Whelp, here goes nothing!
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These thoughts on drawdown strategy are based on my experience over the last 4 years of FIRE. There are quite a few variables that you may deal with. I tried to hit as much as possible. At almost 8 pages in Google Docs I’m reaching concept fatigue, as the material is pretty broad. If you have questions or I’ve gotten something wrong (hopefully not) or I’ve missed something pertinent, please point it out!
A couple of notes up front. All of my examples use our situation, Married Filing Jointly with no kids. You’ll need to scale the numbers to your specific situation (single, kids allowing a higher AGI without paying more taxes due to Child Tax Credit, etc.). Lastly, if you have not been exposed to much of this in detail it is a lot to take in. This is a couple of years worth of knowledge growth that I’ve just tried to dump into one post. I also made no assumptions about what someone knows already, so if you find yourself reading something that seems trivial to you, sorry. Lastly, this is targeted at US people who expect to get health insurance through the ACA in retirement (post-FIRE). If you see ACA-related income values and it seems small, remember that I'm using a 2 person household in these examples. The Federal Poverty Level (FPL) scales with more or less family members. All of the acronyms you see below are the same acronyms that official entities refer to, so if you do a deeper dive on any of this stuff you’ll have continuity there. Also, in any instance where I’m referring to monetary values in the future, I’m using present value. I make no attempts at projecting future inflation, etc.
AgeThis will have considerable influence on your drawdown strategy because of when you start having access to various piles of money. If you retire very early (I quit at age 33), your only access to money (assuming you stay retired) until 60 will be brokerage accounts, Roth IRA contribution and conversion basis, passive income streams, and 72t separate and equal periodic payments (SEPP) on your traditional IRA (tIRA).
Though I think you’ll find by the time I get to the end of this post that a 72t SEPP is not very appealing to the very early retiree. The big disadvantage to the 72t process is that you are required to take payments until age 59.5, and those payments are calculated based on your life expectancy in one of three ways dictated by the IRS. Technically, you can transfer some of your tIRA money to a new tIRA and only set up SEPP on the new, smaller tIRA, but it is quite possible that locking in a portion of your income until 59.5 may come back to bite you. I’ll touch on this later on in the Drawdown Mechanics section.
If you’re older, and the time until you can access all your Roth IRA money (age 59.5) and Social Security or pension (62 at the earliest, for now) is a significantly shorter period, like 10-15 years, things get quite a bit more flexible in how you may choose to approach drawdown. For one, you have significantly less concern about sequence of returns risk because unrestricted access to IRA money really opens up in the early 60’s.
Most younger folks’ drawdown strategies are probably a combination of brokerage funds, a Roth IRA conversion pipeline, and passive income from real estate rentals or owning a business (some may argue about the passivity of these).
ACA (Affordable Care Act) Health InsuranceIf you’re an American, living in the United States, the ACA is truly a force to be reckoned with when it comes to how it impacts your drawdown strategy. If you have managed to secure another source of health insurance whose premiums, deductibles, and maximum out-of-pocket (OOP) values are not based on your yearly Adjusted Gross Income (AGI), then you can pretty much ignore this section. If you are living outside the United States and don't carry US-based insurance you can also ignore this section, though there is a factor I will talk about for Americans choosing to live abroad temporarily in order to juice their drawdown strategy.
A note upfront about some language I’m about to use. For any given year, ACA insurance values use the previous year’s Federal Poverty Line (FPL) data. So in 2021, the income thresholds where Cost Sharing Reductions and premium subsides decrease or are eliminated are based on the 2020 FPL data. When I’m giving specific illustrations and pointing out numbers as a percentage of FPL, I won’t continually remind you that if I’m laying out numbers in 2021 that they are measured against 2020 FPL data. If this is confusing, there are a bunch of spreadsheets out there that illustrate in great detail how all this stuff plays together. I even have what I think is a pretty nice one myself, and I’d be happy to share it if it will help folks understand this better.
The biggest factors for how the ACA will influence your drawdown plans are if you are planning on having children still or if you are not 100% healthy. My wife and I are trying to have our first child. With the insane cost of medical care in the United States, childbirth will immediately max out our insurance plan’s max OOP for the year. Since this is an event that we are planning for, it is fairly easy to control our income during that period to take advantage of the ACA’s Cost Sharing Reductions (CSR). Below 250% of the Federal Poverty Level (FPL), these reductions lower the deductible and max OOP on Silver-tier (only Silver-tier) insurance plans. In our area, if our income was above 250% of FPL, the deductible is $12,600 and the max OOP is $17,100. At the lowest income level for private insurance, between 100% and 150% of FPL (or between 138% and 150% in Medicaid expansion states, the deductible drops to $0 and max OOP is $1,500. So if we’re able to anticipate a birth and drop our income down to where we qualify for the largest CSR, we can save ourselves $15,000 that year. The caveat here is that there is some lead time in the planning because the health insurance you qualify for in a given year is based on your AGI from two years ago. For instance, when annual open enrollment for the ACA started in November 2020, we picked our insurance plan for 2021, and it was based on our AGI from 2019 because that is the most recent finalized tax data.
If you have a chronic medical issue that will require high levels of medical care for many years, or even a medical issue that is temporary but will use high levels of medical care and it’s not a true emergency, you may also benefit from being able to control your AGI to select an insurance plan each year that has significantly smaller deductible and max OOP values. For example, at 37 years old I just learned that I have hip dysplasia. For someone who remained unaware, or if left untreated, this condition typically results in premature osteoarthritis leading to hip replacement (often in one’s 50s). One of the common early symptoms of hip dysplasia is a hip labral tear. In your 30s and 40s, as normal aging starts to degrade the body, the hip is less able to tolerate the improperly formed joint. Hip labral surgery is highly specialized. If needed, this will max out my half of our family insurance plan for the year. A periacetabular osteotomy is a follow on preventative surgery that some people need to stabilize the hip joint and significantly reduce the chance of needing a premature hip replacement. This is an even more highly specialized surgery. So we’re potentially looking at a 2-3 year window where, between childbirth and a surprise hip condition, having greater control to reduce our AGI may yield medical cost savings of $30,000-45,000. Not exactly chump change!
If you (and your family) are all healthy, with no recurring medical issues, this is all quite a bit easier. You could easily choose a Bronze-tier plan, which is typically a High Deductible Health Plan (HDHP). You will most likely still want to stay below the ACA subsidy cliff (400% of FPL) lest you pay big money for premiums. I talk about the Subsidy Cliff in more detail 3 paragraphs below this one. Since premium subsidies are based on the Second Lowest Cost Silver Plan (SLCSP), selecting a bronze plan can be very economical because you get the same amount of subsidy regardless of which tier plan you choose. By choosing a Bronze plan, you’re selecting a plan with a lower premium to start. In many areas, people are able to choose bronze plans with premiums under $100 a month. This situation is the least burdensome on your ability to generate AGI from other sources, both because your premiums remain relatively small and your income can be much higher than those looking to keep their deductible and max OOP values small.
For US residents, living overseas for a year (or two or three) can have a significant impact on your drawdown because, in any year that you are out of the country for 330 days or more (the IRS’ physical presence test), you are not required to purchase US-based health insurance. International travel insurance can be had pretty inexpensively and often this will include a provision for transport back to the US in serious medical emergencies. That that event, your arrival back in the US could be considered a move and this would allow you to pick a new US-based insurance plan under a special enrollment period. With the current US tax code, being out of the country for the year would allow you to max out long term capital gains and/or Roth IRA conversions without having to pay any federal tax, though you may still pay state tax because simply leaving the country for a year will probably not invalidate having domicile in whatever state you were last domiciled in. Since you won’t be staying in any one foreign country for the entire year (I don’t know of any travel visas that last that long) you likely won’t be forwarding all your mail there or getting a local driver’s license, or other things that would help you prove to the US state you just left that you no longer have domicile there.
Using the Federal Tax Brackets in 2021 for Married Filing Jointly (MFJ) - halve these amounts for a single person - you could convert $25,100 (the federal exemption amount) of tIRA money to a Roth IRA tax-free assuming you have no other ordinary income sources, which will then become available to you in 5 years. You can also harvest $81,050 of long-term capital gains tax-free. So that’s an AGI of $106,150 for the year while paying $0 in federal tax. Depending on your situation, it may even be worth paying a little tax to make a significant Roth IRA conversion while being out of the country. According to the 2021 MFJ federal tax brackets, your first $19,900 of taxable ordinary income (after your $25,100 personal exemption) is taxed at 10%. Taxable ordinary income from $19,901 through $81,050 is currently taxed at 12%. This is a reduction from 15% that was signed into law with the 2017 Tax Cuts and Jobs Act. This reduction will expire in 2025 unless additional legislation is passed to extend it. So if we were living in, say, Europe for 330 days or more in 2021 we could perform a Roth IRA rollover on $106,150 while only paying $9,328 in federal tax ($25,100 free because of personal exemptions + $19,900
@10% + $61,150@12%). That’s an overall federal tax rate of 8.78%. Pretty sweet! I will elaborate on the importance of this option in the Drawdown Mechanics section.
Living in the US, your AGI will likely be limited to a significantly smaller number because of the ACA Subsidy Cliff. At 400% FPL, you lose all subsidies for health insurance. This is highly location-dependent, but the jump in premiums for going over the cliff in many areas can be $6,000-10,000 or more. Ouch! As a family of 2, there is no circumstance while we’re living in the US that we want our AGI to exceed $68,960 (400% FPL for a family of 2 in 2021). Even then, there are significant financial disincentives to allow our AGI to rise into the $50,000’s if we don't need it for living expenses because insurance premiums dramatically increase and deductibles and max OOP values get significantly larger. However, if you’re a perfectly healthy person or family, higher deductibles and max OOP values may not bother you. Choosing a Bronze plan instead to keep premiums low and because you don’t expect to use much medical care may be well worth it to have a larger AGI.
Drawdown MechanicsCaveat: There is going to be a great degree of variability as to how influential many of these factors will be on an individual’s drawdown plan. While I can outline the framework for the most common contributors here, you will have to do the legwork in understanding how each of these can shape what you need your own financial picture to look like moving forward. You’ll understand what I mean by this as we go through everything below.
Unless you’ve made an obscene amount of money very quickly while young, odds are likely that you have a significant portion of your stash in a traditional IRA (tIRA) due to the benefits of tax deferral and employer contributions. After that, you probably have some money in a brokerage account, online savings account, I-bonds, or other after-tax vehicles. You may also have some money in a Roth IRA but the amount will likely be dependent on how consistently you contributed funds to your Roth IRA while working, or whether you took any opportunity to convert tIRA funds prior to retiring. Though people do inherit IRAs and a couple of years out of work mid-career may have created an excellent opportunity to make big Roth IRA conversions. So some folks may have larger Roth IRA balances. The bigger, the better. Though, interestingly, if all your money were in a Roth IRA this would actually be a bad thing because you’d have no way to generate a taxable income once retired. Since all Roth IRA money is tax-free (both contributions and growth), there is no withdrawal that will generate a tax event. Without taxable income, you’d be forced to use Medicaid in a state where Medicaid has been expanded by the ACA, or be in the very unfortunate position of having to pay the full cost of private health insurance in a state where Medicaid was not expanded unless you meet the income limits of who can qualify for non-expanded Medicaid as an adult (parents, pregnant women, and the disabled).
My career was mostly over before I learned about MMM and realized how little I actually knew about personal finance. I found the blog at the end of 2014 when I was 31. I’d been working 10 years already, and my lack of understanding about how some Roth IRA funds can be accessed penalty-free before the age of 59.5 meant my wife and I didn’t even have Roth IRAs at that point. Each year, beyond our 401k contributions, we’d been making additional tIRA contributions which in hindsight, with early retirement always being the goal, was incredibly stupid. Even as our combined income began to exceed the limit for making Roth IRA contributions, we could have used the backdoor Roth IRA conversion process, which we did finally start doing once I learned about it on this forum. However, I quit my job for the first time in 2016, and for the last time in 2017 so our Roth IRA balances were pretty paltry going into retirement.
Larger, replacing-my-income level Roth IRA conversions often don’t start happening until after retirement because converting that much money while working is likely very expensive. Being the most highly taxed income (because you’re electing to convert it after already having made a salary, etc.) you may be paying over 20% of it in federal taxes alone. Though if your income is small enough, less than $106,150 ($25,100 exemption + $81,050 12% tax bracket) for Married Filing Jointly - singles halve that - it may be worth filling out that 12% ordinary income bracket with Roth conversions depending on how much after-tax money you’ll have (brokerage accounts, online savings accounts, etc.) going into retirement, especially if you have health insurance through work and the ACA will restrict your Roth IRA conversions more in retirement (because medical expenses!). The larger your Roth IRA basis is at retirement, the less diligent you have to be about maximizing the 5-year pipeline.
So you retire, and at first glance, the first order of business may appear to be establishing a healthy Roth IRA conversion pipeline. You’ve done your due diligence and you know what your yearly expenses are going to be in retirement. The typical advice I see is to have at least 5 years worth of expenses in a brokerage account to live off of because it takes that long to establish a Roth conversion pipeline if you're starting from scratch (or close to it). After year 5, the basis you converted to your Roth IRA in year 1 is eligible for withdrawal penalty- and tax-free.
However, depending on whether or not you have reason to want health insurance with a lower deductible and max OOP, and what the stock market has done over the last 10 years, you may find different areas fighting for your “self-generated” AGI dollars. For instance, if you have a known major medical expense coming up, you may want a plan that requires your AGI to be lower. Above 200% of FPL, insurance premiums, deductibles, and max OOP values escalate pretty quickly. For a family of 2, staying under 200% FPL in 2021 means limiting our AGI to less than $34,480.
Another piece of advice that is commonly given is that it is more tax-efficient to keep your bond allocation (if you have one) in pre-tax accounts and keep equities (stocks) in your brokerage accounts. Depending on how the market has performed recently, and whether you have any funds that can be accessed without generating a taxable event (bonds in a brokerage account, online savings account, etc.), accessing money to pay for your living expenses in the first 5 years of retirement will create a certain amount of taxable income that you cannot avoid. We are currently at the end of a very long bull market cycle. This has spawned a lot of early retirees, but it also means that the stocks in most folks’ brokerage accounts also carry large capital gains with them. My own brokerage account is 80% VTSAX and 20% VBTLX, only because we’re looking to buy a house otherwise it would be 100% VTSAX. At the moment, our VTSAX shares have an average capital gain of 43%, and if we wanted to sell specific shares the gain percentage ranges from 18% to 53%.
So if we needed $40,000 for living expenses this year, it’s going to be comprised of two parts. First, the dividends on your stocks, and/or dividends and capital gains on your bonds if you have any. TAKE YOUR DIVIDENDS! You will have to pay tax on them each year so it does you no good to leave them reinvested once retired and have to pull that additional income from other sources if it means creating another taxable event. Obviously, the size of your dividends are going to depend on your brokerage account balance. We have just over $500,000 in VTSAX and it spawned dividends of almost $8,000 in 2020. Second, selling shares of VTSAX (or VBTLX or whatever) to cover the remainder of our living expenses for the year. In our example, we’ll need to sell $32,000 of VTSAX. That, combined with our $8,000 in dividends, will give us the $40,000 to cover our living expenses. Selling $32,000 of VTSAX will generate a taxable event of $13,760 in long-term capital gains (LTCG), on average (43% appreciation!). If we no longer have money in accounts that can be accessed without generating a tax event, like an online savings account, we have no choice but to take those gains. So if we were trying to keep our AGI under $34,480, we’ve just used $21,760 ($8,000 dividends + $13,760 LTCG) of that space accessing our living expenses for the year. An alternative strategy when selling is to always sell the least appreciated shares first. However, as you burn through your brokerage balance the gain to income ratio will rise, causing your AGI to go up to access the same amount of money over time. Only having more space to generate AGI than what you need for living expenses would let you harvest some of those gains before you need to sell the shares for income purposes, resetting the appreciation of those shares for future withdrawal.
Remember, that Roth conversion pipeline is important unless our brokerage account can carry us all the way to age 59.5. We don’t want to have exhausted our after-tax money only to find that we didn’t fund our Roth IRA well enough to finish the job. This is important because only the basis of our conversions is available to us before 59.5. Worst case scenario, we may have to pay the 10% penalty to access Roth gains, but if faced with that decision we would also have the ability to use tIRA funds as well, though this would generate more AGI since those funds are pre-tax.
So what you can see from the example I’ve given above is that our tax event generating living expenses, coupled with a medical need to keep our healthcare spending low, really starts to put a squeeze on that Roth IRA conversion process. We’re left with only $12,720 of AGI space left for Roth conversions ($34,480 limit of 200% FPL - $21,760 dividends and LTCG for living expenses). Between higher deductibles, max OOP values, and higher insurance premiums and taxes, it is possible that most or all of the dollars we generate by raising our AGI (accessing more money) could be eaten up by these higher costs. If this situation was not brief, it could have some ugly consequences after having exhausted our brokerage funds. $12,720 is less than a third of $40,000, so once we start pulling Roth IRA basis we’ll drain 3 years of conversions every year for living expenses. The closer you are to age 59.5, the less of a risk this is, but it’s worth understanding the concept regardless. Even healthy people in their 30s or 40s can suddenly find themselves with health problems. Of course, it is my hope that in the near future the US healthcare landscape will change and no longer have such a considerable impact on determining an early retiree’s chosen income level but who knows when or if that will happen. And if you’re healthy now, it’s probably still worth having read this if only to have that little nugget in the back of your mind so that if your health did ever change you might remember to revisit this concept. Also, understanding how these things impact each other will allow you to do your own calculations for how raising your income will generate higher costs and whether there's an optimal point for your specific situation.
We also can’t forget that “paper” income will also affect our AGI and change how much money we may be able to dedicate to a Roth IRA conversion. For example, my wife and I converted our mortgage to a 15-year fixed when we were still living in Maryland. When we moved out of state, we converted our house to a rental. While the house is cash flow positive on paper, because we have the higher mortgage payment associated with a 15-year note we don’t actually see any money coming into our bank account. All the income is paying off the mortgage. This will be great for us when the note is paid off in 7 years, but for now, we show $5,000 of income on our tax return and that money can’t be used for living expenses. If you have a situation like this where you have “paper” income, it will further reduce how much income you can generate from other sources if you’re trying to keep your AGI below a specific number. Now that we have retired and no longer have W-2 income, we do not qualify for a refinance. Even if we did still qualify for a refinance the rate will be higher because we no longer live there. So the lesson in this story is if you’re going to retire early, make sure you’ve positioned the mortgages of your rental units as best you can because you may have limited ability to change that once retired. Though this may be less limiting if you have a bunch of rentals and a bank will look at that income stream as consistent, business-generated income. I can't speak to that scenario.
One thing to think about is that there’s an upward spiral to expenses once you have exhausted all sources of money that don’t generate a taxable event, assuming your stocks have significant capital gains. Using my example from earlier, needing to use $40,000 per year for living expenses will generate $21,760 in AGI. You can’t forget about the taxes and insurance premiums you will have to pay though. At this point, every dollar you need to access creates a gain, in our case 43 cents on the dollar. As each dollar raises our AGI, our health insurance premiums and taxes also go up, necessitating access to even more money. So, say we were using a Bronze HDHP and I broke my arm skateboarding. $8,000 later my arm is all set up, but I hadn’t planned on that expense this year. I’ll need to pull $8,000 more out of VTSAX, generating $3,440 more in AGI, but my taxes and insurance premiums go up as my AGI does so my actual withdrawal ends up being more than $8,000. If you’re leaving all your funds in VTSAX for the best growth, this may just be the unfortunate consequence of large surprise expenses but it’s worth knowing this will happen. If it takes place mid-year maybe you’re able to adjust other areas of income generation to keep your AGI where you want it.
One interesting idea to explore is that if your allocation across tIRAs, Roth IRAs, and brokerage accounts is extremely weighted toward tIRAs, it may be worth taking money from your tIRA early in retirement up to the amount of your personal exemption and allowing brokerage accounts and Roth IRAs to grow a little more. If you have kids this amount could rise considerably with the Child Tax Credit to offset it. Since you’d pay no tax on the ordinary income generated from the withdrawal, you’d only pay the 10% penalty. 61% of our portfolio is in tIRAs. Many Mustachians currently find themselves in the position of having accumulated significantly more money than their original target because of the run-up in stocks over the last 5 years. With our living expenses being relatively low, we may find ourselves in the position where our account balances are growing faster than we can reasonably spend our money. If we focus exclusively on drawing down brokerage accounts and Roth IRA monies first, we leave tIRAs to grow for many years. The potential disadvantage to this is ending up with ridiculously large tIRA balances in our 70s when Required Minimum Distributions (RMDs) start. If you end up having an RMD over $100,000, plus Social Security benefits or pension, you may find yourself paying significant taxes on all that income and paying a higher Medicare premium. To boot, your health may have reached a point that you couldn’t possibly spend that much money. My grandparents were very healthy but as they reached their 70s their desire to travel really tailed off as ailments made being away from home for extended periods of time more of a hassle.
So, from all the information I’ve laid out above, you can see how there may be a fairly intricate dance that happens between keeping healthcare costs low and adequately funding your Roth IRA conversion pipeline if you’re expecting to need significant medical care. This is where a 72t SEPP on a tIRA could come back to haunt you. There are other reasons as well. You could choose to go back to work or monetize a hobby. Once that SEPP is in place, there's no stopping it so it's possible you could put yourself in a position with respect to AGI that you don't want to be in.
Another advantage to leaving the country for a year or two early in retirement is that it can help you redistribute your funds between tIRAs and Roth IRAs very quickly. In two years we could move over $200,000 while paying minimal tax. This would help ensure we don’t end up with crazy high RMDs in our 70s and beyond. You may also have an opportunity to do this after you’ve reached 65 and transitioned to Medicare, or if you have health insurance through the military or someplace else that isn’t income-bound you may be able to do this any time. In our case, my wife and I are 3 years apart in age. So when I am 68, she will transition to Medicare and we’ll have 4 years that we can make $100,000+ Roth IRA conversions at very little tax costs before RMDs start at 72 for me (under current tax code). This certainly helps, but it comes after a lifetime of portfolio growth so it won’t have near the same impact as if we’d traveled in our 30s or 40s and that converted money was able to grow in a post-tax vehicle for 20 years.
Some of this ultimately depends on whether you care about how efficiently you’re playing the long game. I have a spreadsheet set up to analyze a scenario for maximum tax efficiency for all years to age 100 based on current conditions. We don’t want to have insane RMDs late in life when we’re no longer spending much money if we could have more efficiently moved that money to other buckets earlier and had better access to it. Of course, this is tempered by our plans for ACA healthcare spending. This takes precedence while we’re still young because we still have many years of market unknowns ahead of us and both the insurance landscape and the tax code could change in the future. Still, it’s been an interesting exercise to understand what is most efficient, and how that compares to what we’re doing now, and where we could focus on improving if we have the opportunity.
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And that's all I've got at the moment. Hopefully, that was fairly comprehensive. Many atypical income situations are going to end up taxed similarly to what I've described above so it's probably fairly easy to swap out those examples if you already understand the tax ramifications of other income generation. The big thing is really understanding, in general, the relationship between dollars going into your bank account, what taxes they're generating, and how that influences your health insurance and overall tax picture. I hope this has been helpful!