Taxable/Tax Sheltered Asset Allocations for Early Retirement

[mach9139]

I am currently 26 and am planning on retiring at 40. I have been maxing out my 401k and Roth IRA and putting additional savings into a taxable brokerage account. My math shows that I can stop contributing to the 401k/IRA all together around 30 and just let it run. As the size of the taxable account increases I have been reconsidering my asset allocation strategy. I am currently looking at going one of two ways:

Option 1) Two separate buckets with two separate allocations. Treat my tax-sheltered accounts as my old man money to take me from 60 to 90+ with a target date 2050 style allocation. Invest in my taxable account to take me from 40-60 with a target date 2030 style allocation.

The advantage I see from option 1 is that the more conservative taxable allocation will give me protection from stock volatility during accumulation and age 40-60 while I am withdrawing those funds. The disadvantage is that I will have sizable bond holdings in a taxable account.

Option 2) One bucket with a common asset allocation. Treat my entire portfolio as a whole to have it carry me from 40-90+ with a target date 2050 style allocation. Hold all bonds in my 401k and keep stocks in my Roth IRA and taxable account.

The advantage I see from option 2 is the tax efficiency. The disadvantage is only having stock funds in the taxable account to draw on in early retirement. That may jeopardize my plans if the market has some bad years, or force me to take early withdrawals from the IRA/401k.

If you are in early retirement or are thinking about pursuing it, do you treat the taxable and tax-sheltered parts of your portfolio together or as two buckets? Are there any other options you would recommend?

[toga62]

I'm doing the same research as you and found these as helpful reads

http://www.bogleheads.org/wiki/Asset_allocation_in_multiple_accounts
http://www.bogleheads.org/wiki/Principles_of_tax-efficient_fund_placement

I am doing Option B myself, but there is nothing to say you can't eventually add a percentage of the bond allocation to your taxable account as well.  You will just need to offset this by changing the percentage of stocks and bonds in your other accounts.

It does appear to me to be a personal decision, depending on how much risk you wish to take with any single account vs how much taxes you want to get away from having to pay.

[Frankies Girl]

I've got sort of the same situation as you - other than being older.

I'm still treating my accounts as a whole in terms of my asset allocation regardless if they're tax deferred or taxable. I have the higher tax liability funds like bonds in my tax deferred accounts.

I'm basically using your option 2.

I'll be retiring in the next 1-2 years (woot!), and the husband in the next 3-4 years (if he chooses) so technically we won't be touching the actual investments for at least 3 years... but the taxable account is what I'll be using for my first stage drawdown. I will also be moving my 401K to an IRA after retirement, and then I'll be starting a Roth pipeline, and will be holding bonds and other tax inefficient funds over in the Roth/IRA as I want taxes to be as streamlined as possible.

As funds switch over to the Roth, I have the option of using that as a withdrawal bucket in the event that I want to leave my taxable alone due to a down year for instance. I can withdraw from a Roth with no penalties or taxes (no matter what age) the amounts of my contributions at any time, and the transfer of funds from the traditional IRA (that used to be a 401K) to the Roth just need to be in the Roth for 5 years in order to withdraw them under the same rules.

[foobar]

Your plan of withdrawing money from the ROTH during down markets is fundamentally wrong in pretty much every case. Why wouldn't you just sell the taxable investment and buy it in the ROTH account? Obviously you have to pay attention to wash sale rules but the advantage of having tax free money is huge. You can buy anything (bonds, reits, stocks,...) and not have to worry about taxable events or dividend payments.   Now if you need to keep your income down for ACA or other reasons the ROTH might make sense but the market being down definitely isn't a reason to switch up your plan.

I've got sort of the same situation as you - other than being older.

I'm still treating my accounts as a whole in terms of my asset allocation regardless if they're tax deferred or taxable. I have the higher tax liability funds like bonds in my tax deferred accounts.

I'm basically using your option 2.

I'll be retiring in the next 1-2 years (woot!), and the husband in the next 3-4 years (if he chooses) so technically we won't be touching the actual investments for at least 3 years... but the taxable account is what I'll be using for my first stage drawdown. I will also be moving my 401K to an IRA after retirement, and then I'll be starting a Roth pipeline, and will be holding bonds and other tax inefficient funds over in the Roth/IRA as I want taxes to be as streamlined as possible.

As funds switch over to the Roth, I have the option of using that as a withdrawal bucket in the event that I want to leave my taxable alone due to a down year for instance. I can withdraw from a Roth with no penalties or taxes (no matter what age) the amounts of my contributions at any time, and the transfer of funds from the traditional IRA (that used to be a 401K) to the Roth just need to be in the Roth for 5 years in order to withdraw them under the same rules.

[Frankies Girl]

Your plan of withdrawing money from the ROTH during down markets is fundamentally wrong in pretty much every case. Why wouldn't you just sell the taxable investment and buy it in the ROTH account? Obviously you have to pay attention to wash sale rules but the advantage of having tax free money is huge. You can buy anything (bonds, reits, stocks,...) and not have to worry about taxable events or dividend payments.   Now if you need to keep your income down for ACA or other reasons the ROTH might make sense but the market being down definitely isn't a reason to switch up your plan.

Well, I did say "in the event I wanted to leave my taxable alone" so tapping the Roth instead during a downturn, which to me, means selling off a little of my bonds or REITs held in the Roth - which would probably be doing better than the stock index, so selling high-ish and give the stocks held in my taxable a bit of time to recover makes sense to me on the surface...but I'll refer you to my sig line in this instance and agree I may not know what I'm talking about. ;)

Still learning stuff, and as it's several years away anyway, I figure I've got some time to read up on the reasons I would actually want to tap the Roth instead of the taxable. It's highly unlikely I would since it would have to be a serious mess in the market for me to run through my taxable at this point before I needed to hit the Roth. But in an emergency situation for instance, the Roth contributions are available without penalties or taxes - which is all I'm saying.

[foobar]

And I am saying why the heck would you want to leave the taxable alone. The market being down sure isn't a good one.  Here is a quick example
Start
Roth: 20k in bonds
Tax : 20k in stocks.

Stocks drop 50% and you need to take 10k out

Would you rather
a) Let those stocks recover and end up with
Roth: 10k bonds
Taxable: 10k stocks

or
B) Sell the old stock and buy new stock in the ROTH
Roth: 10k bonds AND 10k stocks
taxable:0k

You have 20k either way and you have the exact same asset allocation. The only difference is that when you take money out of the ROTH in the future, it doesn't show up as AGI and has a bunch of other advantages. 

Your plan of withdrawing money from the ROTH during down markets is fundamentally wrong in pretty much every case. Why wouldn't you just sell the taxable investment and buy it in the ROTH account? Obviously you have to pay attention to wash sale rules but the advantage of having tax free money is huge. You can buy anything (bonds, reits, stocks,...) and not have to worry about taxable events or dividend payments.   Now if you need to keep your income down for ACA or other reasons the ROTH might make sense but the market being down definitely isn't a reason to switch up your plan.

Well, I did say "in the event I wanted to leave my taxable alone" so tapping the Roth instead during a downturn, which to me, means selling off a little of my bonds or REITs held in the Roth - which would probably be doing better than the stock index, so selling high-ish and give the stocks held in my taxable a bit of time to recover makes sense to me on the surface...but I'll refer you to my sig line in this instance and agree I may not know what I'm talking about. ;)

Still learning stuff, and as it's several years away anyway, I figure I've got some time to read up on the reasons I would actually want to tap the Roth instead of the taxable. It's highly unlikely I would since it would have to be a serious mess in the market for me to run through my taxable at this point before I needed to hit the Roth. But in an emergency situation for instance, the Roth contributions are available without penalties or taxes - which is all I'm saying.

[jhartt3]

So i dont understand why you would be switching from tax sheltered accounts at all.  I'm 27 right now and recently found this site so i have switched from Roth 401k to traditional.  tell me where i'm wrong in the following scenario.

My wife and I both max our t401k's and Roth IRA's, until retirement at 40.  Why would you switch to taxable at 30yo?

At 32yo we plan to add 10k to a taxable account.  In retirement you can use your 0AGI roth withdrawal's plus some taxable money and roll 50k per year to a roth account for use in 5 years.  here is a table i made depicting roth value and taxable value from Year 1 - 5 of retirement and the amount you can roll to your Roth IRA each year for use starting in year 6.  And all this money should be untaxed if it comes from qualified dividends or long term capital gains correct? 

   roth ira         100% tax      traditional IRA   IRA Rollover
   $175,000.00   $175,000.00   $900,000.00   
1   $30,000.00          $20,000.00    $850,000.00   $50,000.00
2   $60,000.00     $40,000.00    $800,000.00   $50,000.00
3   $90,000.00    $60,000.00    $750,000.00   $50,000.00
4   $120,000.00   $80,000.00    $700,000.00   $50,000.00
5   $150,000.00   $100,000.00   $650,000.00   $50,000.00

Since i'm only taking 50k out of my IRA accounts each year to roll over and it comes from LT capital gains and qualified Dividends AND i will be in the 15% bracket since i'm only taking 20k a year out of my taxable account don't i pay no tax?  and does this not work?  Please pick it apart b/c this is my plan currently. 

[jhartt3]

If for some reason this doesnt work.  Why wouldnt you just fund roth accounts instead of no tax shelter accounts b/c contributions can be taken out at any time tax free. 

[TreeTired]

Since i'm only taking 50k out of my IRA accounts each year to roll over and it comes from LT capital gains and qualified Dividends AND i will be in the 15% bracket since i'm only taking 20k a year out of my taxable account don't i pay no tax?  and does this not work?  Please pick it apart b/c this is my plan currently.

I honestly am not following you too well.  I don't understand exactly what you are saying,  BUT (big BUT)   I just want to make sure you understand that any withdrawals from a traditional IRA will be treated as ordinary income.  If you have a non-zero basis, some of the money will be untaxed, but in general any withdrawal from a traditional IRA is ordinary income.  It doesn't matter at all if the gains in the account were capital gains, dividends or interest:   the withdrawal is ordinary income.  If you hold muni bonds in your IRA,  any withdrawals will be ordinary income.  The tax exempt feature of the munis will be lost.

[jhartt3]

thats what i wanted to know.  so you just shot a small hole in my plan.  so i'd be taxed at around 20% on this after state taxes. 

[jhartt3]

so question.  how is investing in a roth IRA different than just investing the cash in an account that will only make LT Capital gain income and Qualifying dividend income.  If you plan to live in the 15% cash bracket.  Arent these one and the same at that point?  you pay no tax on the money on the way out and paid it on the way in.

[foobar]

A couple of big differences
1) 40k out of a roth is 0 dollars of income. 40k of capital gains is 40k of income. This will affect things like % social security that you pay taxes on, medicare copays, and ACA subsidies among others.
2) State taxes might apply to your capital gains
3) You can invest in bonds and reits in your ROTH and not have to worry about the taxes
4) If you need to rebalance, you don't have to worry about the tax consequences

so question.  how is investing in a roth IRA different than just investing the cash in an account that will only make LT Capital gain income and Qualifying dividend income.  If you plan to live in the 15% cash bracket.  Arent these one and the same at that point?  you pay no tax on the money on the way out and paid it on the way in.

[jhartt3]

all great points.  Thank you.  So switching to a Roth 401k rather than cash at 30 (which i may have to do b/c of income anyways)  may be the better move.  the Roth 401k contributions will keep you above living fine until your roth IRA pipeline from converting t401k over kicks in... does that sound better than going pure cash.

[GlassStash]

all great points.  Thank you.  So switching to a Roth 401k rather than cash at 30 (which i may have to do b/c of income anyways)  may be the better move.  the Roth 401k contributions will keep you above living fine until your roth IRA pipeline from converting t401k over kicks in... does that sound better than going pure cash.

I'm not sure if the last part was a question, but I'll try and answer anyway. Trad'l 401k, Roth 401k, Roth IRA, and Trad'l IRA accounts are all "better than going pure cash" if you are able to contribute to them. Taxable accounts certainly have their place (after the aforementioned accounts are maxed), but they are not necessary for an ER. If you have your stache saved up, your SWR can be withdrawn from a Roth account (assuming it is enough to last the 5 years until a Roth conversion ladder). I would also look into 72(t) distributions for ER. Most people opt for the Roth conversion ladder, but the 72(t) is worth consideration for mere ease of use alone.

[jhartt3]

so my table is close to correct.  the only thing i need to account for is the money i'm rolling to my roth from my IRA being taxed at the appropriate level.  so i would need to roll say an extra 6k to cover takes give or take.