Welcome! Today is a premiere! Our first case study for a fellow FIRE planner “John Smith” (not his real name) who asked me if I can look into his early retirement plan, run some numbers and check whether he can retire already. John and his wife have done a phenomenal job and reached the “millionaire club” in their thirties! Congrats!
I should also state that I don’t consider this any competition to the great crowdsourcing FIRE advice project that Brad and Jonathan run on over at ChooseFI podcast. Their first case study for Paul went on for multiple weeks with lots of different experts weighing in (including Big ERN in Part 3!) so our analysis here is probably not as thorough as on the podcast.
In any case, without further ado, let’s just jump right into the case study:
John’s situation
I’m 37 years old. I make about $114k per year (plus bonuses which have varied from 5-12% of base pay in the past few years). I can’t wait to hit FI to ‘retire’ from a 9-5 job, but I don’t have confidence in my current net worth holding up for the duration. Wife is almost 36 and (since 1 year ago) stays at home with the kids (who are 1 and 3).
We don’t feel a large needs to save for the kids educations, since they can learn a trade, pay for their own schooling, get scholarships, or maybe (as I’m hoping) some sort of ‘youtube university’ or ‘itunes university’ will really grow and take over as the legitimate higher education option in the next 15 years. 🙂
Our total expenses, not including my income tax, in 2016 were $60,370. We have tracked expenses going back longer, but those 12 months (with the few adjustments below) are a good indication of things to come (or as close as I can guess at this point).
I made the following adjustments to plan for a more ‘typical’ year:
- removed $7k (of $11k) worth of house repair expenses in 2016 since we had a higher than normal year for repairs due to selling our old house, but I kept in 4k per year for other repairs/updates each year.
- removed $14,500 per year for mortgage – I’m assuming we’d pay off the ~160k mortgage (2.875% fixed rate for 14 more years) just to keep the FI calculation simple
- added $12,000 per year for health coverage for a family of 4 – I am guessing here on the costs, it may be high, it may be low, ACA could be changed… this is a giant question mark.
- added $5,000 per year for vacation expenses (since we didn’t take a vacation in the last 12 months and 5K is a pretty decent vacation budget I figure).
- added $700 per year for gym memberships since we’d like to focus a lot more on health post-FI.
So our expected yearly costs going forward should be around $56,570. Kids can get expensive, but we’ll be trying to control that. This makes our FI number, using a rough calc of x25, $1,414,250.
We currently have a net worth of $1.1M – after subtracting the ~145k in cash we currently have for the purpose of (almost entirely) paying off the balance of our mortgage if we chose. Here’s the rough breakdown of the 1.1M:
- $300k in Taxable Investments.
- And $812k in qualified investment accounts
- $162k in 401k
- $219k in Roth IRA
- $431k in Traditional IRAs.
I realize our net worth is $300k+ short of my theoretical FI number of $1,414,250… but if I assume the $1.1M we currently have, IF SHIFTED/MOVED INTO THE RIGHT TYPES OF FINANCIAL PRODUCTS, could generate $46,800/yr in income, then I feel confident I could make the additional $10k per year we need with small side hustle earnings. I realize the assumption that 1.1M could create an income of ~$46,800 is way over simplified since I didn’t account for taxes etc, but it’s the best I can do for now.
What I DON’T know however, is how to turn $1.1M into $46,800 in yearly income when 66% of that is in various types of qualified accounts. I’m aware of the limited options I have (Roth conversion, 72T, real estate inside of a qualified account, etc), but the real mechanics of creating an income plan (that also accounts for taxes) is what escapes me.
Several more follow-up emails clarified this:
- Annual Social Security benefits expected at age 70 would be about $20,900 for John and $16,100 for his wife, which already takes into account a 20% haircut to future benefits.
- The Traditional IRA is actually mostly a Rollover IRA from previous 401(k) plans, so upon withdrawal, we can assume that 100% will be taxable as ordinary income.
A Retirement Withdrawal Strategy
This situation calls for the Roth Conversion Ladder, (see some great summaries/examples at Mad Fientist, Retire by 40, Root of Good), which I would implement as follows:
- If your side hustle earns $11,000 p.a. contribute all of that to your Roth IRAs ($5,500 each). You mentioned you wanted to make 10K, but I just upped that by another $1,000 to max out that Roth IRA. Might come in handy later! I also assume, conservatively, that you do the side hustle for “only” 10 years, not your entire retirement. Who wants to drive for Uber or Lyft for the next 50-60 years, right?
- Use the taxable account for living expenses, always making sure you withdraw only long-term capital gains.
- I assume that you use the $12,700 p.a. standard deduction and 4 exemptions until year 15, then 3 exemptions in years 16-17 and 2 exemptions after that, when the kids are likely no longer considered dependents.
- You can generate roughly $29,000 of income tax-free (federal) by using the $12,700 standard deduction and four exemptions ($4,050), then adjusted for inflation (2%) per year. Remember, the $11,000 in side hustle income are taxable, too! So, initiate roughly $18,000 p.a. (29,000 minus 11,000) in Roth Conversions from your tax-deferred accounts to fill up this zero marginal “tax bracket” while working.
- I ignore state income taxes in the simulations. They would be a flat 3.07% rate in Pennsylvania. But you also get a child tax credit and potentially even earned income tax credits and I would feel confident that it will be more than enough to offset the modest state tax burden.
Challenge #1: This SWR strategy will not avoid Federal income taxes, i.e., the Roth Conversion Ladder works only partially!
A lot of John’s portfolio is concentrated in retirement accounts. Only $300k, or less than 30% is in easily accessible taxable accounts. Let’s “simulate” forward the account balances, assuming a 6% (nominal) asset return and 2% inflation, see table below:
- The taxable account lasts for only about 6 years.
- Starting in year 7, you will now start withdrawing from the Roth (while still rolling over the maximum every year from the Traditional IRA) to max out the 0% tax bracket.
- Unfortunately, the Roth will run out of money in year 29. At that time, you’ll be able to make penalty-free withdrawals from the Traditional IRA, but they will be taxed at 10-15% marginal.
But the situation is even worse. In the table below, I zoomed into the Roth IRA numbers over the first 22 years (while still below age 59.5). Not the entire Roth IRA is eligible for a penalty-free withdrawal. Only the contributions plus rollovers that are five years or older can be withdrawn tax-free. Let’s keep track of how big the Roth IRA pile of eligible tax-free withdrawals actually is. I assume here that out the current $219,000 are approximately half-half contributions and gains. The new annual Roth IRA contributions add immediately to the pile that’s eligible for withdrawals, but the Rollovers only after 5 years. So we keep track of gains vs. contributions, and subtract the last 4 years of rollovers to get the column “Contributions eligible for tax-free withdraw.” Notice how that column never reaches more than about $173,000.
Once you run out of taxable accounts and you need to live off the Roth you exhaust that pile pretty quickly: In year 11 you need $68,959 in consumption but you have only $2,477 in funds eligible for tax-free withdrawals in the Roth. The shortfall of over $66,000 would have to come out of the Traditional IRA. You’re only in your late 40s and you already have to tap your Traditional IRA/401(k). You can do that penalty-free through a 72(t) (Substantially Equal Periodic Payments) plan, but you do owe taxes on that. See a nice link here and the extensive material on the IRS site. The $66k shortfall, of course, is taxed at a 10-15% marginal tax rate, for a tax bill of probably close to $9,000, considering that you exhaust the entire zero % tax bracket for continued Roth rollovers. Bummer!
Challenge #2: Sequence of Return Risk – Base Case SWR simulations
Notice that the calculations above were mostly about the tax-hacking. True, the Roth Conversion Ladder is not as useful as one would have hoped for and there are some tax bills, but at least John doesn’t run out of money, right? Not so fast! There was no Sequence of Return Risk built into the calculations. Let’s look at how the John Smith withdrawal strategy would hold up with historical asset returns. I inputted your parameters into my Google Sheet:
- Link to the John Smith Base Case Google Sheet
- In our SWR series, part 7 we provide additional details on how to use this and how the SWR are computed.
- Also notice that the sheet cannot be edited by anyone but me, for obvious reasons. If you like to play around and make any changes, please save your own copy, see instructions in the screenshot above!
I assumed an 80/20 Stock/Bond allocation, and also added the extra income from the side hustle for 10 years as well as Social Security, starting in year 33 (John) and 34 (wife). The results are in the table below:
- A reasonably safe withdrawal rate would have been 4.25%. This generates a roughly 10% failure probability in historical simulations, conditional on an elevated CAPE (20-30). Side note: the most recent CAPE I saw was actually slightly above 30, but Prof Shiller hasn’t updated his equity earnings numbers for a while and I’m pretty sure the revised number will drop to below 30 again.
- The proposed annual consumption of $56,570 (a whopping 5.14% withdrawal rate) would have failed in more than 40% of the simulations with a starting CAPE of 20-30. That is unacceptably high!
Cut expenses?
If $56K in annual expenses don’t seem like a sustainable spending level given today’s equity valuation, why not try to hack expenses some more? Are you sure you maxed out all the tricks of frugal living? Have you checked out the Root of Good blog? One of my personal all-time favorite blog post on that blog (or maybe among all blogs) is this one:
Living a $100,000 lifestyle on $40,000 per year
This couple has three kids and they live on $40,000 a year. If you could look at your budget and theirs, meet everywhere half-way you’d be at around $48K a year: a pretty decent consumption budget and almost low enough for the 4.25% safe withdrawal rate!
Work for four more years?
Let’s assume that John works for four more years, bringing in $120,000+ annually. I also assume that he does the side hustle for only six more years after retiring. Working longer, of course, brightens the early retirement outlook in (at least) five ways:
- shorten the retirement horizon, especially the number of years you have to bridge before Social Security kicks in
- Increase the expected Social Security benefits
- additional contributions into the FIRE stash
- additional capital market returns for the existing stash
- make the Roth Conversion Ladder work longer!
Let’s assume the following annual savings:
- Contribute $24,950 p.a. to the 401k. (John’s estimate)
- Contribute $11,000 into the two Roth accounts. (John’s estimate)
- Contribute an additional $10,000 into taxable savings every year. You said that you have enough cash to pay off your mortgage. When you do so, direct the savings from not having to pay the mortgage every month into a taxable account!
With a conservative asset return of 6% nominal (not as conservative as Jack Bogle, though), my estimate is that the financial net worth will increase to about $1,470,000 in today’s dollars. Plug in those updated numbers and see the second Google Sheet here:
Google sheet with SWR simulations
The picture looks much brighter now. At a 4.1% SWR (around 90% success rate, conditional on an elevated CAPE), we’re now looking at a much more generous initial consumption rate. See the results below. The safe consumption amount is now significantly higher: above $60k p.a. (in today’s dollars, not future dollars!), even though the percentage withdrawal rate is now only 4.1% (that’s because the side hustle is now lasting only 6 more years and both the side hustle and Social Security benefits are a smaller % of the increased asset value, hence the SWR is a bit lower here).
One word of caution, though, is that even with this improved asset position, there is still the problem that the Roth Conversion Ladder does not work all the way through retirement. After about 15-16 years, you will still likely face some federal tax liability in the future. Not as bad as in the base case, of course. But with $60k in annual consumption allowance, there’s some room to budget for paying federal taxes.
Some ideas to “boost” returns
Regarding John’s question:
“IF SHIFTED/MOVED INTO THE RIGHT TYPES OF FINANCIAL PRODUCTS, could generate $46,800/yr in income, then I feel confident I could make the additional $10k per year we need with small side hustle earnings.”
Let’s first clean up one small misunderstanding: As we wrote in our SWR series: The number 1 reason your SWR fails is the sequence of return risk. Not low returns, but sequence of return risk! So boosting returns might be barking at the wrong tree here. If a higher expected return also brings higher risk with it, you might be doing more harm than good. If I had to recommend something to generate more stable returns I would look into 2 interesting options:
- Rental Real Estate. I’m not the expert on this so I will defer to Coach Carson. The idea I liked the most is the “house hacking” concept: Buy a multi-family (2-4 units) property, live in one unit yourself and rent out the others and essentially live for free. You mention that you have $100,000+ to pay off your mortgage. Why not use that money to buy a duplex, rent out your existing house and one duplex unit, live in the other duplex unit and get some serious house hacking underway? Again, I’m not the expert on this, but the relative stability of rental real estate income, inflation protection and diversification with your equity-heavy portfolio seem like an interesting idea.
- Option writing. I have written about this topic (see a two-part series here: part 1 and part 2 and make sure you also check out Fritz’ post on the topic, it’s a classic!). The idea is that if you have already achieved FIRE or are close to it, there is no need to shoot the moon and generate outsized equity returns anymore. By selling the equity upside you can generate some nice steady additional income.
But a word of caution: Whether it’s real estate or derivatives trading, you’d be wise not to jump into anything new right after retiring. Explore this while you still have the safety of a paycheck! Run this for a few years (ideally four years!) before you pull the plug on the job only after you are comfortable with the results.
One other thought about the work->retirement transition
Financial Samurai wrote about the benefits of “engineering” your layoff. The advantage of being laid off (not fired, big difference!) is that you will likely get some sort of severance package from your employer. A few extra months of severance pay can make a big difference in your FIRE plan. Also, if you’re laid off you’ll be eligible for unemployment benefits, which is not the case if you leave yourself. Pick up every extra dollar you can!
Summary and a final word
Sorry, I didn’t have better news! Despite your very impressive savings performance, I would consider it a bit premature to retire anytime soon. But then again, I’m Big ERN and extremely conservative about the FIRE arithmetic. Others who look at your numbers will likely tell you to go for it. There are lots of precedents of folks who retired with similar asset positions but keep in mind that many of them retired several years ago when equities were much cheaper. People who retired in, say, 2012 with $1,100,000 had a very smooth ride so far. But we can’t guarantee that today’s early retirees can repeat that experience. In addition to the high CAPE ratios there are several risk factors in this retirement plan:
- The taxable account will last for only six years and the Roth conversion ladder may only work until your late 40s. After that, you have to plan on paying several thousand dollars in federal income taxes every year.
- Even if you are comfortable with the 72(t) plan for digging into 401k/IRA assets penalty-free before age 59.5 make you are aware of all the pitfalls. If you start this route and don’t keep up the substantially equal periodic payments you could be on the hook for the 10% penalty for early withdrawals.
- You already plan with a side hustle in the base case scenario. Normally, I would recommend using the side hustle as an “insurance policy” in case money gets tight during retirement. Make sure you have a second one for an additional $10,000 income potential just in case. Remember, all SWR calculations still have a 10% historical failure rate built in!
- Health expenses: You can probably get away with lower health expenses than your $12,000 estimate. But who knows? Obamacare can either collapse in a few years or could be replaced with something less generous.
Finally, I sensed a bit of frustration about work and an eagerness to call it quits. I know it’s a bit of a cliche but make sure you don’t just retire from work but also retire to something you like. Don’t throw in the towel at work. Try to alleviate what’s bothering you or look for a different company (maybe with a big pay raise?!) and haul in some more cash for a few years. I know four more years will seem like a long time, but I’ve been planning FIRE for more than that and I have another year to go now. Retirement will be more relaxing when you don’t have to worry about the Roth Conversion Ladder failing in your late 40s!
Either way, I wish you all the best! Keep us updated on your progress!