Drawdown Part 3 : Strategy

need… more… benjamins…

There are only three things that are guaranteed in the life of a super early retiree:  death, taxes, and second-guessing your personal approach to quitting your job and taking distributions.

You will scour blogs.  You will devour forum posts.  You will check books out of the library and consume them in bed while eating homemade nachos and getting cheesy grease stains on your comforter which will never, ever come out, even with baking soda and bleach and lots of scrubbing.

The goal?  To find the One True Path.

The only problem is that it doesn’t exist.   This is due to differences in peoples’ situations:  income streams, asset allocations, and core personalities.

What do you yourself, then?  You collect information on various approaches that have worked for other people, and then cobble the bits together into your own personal superplan.

Today I’ll walk through the construction of the superplan that I’ve decided to execute myself, and with any luck, you’ll find some of the details valuable in constructing your own.

Why You Need a SuperPlan

You hit your FIRE number. You understand the 4% rule.   You’ve run simulators that tell you’re financially ready.  Why can’t you just immediately quit and start living your dream life without doing all this extra stuff?

Simple.   You still need to consider how to tackle the following.

Fund Access

Taxes

Holding cash and CDs

Insurance Coverage

Monitoring

Backup Plans and Additional Income Streams

It’s only once you’ve gotten all of that squared away that it’s finally time to wash that job right out of your hair.

Enough preamble.  Let’s do this thing.

Fund Access, AKA Getting Your Money Out

Most of your money is probably in tax-advantaged accounts — 401(k), 403(b), Traditional or Roth IRA, etc.   The end goal is to create a monetary workflow which ends with you pulling daily expenses out of a completely cash-based account, such as a money market or checking account.

At a high level, this workflow looks like this:

Mutual Funds -> 2-year laddered CD portfolio -> 1 year Cash Account 

This structure will give you security and flexibility.  If the market dumps 50% of its value in 2 months, you won’t worry as much because you have a couple of years of CDs to keep your living expenses covered while you wait for your mutual fund values to recover.  

Establishing the Pipeline

• • Roll your company-sponsored retirement accounts —  401(k), 403(b) — into your IRA. If you don’t have an IRA, this is a good time to set one up with Vanguard or another broker.
  • Then establish a Roth IRA if you don’t have one.  Most of the money that we ultimately transfer to cash in the form of CDs will originate from the Roth.  This is because you can take principal out of your Roth IRA at any time, penalty free, as long as that contribution was made at least five years ago.  Roth contributions are post-tax, after all  — Uncle Sam has already got his cut.  A quick example illustrates this best.  You have a Roth balance of 80K.  You contributed 5K a year over 10 years, making principal 50K and earnings 30K.  This means you can take 25K out at any time without restriction or fee — this is the principal you added over the first five years. Next year, take another 5.  Then another.
  • You should simultaneously rolling money out of your IRA every year into your Roth.  If you’re not familiar with this technique, read this detailed post by the Mad Fientist.   The main points are:
    • • You are allowed one rollover event, AKA “conversion,” per year
      • IRA funds are pre-tax, and Roth IRA contributions are post-tax.  The conversion is a taxable event.  You will be charged standard income taxes at this time.
      • The beauty is that you’re retired.  You have no income.  So you will either avoid paying taxes entirely or pay a very low percentage.
      • I plan on rolling 20K/yr.  The Turbotax Taxcaster reports this will result in a bill of slightly over 1K to be paid to the Fed.  Note that I could roll much more than 20K (Can do up to 36K for a single filer) but I want to leave myself a buffer for any additional income I might generate.  Being in the 15% tax bracket has a critical advantage for retirees — If you are in this bracket or lower, you pay zero taxes on long-term gains and dividends.  More on this later.
      • Every year you’re retired, you’re continuing to move money out of your IRA into your Roth, and you’re doing so in such a way that your tax burden is about 5% on the total.  Your Roth bucket grows larger and your IRA slowly goes down.
      • After the fifth year of doing this, you can start to withdraw funds that you put in your Roth in Year 1 (20K).  You can do this because that 20K is principal (AKA basis)
      • This technique is referred to as laddering.  Every year you build another rung as you slowly push money from one (inaccessible) place to another.
      • You do need to carefully track your Roth IRA basis.  This is the amount of your contributions minus any expenses.  If you put 50K into your Roth over 10 years and it’s now worth 80K, your basis is still 50K.  You should be tracking basis via form 8606, to be filed with the IRS yearly.
      • While you’re waiting for the 5-year ladder to be established, you will either draw off of existing 5+ year old roth principal, or a taxable account.

Pipeline Summary:

Using the Traditional-to-Roth IRA laddering method, it is possible to withdraw funds from your IRA, convert them to the Roth either tax-free or at a very low marginal rate, and then five years later make withdrawals for personal use.

Over time, your net worth, broken by account type, will (hopefully)  end up looking something like this:

This chart assumes conservative 5% inflation adjusted growth on a 75/25 stock bond split.  Also smooth growth, i.e. same % growth year over year.  Once real data is plugged in, the graph will look all jaggy due to the inconsistency of year-over-year returns.  I’m leaving out cash/cd holdings here.

In this chart, you pull off of your taxable accounts (blue) for the first several years.  During this time your Traditional IRA account balance is going down because you’re laddering into your Roth.  And your Roth balance is rising because a) you are pushing more money into it and b) the market is going up.

Once your taxable accounts are depleted, you start dipping into your Roth, even as you continue to ladder your Traditional IRA balance over.    By this time you should have plenty of 5+ year old basis in the Roth, and you’re well on your way.

You now have your stash of cash in your grasp.

Note:  You must have at least 5 years of living expenses saved in either taxable accounts or as 5+ year old Roth basis in order to successfully execute this plan.

Taxes

Since taxes are part of your allocated annual spend rate, you’ll want to do your best to keep costs down in this area.  After all, taking road trips and eating healthy, awesome food will bring you more happiness than making charitable contributions to the government, right?

We’ve already gone over how to convert all of your tax-deferred 401(k) balances into post-tax Roth IRA balances with minimal charges.  But, the other part of the equation is making sure that your dividend and capital gains are not taxed, either.

All you have to do in order to achieve this bit of dark magic is remain in the 15% tax bracket.  This is $36,900 for single filers and $73,800 for married couples in 2014.    If you are in this bracket or lower, you will pay zero taxes on long term gains and dividends.

Warning:  If you creep into the 25% tax bracket on income, you have to begin paying paying 15% on qualified dividends and long-term capital gains.  This makes it worthwhile to keep close tabs on your income so that you are prepared for the tax consequences of moving over brackets.  A quick reminder:  Your income will consist of:

• • Money converted from your Traditional IRA to your Roth.  In our example above, this would be 20K.
  • Interest on CDs, checking accounts, and/or money markets, listed on 1099-INT.
  • Ordinary (non-qualified) dividends on stocks or mutual funds that you hold in your taxable retirement accounts.  For example REIT fund distributions held in a taxable account usually fall into this category because they’re not “qualified.”
  • Any earnings from alternate income streams, e.g. rental properties, consulting or contracting.

Your investment broker will provide a statement at the end of the year (1099-DIV)  which summarizes the distributions for you.  Take care to track any distributions which count toward earned income in your taxable accounts.  These are typically listed as “non-qualified” distributions, meaning, they don’t meet criteria to be exempt from US income tax.

Also keep in mind that as a single filer, you’ll receive a standard deduction ($6200) plus a personal exemption ($3950), giving you just over 10K of completely tax-free income to play with prior to having to pay anything based on your income bracket — $10,150, to be exact.   This means that single filers can actually earn 47,050 instead of 36,900 before hitting the 25% bracket.

Note: 2014 IRS figures used for all values above: tax brackets, standard deduction and personal exemption.

Example

I have about 28K in ‘ordinary income’ which breaks out like this:

• • 20K/yr from the Traditional IRA to Roth IRA rollover.
  • About 1.2K of REIT income, which are non-qualified dividends from my taxable accounts
  • About $800/yr in other interest.
  • 6K from “ordinary dividends,” also from my taxable accounts.

Then I also have 3K in “qualified dividends” as reported on IRS form 1099-DIV.

Taken together, I’ve earned 31K in income.

Why do I want to keep tabs on my income?  Simple.  If I get a side-hustle, I want to be aware of how much I can earn without getting bumped into the 15% bracket.  Again, for a single filer this is about 47K (the 37K bracket, plus the 10K standard deduction/single filer exemption.)

This means I could safely make an additional 16K without crossing over the 47K line.  

Tripping: Not the good kind.

So what happens if I go over that 47K income limit?  I’ll simply have to pay 15% on the qualified dividends and/or income that go over the threshold.

Let’s say I made 18K in extra income.  This is 2K over the 47K income limit to keep me in the 15% bracket.  At this point my ordinary income goes up from 28K to 46K.

But I also still earned that 3K of qualified dividends.  In this case, the first thousand would be untaxed, but the remaining 2K would get taxed at a 15% rate.  I confirmed this using the Turbotax Tax-Caster and plugging in values. (It’s highly recommended that you play around with the tool yourself a bit, especially if what I just explained didn’t come across clearly.  Once you start plugging in a few sample numbers, you’ll get the idea.)

What’s the point of all of this?  Simple.  When you’re retiring early and living on a modest income, it pays to be aware of all inflows and outflows of money — and taxes are a signficant part of the equation.  On that note, if you are earning additional income, you may pass into higher brackets and have to pay more.

If you’re on top of it, none of these expenses will be of the unexpected variety, and you’ll handle everything in stride.

Cash and CDs

At this point we’ve figured out how to move money from our tax-sheltered accounts all the way into our checking account with minimal taxable losses along the way.  This is good, because ultimately we’re going to be drawing money out of cash accounts to pay for our daily expenses.

But we can do better than your standard 0% return checking account, can’t we?

Here I’ll turn to CDs, AKA Certificates of Deposit.   These savings vehicles which guarantee a certain interest rate, but simultaneously lock up your cash for designated periods of time, e.g. 6 months, one year, three years.  The longer the date to maturity, the higher the rate you’ll likely receive.   I’m establishing a 2-year ladder as a part of this plan.  For a visual representation of the laddering concept, check out Ally Bank’s tool.

Right now CDs are only returning 1%ish.  I’m planning on holding two years of living expenses in CDs (40K) which amounts to $400/yr, well worth the minimal effort required to establish the accounts.   It’s worth noting that yields are low right now because we are in a low-interest rate environment.  If inflation ever picks up, CD rates will drive higher.  This is important for future planning, because you’ll be counting on the yield from your CD holdings to limit the erosion of real purchasing power in these accounts.

There are a number of other ways to skin this cat, though, if you’re not interested in CD laddering.  You might simply leave your two-year cash buffer in a money market or high yield checking account.   (Heck, you might decide you don’t need a two-year cash buffer at all.)  Do some research and pick an option that works for you.

Reminder:  I’m holding money in CDs so that I have the option to not draw money out of my index fund accounts every year.  For example in 2008, in the crash surrounding the financial industry’s meltdown, I would have not renewed the CD, effectively destroying my ladder.  The following year, when my CD funds were exhausted and the S&P was sitting around 1200 again, I would have reestablished the ladder.  I will play through this scenario in more detail in the following post, Drawdown 4 : Examples, where I simulate how running this strategy through various market conditions would have fared.  Also consider reading this post by Doug Nordman over at the Military Guide to Early Retirement, as it contains similar information.

Because when you’re planning and learning, repetition is a good thing.

Insurance Coverage

Fact:  Regardless of your personal politics, there can be no disputing that the Affordable Care Act (AKA Obamacare) helps the early retiree.

Major wins:

• • Greater availability of non-employer-sponsored plans.
  • No denial of coverage for pre-existing conditions
  • Helps control rising insurance costs over time.
  • Best of all, if you are a low earner, your insurance will be heavily subsidized by the government.  And, since you are retiring early, it’s a near certainty that your income is low.  Perfect!

Mr. Money Mustache wrote an extended post on health care in retirement and concluded that it’s typically best to choose high-deductible plans, and I completely agree.  I’m a young, healthy guy and rarely have to go to the doctor.  If I have a medical emergency, I have plenty of money available to handle a 5K deductible.   To scope out costs, I headed over to healthcare.gov.  This ended up redirecting me to my state insurance exchange for Massachusetts.

Harvard Pilgrim offers a “silver” 2K deductible plan for a 37-year old single nonsmoker for $270/mo, or 3240/yr.

Then I use the subsidy calculator provided by Kaiser, which tells me that given an income of 30K, I should expect to receive $750, making the total annual cost for insurance about $2500, somewhere around 200/mo.

However, if my income is only 22K a year (instead of 30), the annual subsidy rises from 750 to a whopping 1900. This makes the bronze plans cost about $300 for the entire year — very close to free.

I’m not yet 100% sure what plan I’ll choose, but you can clearly see that the cost isn’t going to be a major issue.

Getting Older

Subsidies increase along with premium cost, so there’s virtually no need to worry about this.

For example, I worked through scenarios at age 60, also using the Kaiser calculator.  Similar plans then cost cost $5,500 (approximately double the same plan’s sticker price at age 37).  But in this case the subsidy is now $4,369.  This is because the subsidies are based on your ability to pay, i.e. your income.

Let’s hope the Fed never changes this to evaluate subsides based on net worth!

A Health Plan

My Dad loves to repeat himself.  Every time I see him, he offers the same advice:   Son, having Health Insurance Coverage is not the same as having a Health Plan.  (Aside:  Yes, he really does address me as “son.”  Total goofball, that guy.)

At any rate, he’s completely on the mark here. You must have a plan to stay healthy as you age.  This means eating right, exercising, getting enough sleep, and seeking loving, constructive relationships with others.

You don’t have to be over-the-top extreme — there’s really no need to ultramarathon purely for health reasons, for example — but it’s essential to take care of the basics.  Do your best to stay off of medications and prevent conditions that will increase your cost of living even as they reduce the quality of your life.   This is as simple as keeping your alcohol consumption to a minimum, not smoking at all, eating a lot of vegetables, and walking several miles a day.

After all, if you haven’t got your health, you haven’t got anything.

Monitoring

Part of a good retirement plan is putting a few checkpoints in place.  These will be periods to reflect on the plan, review your numbers, make sure you’re feeling okay with how things are going.

Scheduled checkpoints are different from micromanaging.  If you are looking at your finances every week, or even every month, you’re doing something wrong.  Intelligent retirement plans should be constructed in such a way that this is not necessary — the whole point of quitting your job is to be free to live your life according to your own ideals and dreams.  Being constantly worried about money is not my idea of freedom.  So don’t micromanage — schedule a couple of dates a year to work over everything, and other than that, don’t stress.

My own plan is to do a full yearly financial reckoning in mid-Dec of every year, and a much briefer July review.  In particular you’ll want to review any changes to the tax code which might affect your plan.  If it turns out a course change is necessary, there’s still time to take action prior to the end of the taxable year.

Bottom line:  You’ll want to learn about any potential bumps in the road well in advance of doing your yearly filing with the IRS.

July Review Activities

Here I’ll check in on available cash in the money market account.  The big question is, will it last through the end of the year?  Unless we encountered some very large unexpected expense items, the answer should be an easy ‘yes.’   I have an 18k/yr spend rate, so anything over, say, 15K in this account is going to result in a green light to stay the course.

Also I will consider whether or not I’m earning income.  If so, I will evaluate potential effects on my health-care subsidy and dividend payouts from taxable accounts.

Mid-Dec Review Activities

Bulleted-list time.  There’s lots to do here.

• • • Cash replenishment
      •  If the market has dropped less than 10%, stayed stable, or gone up, I will allow my CD-ladder to renew.  At the same time, I will take next year’s estimated expenses out of one of my mutual fund accounts.  This will initially be skimmed off of my taxable account.  Once that’s nearly depleted, funds will be removed from my Roth.
      • If the market has dropped more than 10% year over year, I will hem and haw about whether or not to renew my CD ladder or wait another year.  I don’t have a hard-and-fast formula for how I will make the decision, but if the drop has been dramatic (say, 25% or more) I will definitely break a CD open, allowing the money in my mutual funds some chance to recover.
    • Yearly 20K Traditional IRA to Roth IRA conversion.  Potentially adjust upward as the government moves income brackets with CPI most years.
    • Expense check-in.  Did I hit my yearly target?  Why or why not?  If I’m significantly over my target, it may be necessary to adjust overall plans.  If not, maybe I could plan on doing more travel the following year, or donating more to charity.
    • Rebalancing in the Tax-Advantaged Portfolios.
      •  If my tax-advantaged portfolio allocations are 10% or more off the set goals, it’s time to move funds around to correct the ratios.  I will not consider rebalancing in taxable accounts because exchanges are taxable events there.
    • On the other hand, I will review potential loss or gain harvesting opportunities in taxable accounts.
    • Reviewing changes in tax code:  Am I affected by any new laws?  In particular, have laws critical to my RE plan changed? Examples include revisions to IRA-to-Roth conversion event allowance, updates to income brackets, health care rules, changes to dividend distributions, etc…
    • Simulation:  I will execute cFireSim and Monte-Carlo calculators with my updated asset sheet to see how things look.  70% success rate or higher, and I’ll stay the course.  However if the predictions are worse than that, this signals that a course adjustment may be necessary.  More on this in the next sections.

Backup Plans

So what do you do in the unlikely event that things aren’t looking good anymore?  Maybe you just finished your yearly monitoring task and your percentage chances of success are looking pretty bad.

It’s not the end of the world.   Really, it’s not.  There are things you can do to patch things up.

Patch #1:  Spending cuts.  Remove all non-essential purchases.  Cancel trips, put a halt to all restaurant excursions, charitable giving, and other optional expenses.   My estimated yearly expenses are currently 18K, but I believe I can get it down to 12 if needs be.  This should allow me to ride out just about any total SS-type market scenarios.  Except maybe a global contagion that wipes out 95% of the population.  That’ll take generations to fix.  (Luckily, I’d probably be one of the people that was wiped out, eliminating any need to give a damn about it.)

Patch #2:  Work-for-pay of some kind.   Sure, this isn’t fun, and you’ll likely be looking for a job at the worst possible time (a major recession) but if you can score something, it’ll help get you over the rough patch.  Your expenses are likely very low, making even a small amount of supplementary income go a long way.

Patch #3:  Social Security.  I believe it’ll be around in some form or other, even 30 years from now.  The general population will not allow these social safety nets to simply disappear; too many folks depend on them to get by.  The social security benefit calculator tells me that I’ll be eligible for payments of 1800 or so (today’s dollars) when I turn 62, even if I never earn another dime.

Worst case, let’s pretend the program has been systematically gutted between now and my retirement age, and I’m only going to see half of the current estimated payment.  Turns out that $900 will cover 90% of my bare-bones (12k/yr) expenses.  It won’t be fun, but if things are really that bleak, I’ll gladly take it.

Patch #4:  Home Equity.  If interest rates are low, you can get a HELOC and tap that account.  Or you can sell your residence and become a renter for a while. While this isn’t a great option because you’ll probably be trying to sell in a depressed market, which will mean potentially taking a loss, the fact still remains that it’s an option if you’re in dire straits.

MMM has a related article on this if you’re looking for additional ways to help yourself feel safe when you finally decide to bounce on your job.

A Note on Alternate Income Streams:

If you’ve read all of the above and are feeling nervous, you probably have a high aversion to risk.  That’s perfectly fine — it means you strive to always achieve the safest path possible.

In this case, consider going into retirement with an altogether different strategy.  Review DRIP investing, or consider being a landlord. Combining rental income with high yield blue-chip stocks is a great way to ride through the worst of bear markets with a smile — you’ll hardly be affected.

Finishing Up

At this point, you know how to access your money, avoid taxes, and get high-quality and affordable health care in retirement.  In addition, you know that you can easily shift plans around a bit if you need to make adjustments, based on market conditions.  And worst case, you have a skeletal back-up plan to put into action if things really go south.

Question: What’s left, to do, other than quitting?  I’d really like to quit soon.

Answer:  Calm down there, bucky.  We still have to work our way through a few specific historical scenarios to see how things would have gone.

In the next post, we’ll take a look at what would have happened had you retired using the Superplan immediately prior to a major downturn. Specifically we’ll examine 1928 and 2008, in Part 4:  Examples.

Also on the menu will be some tweaking of asset sheets and spend rates, to see what effect certain changes would have on the plan.  I’m most interested in comparing downsizing the house to not downsizing the house.

Hopefully I’m better at FIRE than I am at Stratego.  Growing up, my older cousins consistently crushed me.

Drawdown Part 2 : Simulation <<     >> Drawdown Part 4 : Examples