Come On, Take the Money; Running Optional
In the previous post, we discussed the plan to accelerate financial independence as much as possible using a combination of frugality, tax estimating, investing, credit card hacking, and adding a side hustle. In this follow-on post, we discuss having a plan for how to actually withdraw money from the plans after spending a life funding them.
Investment withdrawal strategy
Investing via alphabet soup retirement vehicles like HSAs, IRAs, 401ks is fairly easy once the accounts are set up. Withdrawals can be more complicated and require serious attention and planning to set up withdrawals that minimize any penalties and taxes, while at the same time maximize flexibility as goals, plans and investment returns deviate from the plan.
Early retirement requires some amount of money available for immediate use for any purpose. This will consist of a small cushion that includes a checking or savings account to cover immediate needs that might have to be accessed instantly. The general rule of thumb is to have between one to six months of expenses available in this account. Given that early retirees need to make the most of compound interest and likely have sufficient reserves available to withdraw on short notice, a month to 3 month’s worth of expenses is usually sufficient.
The other component of the accessible-for-any-purpose money would be those dollars invested in a taxable brokerage account that holds a low expense, diversified mutual fund or exchange traded fund. These can be converted to cash in a bank account, usually within a few days time. Since invested money earns more over time, the bulk of the anytime money should be put in here.
The next important component of the rightirement withdrawal fund is converting all those dollars stashed away in 401ks and/or IRAs. Most people think that funds in those accounts can’t generally be withdrawn before the age of 59.5 without paying penalties. These people are unaware of the fact that there are at least two ways to access that money early and without penalty.
Early Retirement Account Withdrawal Strategy #1
The first is what many have termed the Roth IRA conversion ladder. To establish this Roth conversion ladder, one transfers an amount from a Traditional IRA to a Roth IRA, then lets it “season” for at least 5 years. He or she must pay any income tax owed on this transfer as it is considered income. After the 5 year seasoning, the contribution amount can be withdrawn without penalty just like it were a Roth IRA contribution. It should be noted that any growth of that contribution cannot be withdrawn penalty free until 59.5 years old.
This strategy is helpful for many who want to spread out their withdrawals to fill up low income years when the money won’t be needed immediately. The main disadvantage is the 5 year waiting period-it’s not possible to predict how much income you need in 5 years, so this strategy, while helpful, shouldn’t be the sole source of income before hitting age 59.5. The other downside is that it’s not generally advisable to pay tax on money 5 years before you can use it. This strategy is best utilized to fill up any extra income space that won’t generate additional federal taxes or in rare cases were higher income earns higher tax refunds, i.e. the Earned Income Credit.
Early Retirement Account Withdrawal Strategy #2
The second strategy of accessing retirement accounts early without penalty is known as the Substantially Equal Periodic Payments (SEPP) a.k.a. Section 72(t) of the tax code. SEPP allows a fixed amount to be withdrawn from IRAs (401ks would need to be rolled into Traditional IRAs first) each year for at least 5 years or until the account holder turns 59.5, whichever is longer. This means that someone that retires at 30 would have to keep the same amount for 29.5 years! Only one adjustment to the method used can be made, so choose wisely.
Calculating the permitted amount requires consulting several tax references to determine the allowable percentage (≤ 120% of federal mid-term rate, currently at 2.05%), one’s actuarial life expectancy rate, and the computational method (RMD, amortization or annuitization). This is a complex process and one should definitely review this with a financial adviser who is familiar with SEPP plans to make sure you don’t run afoul of IRS regulations. However, once the plan is established, it can become the principal source of income until the magical, if random age of 59.5 is reached and many of the tax restrictions governing retirement accounts disappear.
This strategy is preferred in many cases for several reasons. First, one would pay the tax on withdrawals the same year that the funds can be used. Also, this will slow IRA account growth so that one limits his/her Required Minimum Distributions (RMD) at age 70.5. The downsides to this strategy are 1) it’s complicated to set up, 2) it’s fairly restrictive once established and at 2.5% at present, annual withdrawals are limited to relatively low percentages of total account value for early retirees. It’s also risky in that you could potentially owe penalties on all 72t distributions if you make an error in any year while you’re required to take them.
While setting up and making sure to follow the SEPP plan is difficult, it does permit one to access the money earlier than they otherwise would and if set up on an automated withdrawal schedule, it would limit the day-to-day or month-to-month management of withdrawals.
Early Retirement Account Withdrawal Strategy #3
Additionally, there is the option to accept the 10% penalty on withdrawals. While generally not the preferred option, it might be appropriate for someone who thinks he can retire and not withdraw retirement funds early, only to find that he’s a few months short of 59.5 and out of non-retirement funds. No one likes paying fees to take out their own money, but this strategy can be preferred if only needed for an unexpected event or short term need.
Early Retirement Account Withdrawal Strategy #4
The final option is do a hybrid of the first two options, setting up a SEPP withdrawal and doing smaller Roth IRA conversion ladders when taxable income is low enough to convert to the Roth IRA tax free. This can be ideal for people who have low expenses relative to their tax deferred account balances. This allows one to roll some cash over when income is low enough to roll traditional IRA money to a Roth IRA without paying any taxes. At the same time the SEPP plan can continue to operate as normal.
When combined with other tax advantaged accounts that have money available for withdrawal (Roth IRA contributions, HSA un-reimbursed expenses, etc.), this strategy can add some flexibility to manage early withdrawals while avoiding taxes/fees and also paying necessary expenses when they come up. On the downside as taxes and fees drop, generally, the withdrawal strategy increases in complexity with additional moving parts and IRA regulations coming into play. This is another example of the fire-and forget ideas mentioned in an earlier post: it takes initial effort to establish the strategy, but once in place can yield great benefits.
Regular Retirement Withdrawal Strategies
Moving on to the other components of a rightirement plan. We still haven’t discussed 401ks, which are often the largest retirement accounts people hold. 401ks can generally be accessed after age 59.5 penalty free. The money, which was not taxed when contributed, is taxed upon withdrawal, unless rolled over into a traditional IRA. Once the individual reaches the ripe young age of 59.5, she should use this and any Traditional IRA funds up to where federal tax is owed, as normal income tax rates apply to these funds, rather than the capital gains and qualified dividend rates that might be in a taxable account.
If more cash is needed to cover expenses after accessing the 401k and IRA to the point of paying federal taxes, money can be pulled from either a Roth IRA or an HSA for previously un-reimbursed medical expenses.
Social Security plays an important part of any retirement strategy. Delaying it until age 70 is preferred if a retiree has sufficient investments to cover expenses and is healthy enough to expect to live long enough to enjoy it. Social Security is essentially an annuity that is paid by the government and can be used to address the longevity risk–living longer than the money lasts. For every year past 62 that Social Security is delayed (up to age 70), the monthly payment increases by around 8%. Try getting a guaranteed increase like that from any other source! Interestingly, almost half (46%) of retirees take SS payments at 62, the earliest possible and less than 10% of retirees eligible for Social Security payments wait past their full retirement age to begin taking payments.
Flexible Strategies for the Win
Mixing and matching all the different available accounts, taking into account the benefits and limitations for each can seem daunting, but it does allow for a very flexible approach for contributing to/withdrawing from/transferring between the different accounts to provide the optimal mix of pre- and post-tax funds.
If you don’t have enough money in your taxable account to meet all of planned budget for the year and
- You’re under 59.5 years old, you can:
- Start an SSEP with an IRA
- Withdraw contributions from a Roth IRA
- Apply for a credit card with a juicy sign-up perk
- Withdraw funds related to medical expenses from an HSA
- Increase side-hustle income/hours
- You’re over 59.5 years old, you can also do all the above, plus
- withdraw directly from 401ks and IRAs (including Roths)
- You’re over 65 years old, you can do all the above plus
- Withdraw any money from an HSA as if it were an IRA
- Evaluate when to start taking Social Security
- Be covered under Medicare for medical insurance
- You’re 70 years or older, you can do all the above and should definitely begin taking Social Security
On the other hand, if you have the enviable problem of having more available investment money than needed, you can:
- Step up contributions to a Roth IRA conversion ladder
- Contribute to a Roth
- Reduce time spent on side hustle/outsource parts that you don’t enjoy
- Pay off debt
- Max out HSA/IRA/401k, etc.
- Contribute to your favorite charitable organization
- Harvest taxable gains/losses
There are some cases where it makes sense to report a larger taxable income. The most frequent case is for instances where there remains unused deductions or credits whereby generating additional taxable income, say by converting a traditional IRA to a Roth IRA, does not increase the tax owed. Additionally, there are cases in the Earned Income Credit where a larger income means a larger credit-you actually get paid via a tax credit for earning more money (though that threshold is pretty low).
Optimizing time spent by reducing or re-balancing a side hustle allows for doing more of what you want and offloading undesirable tasks. Reducing any debts like mortgages or other low interest loans reduces future expected expenditures. Often when portfolios have been doing well for several years, it can be time to rebalance by paying off student loans or mortgage debt as the likelihood of continued above average returns drops as returns revert to the mean.
Harvesting capital gains/losses is good to do, especially in cases where there’s sufficient tax headroom to claim 0% long term capital gains. Selling an investment and buying it again serves to step up the basis of the investment-the break-even price that is reported on future returns. Having a higher basis lowers the capital gains to be claimed in future years, or increases capital losses if the market drops.
The Elephant in the Room: What about health insurance?
Retiring early in the United States was made much easier with the passage of the Affordable Care Act (ACA or ObamaCare). Before the passage of the ACA, it was difficult to find insurance plans outside of an employer and those who had pre-existing conditions were especially at risk of being denied coverage. Some early retirees were able to find catastrophic coverage that had a low premium and a very high out of pocket limit and only covered limited medical issues.
Under the ACA, insurance was made available to anyone regardless if their employment provided coverage or not. For people who did not have coverage through their employer, there were subsidies built into the bill to lower to the cost of the plan based on a person’s income, lower income people were given larger subsidies.
While the ACA did provide coverage to many who would otherwise be uncovered, it is not without a sizable list of detractors. As with any legislation, there are winners and losers. Healthy people and those with high incomes soon found themselves paying more for less coverage or having to pay a penalty while receiving no coverage. Also, while the ACA did address the affordability aspect by providing subsidies, it did very little in real terms of reducing the cost of care. As the costs of care rose, those without subsidies became more enraged with the plan.
Fast forward to today where people have elected representatives, the majority of whom oppose at least some aspects of the ACA, who have attempted to change the ACA to focus more on cost. Discussions are heated and efforts toward a viable alternative have so far been fruitless.
This uncertainly has caused many insurers to leave the marketplace until something more certain is enacted. In my state there will be many counties who are covered by 1 or even no ACA-compliant insurance on the marketplace. The remaining company has requested a 40+% rate increase. In other states premiums are projected to rise from the high single digits up to close to 50%.
Looking objectively at the health insurance debate, it’s hard to see the ACA at a national level remaining viable and affordable going forward. It’s also not clear what, if anything, the current party in power can or will do to address the failings of the ACA. In the meantime, early retirees are left in the lurch-they can opt to stay the course hoping the government can get its act together and come up with something meaningful that will a) allow people to maintain coverage and b) reduce the cost of care; or they can plan for a much more expensive health care plan and retire a year or two later; or they can start looking at foreign countries where healthcare is easier to access. None of those options are ideal for people who have already retired and have at least some reason to remain in the US. For those that have always wanted to see the world, this might be the kick in the pants that gets them going.
The tax advantaged options available to an early retiree are few in number but very useful and can be used with powerful effect. The downside is that there is increased complexity to fully utilize those strategies compared to those available to a 65+ retiree. There’s always the threat of changes in laws that might curtail their usage, but generally those already involved in a SSEP for example would likely be allowed to continue to use it.
Having multiple different retirement and regular investment accounts allows one to be extremely flexible in withdrawing what they need based on tax circumstances, unforeseen expenses (or windfalls), fund options, etc. It would be preferable to have a plan that allows for pulling from different accounts from year to year based on the circumstances of that year rather than a rigid “I’ll take X amount from account A and Y amount from account B until I hit 70 then take Social Security.” Knowing how much you expect to spend and how much you can take from non-retirement accounts before accruing tax are important considerations. Once those numbers are estimated, knowing how much you can withdraw from retirement accounts without penalty will provide confidence and flexibility after achieving financial independence. In part III of the How to Retire Early Series, we’ll walk through some examples in how to optimize withdrawals until hitting full retirement age.