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?
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!
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.
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