Better understanding early retirement withdrawals

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
MI_bogle
Posts: 441
Joined: Mon Aug 01, 2016 3:56 pm

Better understanding early retirement withdrawals

Post by MI_bogle »

So I am trying to better understand early retirement withdrawal options for (by boglehead standards) low earners. Ones that cannot afford to max their tax-advantage space and also contribute to taxable accounts.


Let’s take a hypothetical couple earning a middle-class income. They decide to save a decent percentage of their income. Let’s say that they save diligently and manage to max their traditional 401ks and Roth IRAs, but cannot make and/or save enough to also contribute to a taxable investment account.


They have hit their “number” at age 50. Let’s say 30x annual expenses, which are 50k. So their total portfolio is 1.5 million. To make it conceptually simple, the breakdown of assets is 1 million in the 401ks and 500k in the Roths, of which 250K is contributions. They roll their 401ks into IRAs. But since they have no taxable investment accounts to live off until age 59.5, how would they minimize taxes and most efficiently use their portfolio until they reach age 59.5?

They could utilize:
Roth Conversion Ladder
72t SEPP
Withdraw Roth contributions
Some combination of the above?


Could the couple hypothetically start a Roth Conversion Ladder and roll a substantial amount (say 50K per year) from the Traditional rollover IRA into the Roth IRA…. While also withdrawing 50K annually (original contributions) from the Roth to live on in the meantime? Roth withdrawals are First In, First Out, right? So if their expenses were 50K per year and they had 250K of Roth contributions over their working careers, this would allow them to withdraw all of their original Roth contributions over a 5 year period while still effectively contributing 50K annually to the Roth account via the conversion pipeline.

Am I making sense? Would there be a better way to fund their retirement until they reach age 59.5 that resulted in lower taxes? I have read a bunch about the flexibility of having the taxable account to live on, and conversion ladders and 72t, but not much about what to do if you have substantial roth and traditional balances but no taxable account
User avatar
David Jay
Posts: 9617
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Better understanding early retirement withdrawals

Post by David Jay »

How about this:

1. Only Roll-over 500,000 from 401K to tIRA
2. Do a SEPP for 10 years with the remaining $500,000 in the IRAs (50K/yr)
3. At 59.5, begin to take tIRA and Roth withdrawals (balanced to minimize tax. MFJ pays no taxes below $22,000, so take $22,000 from tIRA and $28,000 from Roth for no income tax).

[edit] Sorry, $22,000 includes "over 65" deduction, so it is more like $19,000 if you don't itemize.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
goGators
Posts: 55
Joined: Thu Apr 04, 2013 10:01 pm

Re: Better understanding early retirement withdrawals

Post by goGators »

David Jay wrote: ...
2. Do a SEPP for 10 years with the remaining $500,000 in the IRAs (50K/yr)
...
David, how do you get $50k/yr?
Using http://www.bankrate.com/calculators/ret ... lator.aspx, I only got about $20.5K/yr for a 50 year old with a $500K balance.

OP, have you tried https://www.i-orp.com/? Its 'Withdrawal Report' suggested approximately 2/3 from the 401k and 1/3 from Roth for annual expenses.
User avatar
David Jay
Posts: 9617
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Better understanding early retirement withdrawals

Post by David Jay »

Sorry, I was confusing SEPP and age 55 withdrawals.

There is no penalty for withdrawing funds from an 401K if unemployed. So they should leave $250,000 in the 401K for age 55 to 60 (i.e. 59 1/2).

SEPP would be from the IRA
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
Alan S.
Posts: 9975
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Better understanding early retirement withdrawals

Post by Alan S. »

One solution would be the SEPP plan constructed like this:

1) Assets are 2/3 pre tax assuming Roth earnings would not be tapped. To keep the distributions in the same proportion you would withdraw 16.7 from the Roth each year and 33.3 from the TIRA. If you assume that the SEPP yields about 4% of the IRA balance, you would need a total balance of 1.25 mm (4% *1.25mm = 50k.
2) Before starting the plan, partition the Roth and TIRA accounts by direct transfer into 2 accounts for each type. TIRA accounts would be 833k and 167k and Roths would be 417k and 83k. The smaller accounts would NOT be part of the SEPP and available for emergency needs if necessary. The 833k TIRA and 417k Roth would be used for the SEPP and subject to the applicable restrictions. This would be a single SEPP plan using a TIRA and Roth that would yield 50k of penalty free distributions each year. Even if the Roth distributions came out of conversions under 5 years, the SEPP penalty exception would waive the recapture tax.
3) In any particular year this plan has the flexibility for you to take your distributions in any combination from the TIRA or Roth because they are both part of the same plan. The IRS only requires that you distribute exactly 50k. So if you are in a pinch you can save on taxes in a given year by withdrawing more from the Roth and less from the TIRA.

If you did not need the flexibility you would take out 33.7 k from the TIRA and 16.3 from the Roth for the 50k. Income subject to tax would be 33.7.

CAVEATS: To execute this plan without error, it requires a tremendous attention to detail in both setting up the plan and executing it. With any SEPP you need a strict budget to avoid busting the plan. Further, the IRS does not understand SEPPs very well and they see almost NONE set up this way. Therefore, this setup is prone to IRS inquiries and you would have to explain the plan to them. Note that IRS Regs specifically say that you can convert to a Roth within a SEPP plan, and this plan is safer because there are no conversions done within the plan. The TIRA and Roth are set up before the plan starts. If you can handle the details, this plan would work.

And if you needed more money, you have the other 250k of TIRA and Roth accounts that are not part of the SEPP. You can use them as insurance against busting the SEPP if you need more money, but you would pay a penalty on TIRA distributions.
Roth distribution get reported on Form 8606 under the Roth ordering rules just like any non qualified Roth distribution. You would also need a 5329 to claim the SEPP exception code 02 for the TIRA 1099R and for the Roth if you are taking out conversion money under 5 years.
goGators
Posts: 55
Joined: Thu Apr 04, 2013 10:01 pm

Re: Better understanding early retirement withdrawals

Post by goGators »

Alan S. wrote:....
Even if the Roth distributions came out of conversions under 5 years, the SEPP penalty exception would waive the recapture tax.....
Alan, is this the only reason to include a Roth component in the SEPP plan?
David Jay wrote:...
There is no penalty for withdrawing funds from an 401K if unemployed...
David, I did not know this. Could you provide a link so I can learn more?
Thank you all.
User avatar
David Jay
Posts: 9617
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Better understanding early retirement withdrawals

Post by David Jay »

goGators wrote:David, I did not know this. Could you provide a link so I can learn more.
Lots of discussions about the age 55 rule here on BH - search "401K 55" - here is just one:
viewtopic.php?t=192755
Last edited by David Jay on Sat Oct 22, 2016 8:21 am, edited 1 time in total.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
User avatar
David Jay
Posts: 9617
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Better understanding early retirement withdrawals

Post by David Jay »

Let me go back to your original question, your hypothetical is really very simple:

1. Age 50 to age 55 - $250k from Roth contributions
2. Age 55 to age 60 (i.e. 59.5) -$250K from 401k using the age 55 rule
3. Age 60 to age 70 - balance of IRA (rollover from remainder of 401K) and Roth to minimize taxes
4. Age 70 - if you have been a middle class worker for 35 years, your SS benefit essentially covers your expenses

[edit] see corrections in following posts
Last edited by David Jay on Sat Oct 22, 2016 10:12 am, edited 1 time in total.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
Gryphon
Posts: 167
Joined: Sat May 07, 2016 11:43 am
Location: Missouri

Re: Better understanding early retirement withdrawals

Post by Gryphon »

David Jay wrote:Let me go back to your original question, your hypothetical is really very simple:

1. Age 50 to age 55 - $250k from Roth contributions
2. Age 55 to age 60 (i.e. 59.5) -$250K from 401k using the age 55 rule
3. Age 60 to age 70 - balance of IRA (rollover from remainder of 401K) and Roth to minimize taxes
4. Age 70 - if you have been a middle class worker for 35 years, your SS benefit essentially covers your expenses

Go Blue!
Step 2 doesn't work. The age 55 rule only applies if you leave your job in the year you turn 55 (or later). If you leave at age 50, you can't take advantage of that when you turn 55. See https://www.irs.gov/taxtopics/tc558.html:
The following additional exceptions apply only to distributions from a qualified retirement plan other than an IRA:

1. Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental defined benefit plan if you were a qualified public safety employee (State or local government) who separated from service on or after you reached age 50.
I think they'd have to go with SEPP withdrawals to cover 55 - 59.5.
Last edited by Gryphon on Sat Oct 22, 2016 9:52 am, edited 2 times in total.
dflaher
Posts: 29
Joined: Mon Jan 26, 2015 12:08 pm

Re: Better understanding early retirement withdrawals

Post by dflaher »

Gryphon is correct regarding Step 2.
Alan S.
Posts: 9975
Joined: Mon May 16, 2011 6:07 pm
Location: Prescott, AZ

Re: Better understanding early retirement withdrawals

Post by Alan S. »

goGators wrote:
Alan S. wrote:....
Even if the Roth distributions came out of conversions under 5 years, the SEPP penalty exception would waive the recapture tax.....
Alan, is this the only reason to include a Roth component in the SEPP plan?
David Jay wrote:...
There is no penalty for withdrawing funds from an 401K if unemployed...
David, I did not know this. Could you provide a link so I can learn more?
Thank you all.
No, the benefits of that proposal are:
1) It provides a single solution instead of a phased solution for the entire 10 year period.
2) All early withdrawal penalties are waived including tapping conversions under 5 years and taking TIRA distributions before 59.5, so no other exceptions are needed.
3) It is flexible to a certain point in that you can take the 50k in any combination in any year between the TIRA and Roth. The only requirement is that 50k (or whatever the exact calculation yields) in total is distributed every year. You could reduce taxes by taking more than 1/3 of the 50k from the Roth or you could preserve the Roth by taking the entire 50k from the TIRA if you had high itemized deductions that year. You can also elect tax withholding from the TIRA distributions if you want to, but do not lose sight of the gross distribution which the SEPP requires.
4) You still have one other TIRA and Roth account outside the SEPP for emergency needs as insurance against busting the SEPP if you need more funds at some point.
5) If something changes like receiving an inheritance or you return to work and want to preserve your IRA balance, you can do a one time switch to the RMD SEPP calculation method that typically reduces the SEPP payout by up to 40%.

The caveats of this were mentioned in my earlier post.

There is no penalty exception for unemployment from a 401k plan other than the age 55 separation exception. From an IRA, there is a limited exception for extended unemployment to the extent of your health insurance premiums only. Here is the entire exceptions list for all plans:
https://www.irs.gov/retirement-plans/pl ... tributions
LeisureLee
Posts: 158
Joined: Mon Jan 05, 2015 6:52 pm

Re: Better understanding early retirement withdrawals

Post by LeisureLee »

There are a few unknowns which are important in this scenario - how much of the Roth balance is contributions, and how much Social Security the couple will receive at age 70.

Suppose:
$300k of the Roth is contributions
SS will provide $25k (half of spending) at 70
The couple waits to 70 to take SS (maximum long life safety).

I prefer Roth ladders over SEPP to fund early retirement because one isn't locked into a specific schedule and there's no risk of penalties if the plan isn't followed properly. As long as you have five years of spending in Roth contributions, there's no downside I know of.

$300k of Roth contributions is only six years of spending, so IRA conversions must provide the remaining income until age 60. This means a minimum of $200k (current dollars) would need to be converted, or $33k/yr. Taxes for a $33k annual conversion are ~$1,250. [2.5% of $50k spending]

At the other extreme, if the couple wanted to fully convert their IRA to a Roth by age 70, they'd put all of the bonds in their asset allocation into the IRA (to slow growth) and converting ~$60k/yr would likely fully convert it by age 70. Taxes for a $60k conversion are ~$5k/yr [10% of $50k].

At age 70, $25k from SS and all of the remaining $25k from an IRA would only result in ~$750 of tax, because most of the couple's SS income would be untaxed at these amounts. There is therefore not much incentive to get the IRA converted to Roth by 70 - better to avoid 10% tax now than 1.5% tax later.

So, I'd convert ~$33k/yr from the IRA and spend $50k from the Roth until age 60. [Tax $1,250/yr]
Then I'd spend ~$20k/yr from the Roth and ~$30k from the IRA until age 70. [Tax $1,000/yr]
Then I'd spend $25k/yr from SS and $25k/yr from the IRA. [Tax $750/yr]

I'd aim to use up the Roth by age 70, keeping taxes at ~2-3% of spending rather than the 7-10% they'd be if spending from the IRA first. In exchange, taxes after 70 are 1.5% rather than 0%.
Post Reply