High five! You have saved diligently and accumulated a nest egg that would be the envy of Scrooge McDuck. You, my friend, are ready to retire to a life without rushing and with naps.
But wait! Your money is stashed in a combination of retirement accounts and taxable mutual funds; how, exactly, do you access it? Through the years you have purchased stocks and bonds within these investments. In order to live off this money, you must need to sell some, right?
The Drawdown
In short: yes. But if, when, and how you sell (i.e. drawdown) your retirement investments can have a big impact on the financial success of your retirement.
I have only recently begun to consider my own drawdown strategies as early retirement looms 5-10 years ahead. My focus thus far has been on maximizing tax-deferred retirement accounts and saving additional retirement money in after-tax mutual funds.
I welcome you to join me as I work through my proposed drawdown strategy, with the hopes that you might gain something from this exercise, and that I might (selfishly) garner some constructive criticism.
Below I present 5 “Items of deliberation” for the aspiring early retiree when contemplating a drawdown strategy.
Item 1: Retirement expenses
In a previous post, I outlined what I believe will be our fixed post-retirement expenses (crossed-out expenses were from the pre-retirement budget):
I make quite a few assumptions, but it’s a starting point. Another semi-wild guess of an additional $5000 per month in discretionary spending brings my estimated retirement expenses to $10,000/month and $120,000/year.
Item 2: Nest egg and withdrawal rate determination
I can now work backwards to estimate the total retirement nest egg necessary to safely withdraw $120k/year. I’ll want to ensure my money does not run out before I am worm food, so I’ll shoot for a “safe withdrawal rate,” usually expressed as a percentage of the nest egg. For example, a 4% annual withdrawal rate with a nest egg of $3,000,000 could provide me with the necessary $120k/yr.
The (literal) million dollar question is: what is considered a safe withdrawal rate? Opinions vary substantially, but a tool I find invaluable is a retirement calculator named FIREcalc. For the uninitiated, FIRE means “financial independence to retire early,” and FIREcalc allows users to test different retirement scenarios and see what happens as they live off their nest egg.
How I use FIREcalc
FIREcalc needs 3 numbers to do its magic:
- Annual spending (i.e. retirement expenses): $120,000 in my case
- Years: Number of years you plan to be retired. I set mine at 50 (fingers crossed)
- Portfolio (i.e. retirement nest egg): I want to determine this number, so I can input different values and see the results.
FIREcalc runs the numbers and voila! The output is this crazy looking chart.
What does it mean? FIREcalc is a time-traveling wizard that illustrates your theoretical portfolio performance over (in my case) 50-year time periods beginning in 1871; each of those lines represents your portfolio’s value over time if you were to retire in 1871, 1872, and so on. Where each lines terminates on the right of the graph represents the end value of your portfolio after 50 years of annual spending withdrawals.
Do not try to follow the lines! Do, however, notice the red horizontal line (best seen at the left): this is the zero line. If one of the other lines ends up beneath it, that means you ran out of money!
Success rate
FIREcalc also calculates the percentage of those lines (i.e. 50-year periods) that end with values above zero, i.e. you did not run out of money; this is called the success rate. This percentage is FIREcalc’s most important result, and for the illustrated scenario my success rate was 80.4%. In other words, 19.6% of potential scenarios would have run out of money.
To me (and most people I would think), this rate is unacceptable. However, by increasing the nest egg number and re-running FIREcalc, I can arrive at a higher percentage of success—up to 100%. The nest egg number that gives me 100% success withdrawing $120k/yr for 50 years is ~$3,800,000, corresponding to a safe withdrawal rate of ~3.2% (120,000/3,800,000).
Comfortable with a less-than-100% chance of success? Simply input smaller nest egg numbers and recalculate. Using $3,500,000 in the above scenario, for instance, gives a 97.9% chance of success. Not too shabby either.
FIREcalc may be a time-traveling wizard, but it is no magic genie. It doesn’t know the future, only what has happened in the (financial) past. Regardless, many consider it a solid starting point to ballpark your nest egg number and withdrawal rate.
Item 3: Nest egg components
Let’s crack the ole nest egg open and see what falls out.
Stock mutual funds (held at Vanguard) and bond mutual funds (held at Fidelity) align with my desired asset allocation: 70% stocks and 30% bonds. My retirement portfolio currently stands at ~$2,200,000.
By sheer luck, the amount of money we save annually in our 401(k)s aligns nearly perfectly with our desired bond allocation; the rest of our annual savings, via taxable and backdoor Roth IRAs, consists of stocks.
Next, we examine how the distribution of this money can affect your withdrawal strategy.
Item 4: Order of withdrawal
First, let’s recap the projections so far:
- Annual retirement expenses: $120,000
- Nest egg and withdrawal rate (to succeed 100% of the time): ~$3,800,000 and 3.2%
From here on things get a little hazy, but I’ll attempt a general outline of my current plan.
Dividends from taxable account: Currently our dividends are NOT automatically reinvested, but rather deposited in a money market account, and then manually reinvested. In early retirement, these would be used as income rather than reinvested, and I estimate they could cover 1/3 of our annual expenses.
Selling taxable investments: This would be our primary source or early retirement income until age 59.5, at which we can withdraw 401(k) money without penalty. As retirement approaches, I will need to review capital gain taxation, which is outlined in an excellent article by Michael Kitces. Some of my back-of-the-napkin tax calculations are included below.
First, the brackets!
Let’s assume in a given retirement year we receive $40,000 in dividends (a mixture of ordinary and qualified, but that’s another story), so we need to sell $80,000 in taxable assets to cover our expenses.
That $80,000 is not all capital gains—some of it represents the value of the mutual fund when I purchased it—and only the capital gains are taxed. Each mutual fund purchase I make is recorded as a separate “tax lot” by Vanguard. I can see the amount of capital gains for each lot, and choose which lots to sell. To minimize taxes, I’ll want to sell lots with the lowest long-term capital gains.
For example, $120k annual expenses would be comprised of $40k dividends and $80k sold taxable investments—but that $80k might contain only $30k in capital gains. My income would therefore be $70k ($40k + $30k), just inside the 0% long-term capital gains bracket. Yes, it is possible that I would pay 0% tax on $120k annual income from my investments.
Caveat: I have never sold taxable assets for a capital gain, but this my understanding of the process.
410(k) distributions: Ideally we won’t need this money until we can withdraw it without penalty beginning at age 59.5—for me, over 20 years from now. Currently these distributions are subject to ordinary income tax rates, but a lot can happen tax-wise (and otherwise) in 20 years! I’ll keep my eyes and ears on the tax code.
Roth IRA distributions: I don’t plan to touch this money until I’m a cranky old man complaining that my soup is too hot. Since it is not subject to RMDs, I can leave it alone indefinitely (or at least until I need to spend it).
Item 6: Non-factors and X-factors
Of course, that all assumes I will retire early.
(record scratch)
I haven’t considered these numbers in detail because my current plan is to work part-time (I kinda like my job) for an undefined period of time beginning at some undefined future date. I told you things were hazy.
During those years, I can maintain my health insurance, live off my salary, save some money, and not touch my nest egg. Seems like a good deal.
A few more loose ends:
- Neither my wife and I have a pension, and don’t anticipate one in the future.
- I did not factor in social security. If it’s gone (or significantly reduced) in 30 years, no harm done. If it’s not, it will be a welcome income bonus.
So there it is: my kinda-sorta, half-a$$ed drawdown plan for early retirement, full of holes and estimates. I’d love to hear what others think; experts, have at it!
This post was written as part of a larger project to compare and contrast retirement drawdown strategies, organized by Fritz at The Retirement Manifesto. Please check out what others more knowledgable and closer to actual retirement have to say about it!
Physician On Fire: Our Drawdown Plan in Early Retirement
The Retirement Manifesto: Our Retirement Investment Drawdown Strategy
OthalaFehu: Retirement Master Plan
Plan.Invest.Escape: Drawdown vs. Wealth Preservation in Early Retirement
Freedom Is Groovy: The Groovy Drawdown Strategy
The Green Swan: The Nastiest, Hardest Problem In Finance
Cracking Retirement: Our Drawdown Strategy
The Financial Journeyman: Early Retirement Portfolio & Plan
Retire By 40: Our Unusual Early Retirement Withdrawal Strategy
Excellent plan, Dr C! Thanks for joining “The Chain Gang”! You’re officially in as “Link #6”! We’re considering having the entire drawdown strategy chain published as an e-book, with all proceeds going to charity. You in?
Interesting to watch the plans coming together from those close to retirement vs those with 10+ years to go. You young folks can watch and learn from us old folks as we execute our plans!
I’m in!
I will follow with great interest as my elder statesmen friends begin to pull the early retirement plug. I certainly learned a lot from reading all of your carefully researched and thought-out plans.
Take care,
Dr. C
I like the plan and detail on the capital gains tax in retirement. I have pulled money out of taxable accounts for a gain (when I bought a business last year) and you outlined it well. Nice knowing you’ll be within the 0% bracket in that scenario! I’ll have a similar approach and I certainly want to avoid those capital gains taxes!
Thanks for the great overview and welcome to the drawdown chain gang!
Thanks Green Swan! Glad to hear I wasn’t too far off with my capital gains projections. It will certainly be a welcome surprise if it plays out that way when the time comes.
Take care,
Dr. C
Given your current net worth and goals, I’d give you permission to go part-time as soon as you’re ready. There’s no need to wait until you have fully funded your FIRE stash.
Isn’t impressive how you can have a six-figure spending allowance without paying federal income tax? Especially after all these years of six-figure tax bills.
Cheers!
-PoF
My wife will go part-time after her maternity leave, and I certainly need to run some numbers and do some soul searching to find our path over the next few years.
I want to coin a phrase for my current feelings, which are a variant on One More Year (OMY) Syndrome; I’ll call it Happy With The Status Quo (HWTSQ) Syndrome. Doesn’t quite roll off the tongue, does it? What it means is that I’m completely satisfied with my current job and life situation, so I’m in no real rush to make a major change. If it ain’t broke…
Yes, those capital gains tax calculations were eye-opening!
Thanks,
Dr. C
Good reading. I guess you must have some sort of healthcare coverage that is not going to eat into your stash. Or does that still have to be sorted out? Normally, healthcare coverage is a big chunk of expenses for retirees, especially where AGI is high.
That is an important consideration. My current (tentative) plan is to cut back my work significantly in an “early retirement,” perhaps to 1/4 time, or to the bare minimum amount that allows me to keep employer health insurance.
At some point I will fully retire (before Medicare eligibility) and will need to address healthcare coverage. Given the current state of health insurance, I’m not betting on the options in 10-15 years being the same as they are now.
Thanks for stopping by!
Dr. C
I keep upgrading my post because you guys make mine look like the kid at the NASA science fair who did the crappy baking soda volcano.
I have some time set aside later today to look over everyone else’s plan and see what mistakes I have made here 🙂
Funny, I just cleaned out my garbage disposal yesterday using a baking soda volcano technique.
Thanks for reading,
Dr. C
p.s. I just thought to google your name, and I like the symbolism!
p.p.s. Are you from the ‘Burgh?
I grew up in Pittsburgh, mostly it comes out when I have been drinking, or start seeing big hills, or the Steelers are on.
Great Post. I can just copy your strategy as we’re the same age and expenses and I’m betting close to the same nest egg!
I’m curious (no pun) how the dividends will be taxed. Vanguard is mostly qualified but they are taxed I think at 20-23%. Non qualified are taxed as income. That probably leaves you with an 8-10K tax bill on this dividends which doesn’t break the strategy because you have a flexible 5K Discretionary income per month so could absorb that tax bill easily.
Also complicated by what assets to withdraw depending on market returns. That’s the part I don’t know much about.
Devil is in the details but this is a great outline.
My retirement tax bill is a bit unclear to me at this point, but suffice to say it will be proportionately much less than now. Qualified dividends (from my understanding) should be taxed at the capital gains rate, and ordinary dividends are taxed as income, as you say. It’s still incredible to me how low the tax bill can be if one lives off dividends and sold taxable assets with capital gains.
We can celebrate our simultaneous retirements with gold and beer!
Dr. C
Sounds like a plan, I’ll bring the gold. Please post further details as your RE date approaches. I’d like to see if you worked through the details the same way I will for tips and reassurance.
Done 🙂
If you can keep taxable income under about $75,000 (married filed jointly), long-term capital gains and qualified dividends are not taxed at the federal level. State income tax may still be applied.
Excellent plan!!! Sounds like you thought of everything on this one. The one thing I worry most about is healthcare in retirement. If that was settled I think I’d have a firmer number on my retirement number. Otherwise I would probably be retired at this point 🙂
Thanks MSM! Boy I wish I had thought of everything, but I sure learned a lot from the drawdown plans of some of these other superstar bloggers.
Healthcare seems like a financial boogeyman to many aspiring to early retirement, which is part of why I plan to work part-time for a while before I pull the plug completely. I feel lucky to have that option.
I appreciate your taking the time to read!
Dr. C
Yeah healthcare pre-Medicare age for the early retiree with a family is for sure the elephant at retirement room. I haven’t even let my brain go there yet. But be sure I’ll be following to see what you decide 😛
BTW this is aGoodLifeMD, formerly RadOnculous. I started that blog you and I chatted a bit about. It’s empty now but not for long. Waiting for this new baby to get into his own room then start posting. Your blog was a good inspiration for me to start one. Keep on brother!
Awesome! Wow, that was fast! But I suspect you had been at least considering for a while.
I’ve only been going at this for about 6 weeks, so thank you for the encouragement. It’s honestly a lot of fun and a great learning experience. Many out there will have more expertise than me, but if I can try to help you with anything blog related just shoot me a message!
Yeah, I’ve got a baby coming, oh, NEXT WEEK! I’ve been trying to write ahead a few posts in anticipation of the fatigue. Good luck and happy sleeping for all!
Dr. C
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If your taxable income goes one dollar above $73,800, does that automatically push you into the 15% LTG tax bracket? Might need to be careful not to overshoot!
Sorry for the delayed reply. Darn these spam filters!
From my understanding (as a non-tax-expert), no. It’s similar to how earned income tax brackets work: you are taxed at the 0% rate up to $73,800 and then at the 15% rate on income earned above $73,800. That said, I have never personally filed taxes in this situation, so it would be great to hear directly from someone who did!
If you are interested a more detailed discussion, check out this excellent article by Michael Kitces:
https://www.kitces.com/blog/understanding-the-mechanics-of-the-0-long-term-capital-gains-tax-rate-how-to-harvest-capital-gains-for-a-free-step-up-in-basis/
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