Most people don’t think about their retirement at all.
A smaller portion contributes to a small portion to their 401K and assumes they’ll figure it out when they get old enough.
But almost no one thinks about how they will access their money once they’re retired.
What is a Drawdown Plan?
For most of your life, you have been getting income from a job.
When you are retired, you need to get income from your savings. Unfortunately, the places you get your money from having different tax treatments.
Your drawdown plan is figuring out how much you can take from your account types while preserving as much capital as possible. This plan becomes even more important when you retire early because accessing standard retirement accounts before age 59 1/2 creates usually creates a 10% penalty.
Required Minimum Distributions (RMDs) are Brutal
Roth accounts dominate as they grow tax-free and can be withdrawn tax-free. Next is withdrawing from a taxable account and taking long-term capital gains. Then you have to withdraw from a Traditional 401K or IRA.
You spend your 40-year maxing out your Traditional 401K. You’ve been told to avoid Roth accounts because you make so much money now that you will obviously be taxed less once you retire.
However, any withdrawals from these accounts are treated as normal income.
What’s even worse is that at age 72, you are required to take money out of them. This is called a Required Minimum Distribution. It can range from a minor tax nuisance to a killer for significant amounts.
You probably assume that this is fine because you plan to take money out of this account anyway. Who cares if it’s required? Unfortunately, even in the lowest tax bracket, you’re still going to lose at least 10-12% of your money. Versus 0% if you took it out of a Roth or long-term capital gains.
Large Account Example
- Jim has $3 Million in his 401K when he retires at 65.
- He is married-filing-jointly with ~$100K/yr in expenses.
- He takes out ~$110K from his 401K to pay his expenses and taxes (to simplify, we’ll assume he lives in Florida and no state income tax).
- This gives him an effective tax rate of ~9%.
At age 66, his initial $3M has compounded to $3.15M (assuming 5% gains) – $110K = $3.04M.
At this rate, by the time he is 71, his 401K will be ~$3.25M.
When he’s 72, based on the RMD table, he is required to take out $120K ($3.25M/27.4). But that’s fine because he actually expects to take out ~$125K for his expenses anyway (with 2% inflation).
However, it only takes until age 75 for his required withdrawal to outpace his expenses. This gets worse the longer Jim lives and/or the better his portfolio performs.
This also doesn’t take into account any social security Jim is probably receiving since he worked in a job that also provided a 401K. After age 70, you have to collect your social security income which is partially taxable.
Our Unique Situation
Our money is not the same as the one I outlined for Jim. Most of our money is not in our 401Ks.
- Taxable Accounts: 80%
- Primary Residence: 10%
- Traditional IRA/401K: 6%
- Roth IRAs: 4%
We don’t need to access our retirement accounts until we’re 60 because of the money outside of those accounts. Ideally, I would like to slowly transfer money from the IRAs/401Ks to Roth accounts if we can stay in a low-income bracket each year. After five years, those conversions become contributions, and we could take money out if we needed to.
Both Colorado and Illinois have flat state income taxes ~5% and don’t give preferential treatment to long-term capital gains. This is not ideal for us and why a home in Florida with a 0% income tax may be ideal in the future.
Our advantage lies in manipulating our capital gains situation to pay little to no federal tax and maximize our savings.
Planning to Pay No Federal Tax
Long-term capital gains (assets you’ve held for at least a year) have preferential treatment in the United States. If you are married filing jointly, you may gain up to $80,800 each year without being taxed.
But there is a huge catch. Short-term gains get counted first which means if you made $81k in salary, IRA distribution, rental income, social security, etc. Then your long-term gains would now be taxed in the next bracket at 15%.
If you can avoid other income, though, you get to keep all of your money (besides possible state taxes).
Also, this tax is on long-term capital gains. If you need to pull money from your taxable account, you can decide what you are selling and how much cash you want to pull out. This isn’t the case with a 401K. Any money you take out is taxable as income.
For example, let’s say that your expenses are $100K a year. If you take the standard deduction of $25K and sell $105K of long-term capital gains as your only “income.” You just paid no federal tax and lived like someone making a $125K salary.
The Actual Plan
I am working on an actual forecast for every year of our life for the next 52 years. I plan to live until I’m 90 unless I can get my children working on anti-aging technology.
I place estimated inflation (2.5%) and an estimate on growth for each account. I also factor in major events like paying off a mortgage, buying a new car, children moving out of the house, my father passing, retirement account accessible years, and possibly social security*.
Social security takes your 35 highest income-earning years and averages them. I only have 13 “real” income-earning years. I will have a lot of zeroes and an average of $37K. But according to Social Security, if I delay to 2052, it could be worth $60K/yr in 2052 dollars… in theory.
Using this data and any income my wife or myself may make. I can determine how much money we need to have withdrawn and from what accounts. At the end of each year, I can look at our current tax situation and hopefully even move some money from our 401Ks to our Roth IRAs tax-free.
That’s right, another “no tax” loophole. Since the standard deduction is $25,100, if you make no “income,” you can transfer up to $25,100 from your 401K to a Roth IRA each year. However, my wife still enjoys her work, and we will not be able to do this any time soon. But, it’s something to keep in mind, and even paying 10-12% now would not be something I’d be regretting if/when I’m 80.
Unfortunately, there is no one-size-fits-all solution. You should be aware of your options and realize that if you can manage your expenses and your accounts, you may be able to retire with significantly less than what most people tell you.