball number for some of you. It only gets better the more you put in at once taking advantage of sales because you have the cash.

I will have a pension. Let's say I need an additional 1000 a month. That's 12000 a year and with the 5% yield I just got off of O that would mean I need $240,000 yielding five percent in 20 years time. I bet I can do that. Don't forget my dividends will increase.

My apologies. Maybe my line of thinking in not right for the OP. I was putting a lot of emphasis on the title of this thread.