Early retirement withdrawal strategy

[M]

Hi All, wanting to see what you think of our withdrawal plan for when we start our ER in a year with no further expected additional work income after that. Shooting to stay in <=12% federal  bracket all throughout retirement. Want to use ACA so aiming to keep under cliff.

Draft Withdrawal Plan
-Right away make Yr 1 of Roth ladder conversion to stay within 400% FPL and 12% federal tax bracket.
-In years 1-5 live on Cash, supplement with Roth IRA contributions and maybe 72T SEPP to get to year 6. If we don’t do 72T, in yrs 6-10 primarily live off the Roth ladder conversions made from yrs 1-5 and supplement with Roth IRA withdrawals of contributions if needed.
-When spouse reaches age 59.5 until 401k is depleted- withdraw roughly annual expenses. When pensions start reduce 401k withdrawals to just cover remainder of annual expenses. Do the same when SS kicks in. Once 401k is depleted then live off Roth IRA and HSA.

Questions:
1) Do you see any red flags or have suggestions on this withdrawal strategy, in particular to minimize taxes, still be eligible for ACA subsidies, and of course have enough money for life?
2) In our situations do you have concerns with using 72T SEPP in addition to Roth ladders?
3) We had wanted to take SS as early as possible to lock it in, but this doesn’t help with drawing down our 401ks  as quickly as possible. What considerations are most important for deciding when to take SS?

Thank you!

[gocurrycracker]

Hi M,

Some quick things to think about...

Assuming no changes in tax law for the next 40 years...


#1
When you are 90 years old and doing RMDs, let's say you have a mandatory withdrawal of $300k (inflation adjusted, $3 million IRA value) as your only non-SS income. That means you will have a federal marginal tax rate for MFJ of 24% (effective tax rate of ~18%.)

Compare that to year 1-n of retirement, doing Roth conversions to reduce future taxes...
You'll pay 10% - 12% federal income tax.
You'll also pay 10-15% "ACA tax" via increased insurance premiums / reduced ACA subsidies.
You may potentially also pay more $ for the medical care you do use, through reduced cost-sharing subsidies. This could be another few % "tax"

Or another way to say this, you could be paying guaranteed 25%-27% tax rates now to avoid possible 24% tax rates later.

I go through some of this in a post that explores the idea of us moving to California in a few years and using the ACA for insurance.
https://www.gocurrycracker.com/going-back-to-cali/

The tax idea is explored further in the subsequent post (see the charts):
https://www.gocurrycracker.com/harvesting-massive-capital-gains/

(The numbers are not the same as your situation, but the concepts are... )

In short, while on the ACA I would argue to keep your income below 250% FPL if you can do keep CSR subsidies and marginal tax rates below 25%.


#2
The SEPP is a good tool for people retiring within 5-10 years of age 59.5 (i.e. you)

Because you are making a commitment to continue annual withdrawals for 10 years if you start an SEPP at age 50, it is best to break existing Traditional accounts into several Traditional IRAs and start an SEPP on just 1 of them

Considering the alternative is to do a Roth conversion and a withdrawal of prior year Roth contributions in the same year, I would probably opt for the SEPP


#3
Starting SS earlier or later is actuarially neutral for the SSA, i.e. they expect to pay you the same total amount. The idea to delay for greater payments later is often done by people with minimal real assets, who know they can't survive long term on the smaller amounts.

My intention is to decide when to take SS when I come of age. I'll do this based on my health and the current state of the world.
If I am in perfect health, then delaying can have good ROI if I believe I can live well beyond what the actuarial tables say. But if my body is already failing, then start sooner as my heirs can't inherit my social security

And if the world is in a crappy place (WW3 just started, stock market collapsed, another wave of COVID-2032, etc...) then I can start SS early(er) so avoid drawing down assets in a bad market.

For your idea of having an extra year or more to do lower tax Roth conversions to avoid high tax later, it really depends on the value of the IRA at that point - if your IRA is worth $3 million then a Roth conversion of $10k doesn't make much difference whether it is tax free or not.



In summary:
- SEPPs are good
- do the tax math on Roth conversions now vs RMDs later (it's not as great as many think)
- when to take SS is dependent on health and wealth


Let me know if this makes sense or not

[M]

Thank you so much for your reply and for challenging me to think of this different option! It took me a while to digest all of your info and to run a comparison scenario. I kept expenses and other assumptions as close as possible and here’s how it turned out to keep MAGI at 250% FPL.

-ACA- Silver Plan 250% FPL $4500/yr vs 400% FPL $6600. Doesn’t seem that CSR is an option or if it is it’s not obviously better. But that’s a savings of roughly $2k x 15 yrs = $30k plus any earnings.

-Taxes- This option ends up paying roughly about $123k more until death in taxes, however the timing is roughly $4k/yr less for the first yrs when MAGI is less and then more later not only because of higher income from the need to draw down 401k but also because MAGI is too high so taxes are owed on SS annuities.

-Portfolio- Despite higher overall taxes owed, the new option portfolio ends roughly $140k more at death. This option used more Roth IRA sooner and almost depletes it by the time we start to take Medicare. Of course the 401k acct. grows more longer until RMDs force more aggressive withdraws.


Questions:
1- I see what points you are making come true in this option. Essentially we can save $6k/yr in healthcare and tax expenses in ER. However, by keeping such large 401k balances, doesn’t this interject a higher element of risk for a small overall gain ($140k total) especially when considering future taxes have a good chance of going up and death of one spouse would leave an even higher tax burden?
2- The overall tax burden being higher and yet the portfolio growing larger was a surprise to me. My explanation is it has to do with timing- the earlier savings of ACA premiums and taxes allows that roughly $90k to be invested and earning. Is that the reason?
3- I’ve read your writings and gather you value taking breaks when they are available. I’ve done that sometimes.I’m hesitant in this case to take the full breaks leaving the 401k growing and depleting the Roth IRAs early when the potential beneficial margins seem low as compared to the locked in certainty. Am I wrong to think this way and what am I missing?

Thank you again!

[gocurrycracker]

Out of order answering...

#2
Another way of saying "we paid more taxes but the portfolio grew larger" is "we paid less in taxes"

If you look at raw dollar amounts ("$2k x 15 years", "$140k total", etc....) it is harder to compare vs looking at the tax rate you paid (both marginal and effective.)

Example:
You have $10k. Your choices are A) Roth conversion now, which will cost $2k in tax, B) Do nothing now, the value grows to $100k in the TSP and pay $15k in tax when you are 90 years old.

Which is better?

B is better - Sure, 15k is more than 2k, but an 18% tax rate is better than a 20% tax rate. (The present value of that $15k tax will be less than $2k.)

#3
I don't take tax benefits when they are available. I take them when the math says I should.

#1
It's impossible to know what future tax law will look like, but assuming taxes go up I would expect higher marginal rates on higher incomes. There would still be a standard deduction, a ~10% tax bracket, etc...  Maybe the 24% tax bracket becomes 26%-28%, etc...

But... by doing Roth conversions now, you are choosing a 27% tax rate up to ~300% FPL and a ~22% tax rate up to 400% FPL.

To see something higher than a 24% tax rate on RMDs you would need annual income of >$350k (in 2021 dollars). The Traditional IRA would need to be north of $5 million at age 85 or so for that to be forced. Unlikely. And then you'll still have a lower tax rate on the amount <$350k (18% effective tax rate on 1st 350k)

More likely you would see tax rates of much less than 22-27%.

You are spot on about the tax risk that comes with the death of a spouse, however. You also lose their SS benefits, etc...
https://www.gocurrycracker.com/the-real-death-tax/


About the CSRs

It's a hard thing to compare, you can't just look at the top line quotes from the exchanges. And if you don't use the insurance, they don't matter at all.

See the Cost sharing subsidy section of this post:
https://www.gocurrycracker.com/obamacare-optimization-early-retirement/

The difference between being at 199% FPL and 200% FPL , for example, could be the difference between a individual deductible of $2k vs $5k. If you use it, that $3k delta is substantial (basically triples your "tax" rate)

In the going back to Cali example I linked, the estimated cost of usage was substantially higher without the CSR (another way of saying the government gives the health insurance company more money so they charge you less)

What some people do is tick/tock their ACA coverage - plan to use little health benefits in year 1 and have high income (<400% FPL) and then in year 2 plan to use lots of health benefits and keep income low (<200% FPL)

 

[M]

Hello! I’ve studied what you are saying and have been wondering if I’m figuring the marginal tax comparison correctly. I’m comparing keeping at 200% FPL vs some other higher income amount. What I’m doing is comparing marginal tax in the early years vs once RMDs start, but I’m uncertain how to count the ACA as a tax and should I also be including Medicare later?  For example:

-For calculation in early years add marginal tax of federal and state taxes and look at ACA
-Do this for both 200% FPL and whatever higher income I’m trying to compare. For ACA include the premium increase in the higher income option and use zero for 200% FPL. Or should I be adding premium to both calculations? I was doing this thinking it would show me the difference in subsidy amount.
-Roughly calculate what the balance will be in TSP/401ks for each of these to calculate the rough expected RMD at ages 72.
-Add Federal and state marginal taxes from RMDs plus pensions plus SS. Then add Medicare premium.
-Compare early retirement vs after RMD marginal tax rates.

Is this correct? Thank you!

[gocurrycracker]

Yes, correct