retirement costs after health care bill kicks in

[KTP]

Do you think it is possible to semi-retire at age 45 if you have $600,000 in a 401K/Roth/IRA and $750,000 in a taxable account? Say our non-medical expenses are $40,000 a year, and any extra expenses are paid for with contract work (software engineer and electrical engineer). I was running the numbers and I think that is where we will be in 5 years if the stock market returns 0% a year average. If we get 8% a year it will obviously be better.

Healthcare costs were always the big unknown, but I think starting in 2014 there will be help for people who have low income to purchase insurance? Depending on how we draw out the $40,000 a year, our taxable income could be very very low (hey, maybe we could get food stamps!).

I am getting excited thinking about traveling the country in an RV and doing a lot of tent camping also while not needing Depends.

[jIM_Ohio]

40k on 750k is a 5.3% starting withdraw rate. Too high for retiring at age 45.

[KTP]

it isn't 750k, it is 750k taxable account and 600k in a retirement account.

If you invest the 750k such that it just keeps up with inflation, and draw it down to zero, it would last about 20 years (with a 40k withdrawal rate). At age 65 you could then tap into the 600k retirement account, which if invested in stocks would have grown to at least 1.2 million over 20 years, if not more.

[jIM_Ohio]

You gave different variables in second post... or I misunderstood it LOL

read my signature LOL

it isn't 750k, it is 750k taxable account and 600k in a retirement account.

If you invest the 750k such that it just keeps up with inflation, and draw it down to zero, it would last about 20 years (with a 40k withdrawal rate). At age 65 you could then tap into the 600k retirement account, which if invested in stocks would have grown to at least 1.2 million over 20 years, if not more.

Do you intend to only spend taxable monies for 20 years? If that is the goal, then yes it will last that long. I don't think that is the way to do it though...

If you have 600k in another account which is tax deferred, then you might be able to make this work...


If it were me, I would look at all 1.3 M invested and say that 1.3 M needs to generate 40k, which is a 3% withdraw rate, and that looks normal.

You can tap the retirement accounts sooner- look up 72t exception (substantially equal periodic payments or SEPP).

I would NOT as a plan suggest you drain taxable accounts down to zero as the primary plan- if you have a more detailed plan and that happens "OK", but there is rebalancing, asset allocation, and Roth conversions which would trump the taxable account draw down IMO.

For example with 1.3 M and a 3% withdraw rate, I assume you are going to hold about 40-60% equities? Maybe more. If you hold bonds, you either want them tax free in taxable account, or in a normal bonds in a tax deferred account.

If the choice is muni bonds in a taxable account, then I would not draw this to zero, I would live on interest and SEPP the tax defferred accounts, and this is probably a lower tax bill.

If the choice is normal bonds in a tax deferred account, then you need to realize in 20 years you have more bonds than you may want (because the 750k taxable account was all equity and now you don't have that account anymore because you drew it down to zero).

What I would "try" to do is this

1) you state 40k of expense is what you NEED- how rigid is this? 40k is OK, but if something goes wrong, can you cut this down to 20k and be happy, or do you need 30k for fixed expenses and only 10k for disretionary expenses? Break down a worst case budget for the 40k you suggest you "need" and have that in back of mind as a worst case scenario.

2) You state 1.3 M of total assets, 750k taxable and 600k tax deferred. What is the current allocation of this portfolio? % stocks-% bonds and % domestic and % international. When you semi retire, do you intend to change the allocation?

3) What is the payout of the 1.3 M portfolio right now? Payout is the sum of
a) capital gains (paid by funds)
b) divididends (paid by funds)
c) interest (paid by bonds and cash accounts)
d) other distributions

If 3) is more than 40k, can you break down where the money is coming from? (Taxable vs tax deferred)

4) How much, if any, is in a Roth?

5) You state semi retire. Is this because of health care costs? Can you factor the costs into a budget and document this? If your expenses are higher than 40k with these costs, redo all of above and add an additional line item to income for income from employment.

5a) one way to get around this is to be a leased employee. My wife works for a large company. There new big business is leasing employees. A client hires a person, then pays my wife's company to hire them, then temp them back into their business. My wife's company is big enough to get large group rates on health insurance and other benefits, which the leased employees can now take advantage of. Something worth looking into if you plan to consult.

6) What is the tax basis for the taxable investments? If you sold, are you sitting on a big gain?

7) Once you piece things together like this, look at a draw down scenario

a) for example convert tax deferred (401k/IRA) to a Roth at low tax brackets gradually (if bracket cap is 71k and you have 40k of income, convert the difference to a Roth (31k) paying taxes from taxable account so when you hit age 65 you have a huge tax free income stream. 600k in a Roth is >>> 600k in a tax defferred portfolio. Convert equity positions before bond positions.
b) try to live off interest and dividends "as long as possible" and not sell assets. If you are more conservative with investing, then try to have that budget of "needs" vs "discretionary" come into play so you know what could be cut if things don't work out.
c) a draw down scenario might include one or more of the following:
c1) 95/5 Withdraw 5% of portfolio, but always leave 95% of portfolio intact. This means in a down year you cut expenses considerably, but in up years you might withdraw more.
c2) classic 4%+3% (4% of initial balance plus 3% adjustments upwards for inflation each year)
c3) classic 4% with downward adjustments if market drops.
c4) something else

If you can live on dividends for 10 years, then rethink plan, you will have significant more success.

Have you ran a monte carlo on your strategy?

[KTP]

Thanks Jim. We had some discussions on this a year ago, and I remember you mentioning the 72T exception.

Some exact figures on what we have invested so far:

401K (100% in stocks via mutual funds, some international): Current balance $338,000
Contributing max to 401K + employer match = +$24,000/year

Expected balance in 5 years: $500,000

Roth IRA: Current balance $26,800
Contributing $5k/year to normal IRA then doing Roth conversion
Expected balance in 5 years: $60,000

Traditional IRA: Current balance $34,000
No further contributions
Expected balance in 5 years: $40,000

This is all pretty rough, but estimates are hopefully on the very low side as far as stock market returns. Hopefully about $600,000 total or more in the retirement accounts.

In the taxable accounts, currently we have:

$56,200 Vanguard intermediate term municipal bond fund (earns about 3.7% tax free)

$172,000 Invested in about 15 blue chip stocks (spy,wmt,mcd,xom,mrk,mo,png,jnj,pm,aapl...). Cost basis is about $150,000 and average dividend is around 3.5%

$27,000 Checking account earning 0.025% (yay)

We have about $60,000/year to invest in the taxable account for the next 5 years. Expected balance in 5 years hopefully is at least $600,000.

House: Owe $185,000 on 4.5% 30 year. Paid $314,000. Current market value $400,000+?

Plan to sell house and add proceeds to taxable account to bring it up to at least $750,000.

This is where I get the figures of $600,000 in retirement accounts and $750,000 in taxable account. Our goal is to spend several years traveling the country doing a lot of hiking and camping, but perhaps doing a few software/hardware engineering contract jobs to supplement the savings withdrawal.

We live on less than 40,000/year now but we do have full health coverage through employment.

[jIM_Ohio]

Thanks Jim. We had some discussions on this a year ago, and I remember you mentioning the 72T exception.

Some exact figures on what we have invested so far:

401K (100% in stocks via mutual funds, some international): Current balance $338,000
Contributing max to 401K + employer match = +$24,000/year

Expected balance in 5 years: $500,000

Roth IRA: Current balance $26,800
Contributing $5k/year to normal IRA then doing Roth conversion
Expected balance in 5 years: $60,000

Traditional IRA: Current balance $34,000
No further contributions
Expected balance in 5 years: $40,000

This is all pretty rough, but estimates are hopefully on the very low side as far as stock market returns. Hopefully about $600,000 total or more in the retirement accounts.

In the taxable accounts, currently we have:

$56,200 Vanguard intermediate term municipal bond fund (earns about 3.7% tax free)

$172,000 Invested in about 15 blue chip stocks (spy,wmt,mcd,xom,mrk,mo,png,jnj,pm,aapl...). Cost basis is about $150,000 and average dividend is around 3.5%

$27,000 Checking account earning 0.025% (yay)

We have about $60,000/year to invest in the taxable account for the next 5 years. Expected balance in 5 years hopefully is at least $600,000.

House: Owe $185,000 on 4.5% 30 year. Paid $314,000. Current market value $400,000+?

Plan to sell house and add proceeds to taxable account to bring it up to at least $750,000.

This is where I get the figures of $600,000 in retirement accounts and $750,000 in taxable account. Our goal is to spend several years traveling the country doing a lot of hiking and camping, but perhaps doing a few software/hardware engineering contract jobs to supplement the savings withdrawal.

We live on less than 40,000/year now but we do have full health coverage through employment.

You have thought this thru reasonably well. With the 3.7% dividend payout/interest payout in taxable accounts, I would **try** to focus on those to fund the early retirement while doing the Roth conversions with the 401k monies.

Because you plan to sell the house, I would not be paying it down (if you were considering that as an option).

In any year you have a down market (like 2008) try to do as much Roth Conversion as reasonable.
If you have losses in taxable accounts, consider realizing the losses and liquidating some of the dividend payers if you intended to go more conservative with investing.

[KTP]

Since a large portion of our taxable account will have already been taxed (cost basis including tax free money from sale of house on taxable account will be at least $600,000 of the $750,000, and probably more since I am taking the current dividends in that account and re-investing them after tax into more of the stock).

This means that in any particular year, a sale of stock to obtain the estimated $40,000 in funds may only generate a few thousand dollars in capital gains tax. This would be great for doing like you suggested and converting a small amount of the taxable account into a Roth each year...staying down low in the tax rate...maybe even under 15%. In 10 years at age 55 we could end up with a lot of the 750,000 converted to a Roth. Very exciting idea!

It really is all pretty complicated and somewhat scary though. Is there anything I should be doing now to prepare us for this type of scenario, or am I doing about the best I can by maxing 401K, doing the $5000 to IRA then rolling over to Roth each year (as long as they keep the income limit removed to allow that), and investing as much as possible into stocks and bonds in the taxable account (aiming for 25% bonds, 75% stocks..pretty aggressive, but also pretty stable stocks...McDonalds isn't going bankrupt anytime soon).


Edit: Oh, I just read your response...are you suggesting we would convert the 401K monies to Roth? I thought you meant convert the 750K taxable account slowly to a Roth. By the way, thanks for the free help Jim!

[jIM_Ohio]

Since a large portion of our taxable account will have already been taxed (cost basis including tax free money from sale of house on taxable account will be at least $600,000 of the $750,000, and probably more since I am taking the current dividends in that account and re-investing them after tax into more of the stock).

This means that in any particular year, a sale of stock to obtain the estimated $40,000 in funds may only generate a few thousand dollars in capital gains tax. This would be great for doing like you suggested and converting a small amount of the taxable account into a Roth each year...staying down low in the tax rate...maybe even under 15%. In 10 years at age 55 we could end up with a lot of the 750,000 converted to a Roth. Very exciting idea!

It really is all pretty complicated and somewhat scary though. Is there anything I should be doing now to prepare us for this type of scenario, or am I doing about the best I can by maxing 401K, doing the $5000 to IRA then rolling over to Roth each year (as long as they keep the income limit removed to allow that), and investing as much as possible into stocks and bonds in the taxable account (aiming for 25% bonds, 75% stocks..pretty aggressive, but also pretty stable stocks...McDonalds isn't going bankrupt anytime soon).


Edit: Oh, I just read your response...are you suggesting we would convert the 401K monies to Roth? I thought you meant convert the 750K taxable account slowly to a Roth. By the way, thanks for the free help Jim!

Divide this into chunks... don't try to solve withdraw decisions with conversion issues- they are different things. Related, but try not to combine everything into one step.

If you plan to sell the stocks to live on, why reinvest dividends? You are putting 3.7% of the money at risk (or whatever yield is) on money you might need in 5-10 years or less.

My advice would be try to live off the dividends and interest- it's the easy plan.

If you cannot do this, you need a cash position to spread risk, as if market drops (like 2008) and you need to sell, your 750k in taxable account is now 375k, then you take out 40k and sold low, so you lost shares... so any bounce back up is a smaller bounce.

So if you need to sell stocks, plan to sell them 2-5 years before you NEED the money to make sure you have a good price to sell at. If market drops and you planned 2-5 years out, you can wait for a recovery or go to plan B which does not include selling at a loss.

[KTP]

Divide this into chunks... don't try to solve withdraw decisions with conversion issues- they are different things. Related, but try not to combine everything into one step.

If you plan to sell the stocks to live on, why reinvest dividends? You are putting 3.7% of the money at risk (or whatever yield is) on money you might need in 5-10 years or less.

My advice would be try to live off the dividends and interest- it's the easy plan.

If you cannot do this, you need a cash position to spread risk, as if market drops (like 2008) and you need to sell, your 750k in taxable account is now 375k, then you take out 40k and sold low, so you lost shares... so any bounce back up is a smaller bounce.

So if you need to sell stocks, plan to sell them 2-5 years before you NEED the money to make sure you have a good price to sell at. If market drops and you planned 2-5 years out, you can wait for a recovery or go to plan B which does not include selling at a loss.

I am confused. What should I be doing with the current dividends my blue chip stocks are paying over the next 5 years? We don't need them to live off of because we have income from jobs. I think there has been maybe some misunderstanding. We are NOT retiring now...we are planning to retire in 5 years if the money is there. If the money is not there, we will keep working. I am trying to do the best I can through investments and tax planning to ensure the money is there in 5 years so we can retire early.

[jIM_Ohio]

I am confused. What should I be doing with the current dividends my blue chip stocks are paying over the next 5 years? We don't need them to live off of because we have income from jobs. I think there has been maybe some misunderstanding. We are NOT retiring now...we are planning to retire in 5 years if the money is there. If the money is not there, we will keep working. I am trying to do the best I can through investments and tax planning to ensure the money is there in 5 years so we can retire early.

You need to decide "how" you will be taking money out... that will "control" some of where new money goes in next 5 years.

If you think you can live off earnings (dividends and interest) alone, that is "best case" scenario for as long as that lasts (dividend growth tends to be higher than inflation, so it is "safe" in many respects).

If you cannot live off earnings alone, you will want a cash buffer (IMO) of between 2-5 years of expenses (size depends on your risk). If you plan to work some during retirement, I would error on low side of that (2 years expenses in cash) and as life happens add to this.

[KTP]

Ok, I see what you meant.

Of the $750,000 of our savings that is not in a 401K or Roth, $150,000 will be in short and intermediate term municipal bonds, and at least $50,000 will be in cash or something like a cd/money market. The remaining $500,000 will be invested in high dividend yeild stocks that while not expected to skyrocket in capital appreciation, should remain a lot more stable during market downturns. I would expect about $17,500 from the dividends from these stocks, and about $5500 from the municipal bonds. Perhaps another $500 a year from the $50,000 in cash. So we are talking about an income of around $23,500 from the $750K without touching the principal

The remaining $16,500 that I estimate we would need each year would have to come from either part time work or taking an early distribution from the 401K? Or we could draw down some of the $750,000 principal. Originally I was thinking that if we were to draw down some of the $750K by selling underperforming stocks in our portfolio for 0 capital gain or even a small loss, that we would only be taxed on the dividends (the $17,500). A married couple with an income of $17,500 a year...that HAS to be a pretty dang low tax rate. I should run the numbers on this because it may be that we could actually have a tax gain instead of a tax bill.

Of course if we draw out of the 401K to convert it into a Roth we would increase our tax hit a small amount, but this may be worth it. If only I could get the tax tables for tax year 2016...

[jIM_Ohio]

Ok, I see what you meant.

Of the $750,000 of our savings that is not in a 401K or Roth, $150,000 will be in short and intermediate term municipal bonds, and at least $50,000 will be in cash or something like a cd/money market. The remaining $500,000 will be invested in high dividend yeild stocks that while not expected to skyrocket in capital appreciation, should remain a lot more stable during market downturns. I would expect about $17,500 from the dividends from these stocks, and about $5500 from the municipal bonds. Perhaps another $500 a year from the $50,000 in cash. So we are talking about an income of around $23,500 from the $750K without touching the principal

The remaining $16,500 that I estimate we would need each year would have to come from either part time work or taking an early distribution from the 401K? Or we could draw down some of the $750,000 principal. Originally I was thinking that if we were to draw down some of the $750K by selling underperforming stocks in our portfolio for 0 capital gain or even a small loss, that we would only be taxed on the dividends (the $17,500). A married couple with an income of $17,500 a year...that HAS to be a pretty dang low tax rate. I should run the numbers on this because it may be that we could actually have a tax gain instead of a tax bill.

Of course if we draw out of the 401K to convert it into a Roth we would increase our tax hit a small amount, but this may be worth it. If only I could get the tax tables for tax year 2016...

You are thinking about this the same way I do...

take some out of the 401k (rollover) IRA to live on
then take some out of the rollover and convert it to a Roth... try to pay taxes from your taxable pool funds on the conversion. Convert to top of 15% bracket.

I mention the conversion only to suggest you need to budget for a higher tax bill each year than the 40k income need. Because you will be paying quarterly income taxes, you do need to make sure you have a "tax" line item in budget, and basically budget that you will pay to top of 15% bracket each year (because what the income doesn't cap out, the Roth conversion will).

You have slightly higher than 1 years expenses in cash, I suggest over next 5 years you up this to 3 years expenses. This way if the income drops (for example rising interest rates or dividends slashed) you have a way to recoup lost income.

You mentioned above that its possible income is in 10% bracket, and you need to keep in mind that most of the 10% bracket is tax free (take married filing jointly standard deduction and 2 exemptions, and my math has that really close to 10% bracket cap for married filing jointly). Meaning you will owe "little" taxes until you start filling up the 15% bracket.

--
notes for the conversion
Reference Room

Know the 15% bracket cap, and know that you can recharactorize conversions after Jan 1 and have it effect the prior year's tax bill. For example if bracket cap is 71k and you take 40k in income, you have 31k to convert. You could convert 35k Dec 31 and then recharactorize 4k of it after you do tax return and see that you went over. Only take advantage of this if you are in a hurry to convert. I think you could convert 200-300k over 20 years, but if an investment in traditional skyrockets, it might take longer- that is a good problem to have though.

Leave 450k in the 401k/rollover accounts. the logic is this- the 10% bracket is "tax free" if you get standard deduction and 2 exemptions ($11,400+$3650+3650=$18,700 tax free income per year; using 25X rule this is $467,000). No reason to pay tax on a Roth conversion if the distribution from a traditional account would have been tax free anyway.

Remember there is a 5 year period on conversion monies which states the conversion needs to be in Roth 5 years before you take it out. Should not be an issue, but know the rules.

Once you have most of the money in a Roth, you might change withdraw strategy some.

You are starting by doing withdraws in this order

1) Taxable
2) Tax deferred
3) Tax free

if you have most money in a Roth (meaning you converted everything possible), you would probably lower tax bill by doing this

1a) Tax deferred (up to 10% bracket to use up std deduction and exemptions)
1b) Roth (tax free income)
2) taxable

When you are in situation 2, you will probably want more of money in muni bonds and less in taxable interest and dividend paying (taxable) securities.

This would drop the tax owed in budget down considerably

If you have high medical expenses you might be able to itemize and get more out of rollover tax free.


Then a third phase is the SS phase- I need to brush up on the SS income worksheet, but the summary is any income above (44k??) causes SS to be taxable. To be exact, it might make 85% of SS benefits taxable (at whatever rate- like 15% bracket). Roth distributions count against this- I THINK, muni bond income counts against this I THINK, withdraws from a taxable savings account WOULD NOT count against it for sure. So if you get all your taxable money in cash equivalents (CDs) when you need SS, its possible you can avoid the SS tax too.


It's not about avoiding taxes, but if you are dealing with 40k of expenses, you are "right" at the threshold where decent planning can save you significant tax money.

[KTP]

Thanks again Jim for the long writeup. I am digesting it now.

This is fun stuff to think about during our 5 year wait. Originally I had figured we would need significantly more than $40,000 a year because of greatly increasing health care costs as we age (maybe not too bad at 45 for non smokers, but certainly significant at 50+). The healthcare legislation, which orginally I was somewhat against because it seemed a great tax burden, may make our plans that much easier if I understand it correctly.

If I read the following correctly, starting in 2014 we cannot be declined for coverage, and with our $40,000 max income our premium would be capped at worst case $4000/year. I don't know if we should take into account getting into the Medicaid program in your scenario of converting the 401K gradually to Roth. Would there be significant tax savings to staying under the $29,000 income limit so we could qualify for Medicaid at age 45? (This must sound horrible to most of the people on here, but hey, you voted for it so don't blame me for saying if you can't beat them, join them).

"(CBS) Under the health care bill, most Americans are now required to have health insurance. The government will help people pay for it by expanding Medicaid programs to include families making less than $29,000 - and singles making less than $14,400 per year.

To make their insurance more affordable, families making less than $88,000 a year will have their monthly premiums capped at anywhere from 2 to 9.5 percent of their income. Right now there is no cap. And a significant change - young adults can now stay on their parents' coverage until age 26. "

[EEinNJ]

KTP, I love the idea of early retirement myself, and our situations are not that different. But, when I've considered this myself, I've come up with a bunch of show-stoppers.

The first is the cost of health insurance, which is going up at double-digit rates. This only gets worse as you get older, especially if you're buying it as an individual. I had high hopes for the health reform bill, but they screwed it up so for the middle class it will be more of a tax increase than a help. Another is state & local taxes, unless you maintain a domicile in a low-cost state that is in good financial shape (and if you find it, let me know!).

As to contract work, having done a lot of that, it's nice work when you can get it. While they are easier to get than "permanent jobs", like any job these days they're a lot harder to get because so many will take whatever they can get. In my experience the jobs got shorter, the time between them longer, and the rates topped out. But I'm in the controls/automation field, if you've got IT skills that's a whole 'nother market. I certainly enjoyed my "pre-retirements" at first, but eventually boredom and a need for steadier work surfaced.

I don't intend to discourage, more to comment that you can carefully arrange your investments and tax strategy, and guess at future returns, but there are big trends at work that are out of our control. Therein lies the risk

[jIM_Ohio]

Thanks again Jim for the long writeup. I am digesting it now.

This is fun stuff to think about during our 5 year wait. Originally I had figured we would need significantly more than $40,000 a year because of greatly increasing health care costs as we age (maybe not too bad at 45 for non smokers, but certainly significant at 50+). The healthcare legislation, which orginally I was somewhat against because it seemed a great tax burden, may make our plans that much easier if I understand it correctly.

If I read the following correctly, starting in 2014 we cannot be declined for coverage, and with our $40,000 max income our premium would be capped at worst case $4000/year. I don't know if we should take into account getting into the Medicaid program in your scenario of converting the 401K gradually to Roth. Would there be significant tax savings to staying under the $29,000 income limit so we could qualify for Medicaid at age 45? (This must sound horrible to most of the people on here, but hey, you voted for it so don't blame me for saying if you can't beat them, join them).

"(CBS) Under the health care bill, most Americans are now required to have health insurance. The government will help people pay for it by expanding Medicaid programs to include families making less than $29,000 - and singles making less than $14,400 per year.

To make their insurance more affordable, families making less than $88,000 a year will have their monthly premiums capped at anywhere from 2 to 9.5 percent of their income. Right now there is no cap. And a significant change - young adults can now stay on their parents' coverage until age 26. "

The cost/tradeoff is this (at a general level)

You will pay less tax
and keep more money from being taxed (short-mid term) in exchange for
a health care benefit in addition to other health benefits.

Meaning you are paying $4k for some health coverage
the medicaid is coverage in addition to that (guessing for co-pays or prescriptions)

Can you opt in to medicaid a year after you have problems?

Meaning if you are healthy from age 45-55, then at 56 you have problems, can you opt in at 57?

convert from 45-55, but only opt into medicaid if you need it. Just liquidate taxable portfolio the year of the problem, don't do a Roth conversion that year then income the next year is under then 29k need. When you withdraw from a savings account that money is not reported on tax return.