The lucky winner of our Financial Review goes to reader Bob. We exchanged many emails over the holidays, and put together a great plan that will help Bob and his wife overcome their financial concerns, retire earlier, and save $1.5 million or more in taxes
Along the way we learn about RMDs, and the sweet deal that Federal employees have in terms of pension and health benefits
Hey Jeremy and Winnie
Love your site! My wife and I have been talking about ER for some time now but are scared to death of running out of money and are worried we haven’t saved enough. Your tax-free approach is a different take of which you don’t hear a lot of folks talking about. I just turned 57 and she is 54. Getting a little freaked out about retiring at this age. ;)
I’m already thinking on how to move investments tax efficiently to get out of the tax trap.
Here is our financial situation:
We have our main home, a rental property, and a condo in Texas. We plan to sell the rental property and use the proceeds to pay off our mortgage. The condo is already paid for
We have the following investments:
250K Roth IRA
500K taxable brokerage account
72k private equity investment at 7.5% yield
My wife will also be eligible for a pension as long as she works until age 56, her Minimum Retirement Age, which she can start drawing from at age 60. My early SS and her pension would provide an equal income, totaling ~$4,300/month. She would also be eligible for SS starting at age 62, and for Federal Health Insurance coverage starting at age 60. We currently pay a total of $612/month for coverage for both of us, which includes our HSA contributions.
Our current thinking is for both of us to work until the end of 2016. I’m earning 95k/year and my wife is earning 75k/year, totaling 170k a year. We both max out our 401k/TSP and also contribute to our ROTH IRAs.
My question is how would we be able to get the deferred 401k and TSP money converted to the Roth IRA in the most tax efficient manner? I understand about drawing down the taxable account but concerned about the RMD at 70. If it would work, we could hold off on the SS and the government pension in order to get this converted, as SS would be ordinary income? What are you thoughts with the 4% living rate?
When we retire, we would like to hit the road traveling and spent our winters at our condo in Texas. We estimate we will spend 48k a year. We’ve always been pretty frugal on the things we buy, as big houses and expensive cars don’t really do it for us. We also don’t have any children to inherit our assets
The photos you’ve posted are great. I check out all of them. Keep up the great photos and thanks for your assistance in helping everyone get out of the rat race early.
I have some good news and some bad news.
The good news is: The only people in the country more financially able to retire TODAY have last names that sound like Kennedy, Rockefeller, and Getty. Congratulations!
Any way you look at it, you are ridiculously wealthy. In fact, you and your wife have been financially independent for at least 10 years. While it is certainly normal to feel some concern about the paychecks stopping, the bigger concern at this point should be making sure you aren’t wasting your life working when you could be pursuing your passions
The bad news is because you have saved such a substantial portfolio, you are going to pay tax. Lots and lots of tax
Still, I will suggest some ideas that will save you $750,000 – $1.5 million in tax over the coming years
Let’s get started
Let’s look at your total financial picture
Total invested assets: $2.65 million
Homes: Main home and condo, no mortgage
Monthly Pension and SS: $4,300($51.6k/yr)
Wife’s SS: $26k/yr (estimate, not included in analysis)
Monthly spending in retirement: $4,000 ($48k/yr)
You expressed some concern about the 4% Rule, but you have so much income and assets that we don’t even need to consider it. Your target withdrawal rate is actually 0% (!), as the Federal Pension and Social Security will cover 100% of your expenses.
There are a few ways to look at your current financial options:
- Spend $48k/year with 0% withdrawal rate. Pension and SS cover all expenses
- Spend up to $157k/year, 3x your current plan – 4% Rule allows for this level of spending
- Spend up to $237k/year, living like a Rock Star for a few years (7% withdrawal rate) Since Pension and SS support 100% of your target lifestyle, you can take risks
Any fear of not having saved enough has no basis in reality
Value of Working 2 More Years
Your plan of working until the end of 2016 is based on the idea of reaching the Minimum Retirement Age (for your wife, 56) for the federal government pension (FERS)
But what happens if your wife quits today, at age 54?
Since I’ve never participated in these plans, I had to do a bit of reading. This is what I determined (See Jane’s example)
With over 5 years of qualifying service, your wife qualifies for a FERS Deferred Retirement. By retiring 2 years before the MRA, the pension payments are reduced AND she is ineligible to participate in the Federal Employee Health Benefits. You also forgo 2 years of income and some small incremental SS benefits
These sound like bad things, but remember: You don’t need any more money. But let’s be objective, and use cold hard reason and logic to determine the actual financial value of that time
Value of Pension
The formula for determining the FERS monthly annuity value is as follows:
High-3 Average Salary x Years of Service x 1% = Payout at Age 62 (Estimated $2,300/mo)
Since your wife has already saved $1.1 million in her TSP, she must have worked for the government for quite some time. I am going to assume 20 years since I don’t know exactly. In this case, working 2 more years would increase the payout by 10%. Assuming that the final 3 working years are the highest income years, with annual raises of 3%, the High 3 average would also increase by 2-3%
The net impact to the payout for 2 years of work comes to about 12%. Your expected payout of $2,300/month would be reduced to $2,024, a reduction of $276 monthly
Is it worth working 2 years to received $276/month? What if instead we purchased an inflation-adjusted annuity with spousal survivor benefits for the same income?
Present value of that annuity (2015) is about $82,000
Value of Health Benefits
By retiring 2 years earlier, your wife loses eligibility to participate in the Federal Employees Health Benefits
This needs to be compared to what could be purchased on the open market
Coverage between Government Group Health Plans and a Silver level family plan purchased through Healthcare.gov seem similar (my opinion), with minor co-pays and Out of Pocket costs of ~$8k year max. On Healthcare.gov, plans cost about $1k/month. Through the FEHB, plans cost $462/month
That is an incredible $538/month savings! This is because the Federal Government continues to pay 72% of the cost of insurance after retirement, something unheard of in the private economy
As we did for the annuity, we can translate this into present value. An annuity with $538/month payout would cost $160k (and perhaps more as health insurance costs have been rising faster than inflation)
For 2 years of your wife’s time, she would receive:
150k in additional income (pre-tax) (After tax: ~$90k)
An annuity worth $82k
A lifetime health insurance subsidy worth $160k
A small increase in Social Security benefit (ignored here)
This looks like a great income, roughly $165k/year after tax for a total of $330k. This is equivalent to ~10% of your net worth (excluding pension and SS)
The Retirement Years
Whether you retire today, in early 2015 (age 57 and 54), or work 2 more years until the end of 2016, there is a period of years before Social Security and Pension payments begin
What is the best way to pay for your cost of living during that time, which accounts should the money be withdrawn from, and how do we pay the least possible amount of tax?
Bridging the gap
Most people are aware of the 10% penalty for early withdrawal from tax-deferred accounts. This is the stick the government uses to discourage you from using this money before retirement
For this reason, many people set aside funds in a taxable account or ROTH IRA to cover these years, to bridge the gap between no longer receiving a paycheck and eligibility for penalty free withdrawals from 401ks/IRAs or eligibility for Social Security
This works, of course, but there are better ways. There is one exception, referred to as Separation from Service, which states that if you separate from service from your employer during or after the year you reach 55 years of age, then you can make withdrawals from 401ks/TSPs without restriction and without penalty. This only applies to qualified plans like 401ks & TSPs, and DOES NOT APPLY to IRAs. If you rollover your 401k or TSP to an IRA, you lose this option
Since both you and your wife will be 55 or older in 2015, you both qualify for this exception, and this is what I recommend you do
For others in a similar situation but younger than 55, there are other methods to access tax-deferred funds penalty free, most notably Substantially Equal Periodic Payments and a ROTH IRA Ladder (what we do.) The Mad Fientist wrote a great guest post about this topic on Jim Collins’ site
Starting from day 1 of retirement, you should fund all of your annual expenses by withdrawals from your 401k and TSP
Your Tax Base
Currently, you live in a State with an income tax but have a condo in Texas. As soon as possible after retirement, you should change your tax base to Texas which has no tax on income of any kind
This will reduce your effective tax rate by up to 6%
Required Minimum Withdrawals
The government is very kind in providing options for decades of tax-deferred growth in our 401ks and TSPS. But tax-deferred is exactly that, deferred. Someday, you have to pay the IRS
As we start withdrawing funds from the 401k/TSP, we will pay tax. But this isn’t enough for the IRS. They want taxes on ALL of you deferred savings, and so they mandate Required Minimum Distributions starting at the age of 70.5. Jim Collins has a great RMD overview that is definitely worth reading
These minimum withdrawals increase with age, and can be substantial, resulting in tax rates of up to 39.6%. Even worse, because RMDs push us into higher tax brackets, qualified dividends and long-term capital gains become ineligible for the 0% tax rate and Social Security income becomes taxable
To minimize taxes, before RMDs are required at Age 70.5, we want to withdraw as much money as possible out of tax-deferred accounts while paying the least amount of tax
Our goal is to minimize total tax paid, and so we will choose to pay tax in the short term at 10% and 15% in order to avoid paying tax later at 25% to 39.6%
Between now and 2028, when you turn 70.5, you want to withdraw enough funds from the 401k and TSP to reach the upper limit of the 15% tax bracket, plus deductions
In 2014, for a married couple filing jointly with standard deductions and exemptions, this limit is $94,100. Any income from interest, dividends, pension, or social security will reduce the amount you can withdraw from the 401k/TSP, dollar for dollar
For this reason, we want to minimize other income sources. I would recommend delaying Social Security until after Age 70.5, and taking the Federal Pension at the latest date possible (I believe Age 62.)
Minimizing Taxes from RMD
There are 3 different tax situations you will face during retirement
- The Gap between Retirement before the Pension begins
- Receiving Pension payments but before RMDs
- Required Minimum Distributions
A picture is worth 1000 words, so here are some examples
These charts use Bob’s Age as the X-axis and Annual 401k/TSP withdrawals on the Y-axis. I’ve assumed 7% annual growth of 401k/TSP (probable) and tax brackets adjust with inflation of 2% (IRS inflates brackets slower than inflation to increase tax income)
Starting in 2015 at Age 57, withdraw funds to the max of the 15% tax bracket. Because other income is low, the Standard Deduction and Personal Exemptions allow us to withdraw a bit more.
One your wife’s pension starts at Bob’s Age 65 (Wife’s Age 62), reduce 401k/TSP withdrawals by an amount equal to the pension payments
At Age 70.5, RMDs begin. In the early years, the 15% tax bracket is greater than the RMD, but over time the RMD grows faster. Any funds withdrawn from the 401k/TSP before Age 70.5 that are not spent on consumption, Convert into your ROTH IRA, which will allow those funds to continue to grow tax free
If instead you were to fund the early years from the taxable account, you would pay minimal taxes in the years before RMDs begin. This would allow more tax-deferred growth, at the cost of greater taxes later
The total delta in tax between today and age 90 is ~$750,000. By drawing down the 401k/TSP in the earlier years, you eliminate $750,000 in tax! And if we look out to Age 100, this method saves over $1.5 million!
Sounds impressive, doesn’t it? Even so, you will still pay up to $2 million dollars in tax by Age 100
Present Value of Future Tax Payments
These sound like big numbers and big savings. Let’s look at the cost of those future taxes today, in 2015, similar to how we determined the value of working two more years
The NPV of all future tax payments to Age 90 is about $300k, roughly equal to the value of working 2 more years.
That $750k future tax savings? About $60k in 2015
(Determined using NPV function in Excel, assuming 7% alternate investment option)
End of Life and Charitable Contributions
Even with several decades of living the dream, making substantial tax payments on the way, the value of your portfolio at Age 100 will still likely be in excess of $10 million.
Now wouldn’t be a bad time to think about what to do with that wealth, potentially even contributing to causes you believe in.
To minimize taxes, you can contribute funds to an endowment in the years with your highest tax burden (another Jim Collins classic.)
By all accounts, you are already financially independent and able to fund your desired lifestyle for the rest of your life. You no longer need to trade your time for money
You have the opportunity to increase your net worth by <10% via your wife’s pension and access to the government health plan. The cost is 2 years of life
According to the social security life expectancy calculator, you can expect to live another 28 years. Of course, not all of those years are equal. Is it worth trading 7% or more of your remaining life (2 years) to increase your net worth by ~10%?
Only you can determine if this is a good trade
By leaving your 401k/TSP with your employers, at least through the age of 59.5, you can withdraw funds penalty free beginning in 2015 or as soon as you retire. Using this to fund the gap years will minimize long term taxes
Were we in the same situation, I would quit work today and start traveling. Any additional income is unnecessary
Because of your strong concerns of insufficient savings, perhaps you quit today and your wife works 2 more years, assuming she is agreeable. It is hard to predict the future of health insurance costs, but many believe it will increase faster than inflation. A guaranteed lifetime subsidy on health insurance would be hard to turn down.
During these years, and the first several years of retirement, I would use a tool like Personal Capital to track expenses like a hawk. By seeing income exceed expenses, and watching net worth continue to grow despite withdrawals, will help minimize any fear of not having saved enough
To minimize taxes, I would move to Texas as soon as convenient, and otherwise follow the plan outlined above.
Good luck, and may you mock the longevity tables
Update: A follow up was posted 5 years after the Bobs retired. Check out the rest of the story: Scared to Death of Early Retirement, No More. An Update.
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As a random guy on the Internet, this is the actual value of the recommendations I provide :) This is for entertainment purposes only. Always consult a professional.
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