Welcome back to our case study series! To see the previous installments, please check out the first three parts:
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “John Smith”
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “Captain Ron”
- Ask Big Ern: A Safe Withdrawal Rate Case Study for “Rene”
Though, before we get started, I got a favor to ask: The nomination phase for the 2018 Plutus Awards is underway until September 8. Please take the time to nominate your favorite bloggers and podcasters to give them the recognition they deserve:
You don’t have to fill out the entire form and you can nominate each blog/podcast in multiple categories. And if you like that one blog that does a lot of research on Safe Withdrawal Rates and publishes case studies for fellow FIRE enthusiasts and other fun personal finance content (wink, wink) please consider nominating it in one (or all?) of the following categories:
- Best New Personal Finance Blog (Yes, that blog was started in 2016!)
- Best Financial Independence/Early Retirement Blog
- Best Investing Blog
- Best Retirement Blog
But now back to our case study. Mrs. Greece, not her real name, not even her country of origin, contacted me a while back and wanted me to take a look at her financial situation. Here’s Mrs. Greece’s background…
We are both immigrants but from different countries. We’ve resided in the USA for 17+ years. I’m 42 and he’ll be 49 soon. We have two children (rising 6th and 3rd graders). We live in a city in one of the Southeast states (it has 5-6% income tax).
My husband is definitely a breadwinner for our family as he makes $144k (plus 15% bonus of the base salary for the last few years, but it all depends on his employer’s overall financial situation as he’s not in sales. If the company didn’t make good numbers, he would get a much lower bonus if at all). I earn a little over $60k.
Re our financial assets, they were worth $2.2M on 6/30/17. I guess, I should be jumping happily, but I don’t as it’s all on paper like some kind of mirage. The breakdown of the above number is as follows:
- Our 401k’s – $1.12M (His $760K and mine is $360K);
- Our Roth IRA’s – $230K;
- Taxable accounts – $860K ($450k in 50 individual dividend blue-chip stocks, $200k in 3 mutual funds, $100K in I-Bonds, and the rest in CD’s).
- AA stands at 78/22 today.
- Our house is paid for and I’d estimate its value just above $200k. Since we must always have a shelter, its value is excluded from our financial assets above.
I’m lumping together CD’s and I-bonds in taxable accounts along with bond and TIPS funds in 401k to get to this 22% of bonds. I must admit that I’m quite clueless about bonds, but Mr. Bogle says one needs them so we have them. As they seem to be correlated in the same direction as equities in this bull market it’s scary to increase them though. What I’m not sure is whether it’s smart to hold a TIPS fund. I got this idea from reading financial articles and Bogleheads forums in the past.
First of all, congrats on building such an impressive portfolio. I think it would be more tax efficient to keep some of your bonds in the 401k if you have a decent low expense ratio bond fund available.
How about expenses?
Expenses have averaged $50-60k/year for the last 6 years. If we were to quit working right now, I’d assume that costs for summer camps and after school would be replaced by insurance fees, so I’d definitely keep $60-65k for this analysis.
Nice! I like how carefully you have monitored your budget and how you kept a lid on expenses despite the impressive combined salary! You definitely avoided lifestyle inflation!
I’m also curious about the analysis that excludes part-time work as well. I’d rather work in my current position for another few years than start driving for Uber at nights unless I was fired or laid off. I would be better at volunteering at a library, e.g. […] [W]e wouldn’t rule out living a few years in the EU after the kiddos finish HS just to save on the healthcare insurance. […] So…geographical arbitrage might be in the cards as well.
That’s good to know! Let’s do the analysis and find a fail-safe withdrawal rate! Though you can always use geographic arbitrage just in case!
Unless something drastically changes, the blue-chip stocks would be the last thing we would sell. Right now I sort of consider them as our inheritance for our kids. They’re on the way to generate $13k+ in dividends this year but are reinvested.
That’s one thing we can take into account, but depending on your retirement timing you might have no choice but to liquidate the taxable account with the beloved blue chip stocks to avoid having to liquidate the 401k prematurely. If that’s the case, why not buy them back in the Roth IRA and/or 401k? Remember, money is fungible!
I also ascertained the Social Security and pension payments:
- Mrs. Greece Social Security: $1,111/month at age 67, starting in April 2042. In the simulations, I factor in a 20% haircut to account for future potential benefit cuts.
- Mr. Greece Social Security: $2,110/month at age 67, starting in December 2035. In the simulations, I factor in a 10% haircut to account for future potential benefit cuts. (smaller haircut because Mr. Greece is older)
- Mrs. Greece pension: $593.00/month (with 75% Joint Survivor Annuity) in May 2030. Not inflation-adjusted.
- Mr. Greece pension: $314.70/month (with 75% Joint Survivor Annuity) in December 2023. Not inflation-adjusted.
There was the issue of whether to claim the pensions right when they become available or to defer them. Since the accruals of the pension benefits seem to be tied to a relatively low T-bill rate (same as in my own situation), I’d claim the pension at the earliest possible date.
Safe Withdrawal Rate when retiring today
Let’s plug some numbers into the Google Spreadsheet and see what kind of withdrawal rate would have been appropriate. A 78/17/5 split between stocks, bonds, CDs/cash actually seems appropriate for this situation. I will use that in the simulation. You have a very long horizon, plan for 55 years, which asks for a high stock weight. I also set a final asset target to 25% as the minimum bequest target: See results here:
As always, this sheet is read-only for you, so please save your own copy (Click: File -> Make a copy) if you want to change any of the assumptions.
The absolute fail-safe withdrawal rate would have been 3.76%. But that was for the 1929 cohort, and I’m pretty confident that we are not in a 1929 kind of economy today. Outside of the Great Depression the failsafe was pretty much exactly 4%, even with elevated CAPE ratios! With a $2.2m portfolio, this implies an $88,000 initial withdrawal amount (then adjusted for inflation). Even after accounting for taxes you’ll definitely hit the $65,000 consumption target.
Account Balances over time
The SWR calculation is only one part of the equation. We also have to check how the balances evolve over time to make sure you don’t afoul with the IRS due to early withdrawal penalties. Let’s check how the account balances would evolve over time when you both retire on December 31, 2017. I use the following assumptions:
- Slowly reduce the TIPS portfolio and the CD ladder to 1x annual expenses each. Once the account sizes are right, you grow the principal by the rate of inflation so as to keep exactly 1x expenses in each account and you withdraw the remaining interest income.
- You have to bridge about 10 years until your husband can start withdrawing from his 401k penalty-free (though there is the SEPP loophole, but we want to use that only as a last resort). Given that you have “only” about $200k in your mutual fund portfolio you will have to liquidate your beloved taxable stock portfolio as well. I assume you withdraw from both portfolios proportionately.
- Along the way, you perform Roth conversions to max out the “tax-free bracket” (standard deductions + exemptions) plus the 10% federal income tax bracket. That’s because you expect at least a 15% federal marginal rate in retirement.
- In 2028 you can start withdrawing from your husband’s 401k. I assume you now start reinvesting the dividends in the taxable accounts. (i.e., outflows = 0).
- The withdrawals take into account estimates for taxes. These are my estimates which account for the state (6% flat) and federal taxes to the best of my knowledge. I then use the Excel Solver to solve for the withdrawals (shaded in yellow in the second table) to exactly match the consumption target.
- I assume you keep a 75/25 split in the 401k and a 100% equity allocation in the Roth. Since the Roth is the last account to be tapped and it’s the most tax efficient we want this to have the highest expected return. With this, you start close to your current allocation but shift more into stocks over time. If you’re not comfortable with that, simply shift into bonds inside the Roth and/or 401k.
- I use conservative return assumptions for equities: 5.75% for the next 10 years then slowly increasing to 7% nominal. Bond returns shift from 2% to 3.25% (nominal) over time. I assume you use a CD ladder of 1-year CDs and returns are just a little bit below the bonds.
- You would deplete about two-thirds of the taxable stock portfolio by the time you gain access to the 401k. That might be a little bit too close for comfort. There is a risk of running out of money in the taxable accounts if the market takes a real big dive. But keep in mind that you still have the cash reserve in the CDs and bond portfolio and a large stash in the Roth IRA, where you can withdraw principal (but not capital gains) from your Roth Conversion ladder from 5+ years ago.
- You’d do a really great job of keeping a lid on your 401k balance with this aggressive Roth Conversion ladder. When required minimum distributions (RMD) start you’ve already depleted the 401k to below $1m in exchange for a multi-million dollar Roth IRA! How cool is that?
- Notice that despite the withdrawals you maintain and even grow the value of the portfolio even in real dollars. It moves sideways in the beginning but then starts increasing again once Social Security kicks in and the withdrawals drop!
So, both from the SWR historical simulations (4% SWR) and the account balance study it looks like you and your husband ready to retire this year!
Wait for 3 more years?
There are several reasons to delay early retirement:
- As we saw in the calculations above you might get close to depleting all taxable accounts before your husband turns 59.5, especially if we experience a bear market before then. Sequence of return Risk! Delaying retirement and stocking the taxable accounts will clearly alleviate that problem.
- You will avoid drawing down the “beloved” blue chip stocks.
- From our numerous emails, it sounds like your husband is in no rush to retire and it also sounded like you haven’t planned much for what exactly you want to do once you retire. If you are not too eager to retire and you don’t really know yet what you want to retire to (we all know what we want to retire from), then it may not be a bad idea to wait a little longer.
- You currently have only $60,000 in your two kids’ 529 college savings accounts. If your kids want to go to college and graduate school it may not be a bad idea to have some extra reserves.
So let’s do the same calculation but delay retirement by 3 years. Specifically, assume this:
- Max out the $42,000 in annual 401k contributions. Since your husband turns 50 next year his max goes up to $24k! Also, you didn’t specify anything about company matching, so the 401k might even grow more if we add the matching.
- $20,000 from the CDs and taxable Bonds plus an additional $30,000 savings from your income go into the after-tax mutual fund account.
- You continue with the backdoor Roth IRA ($6,500 for your husband after age 50, $5,500 for you).
- You can leave the beloved blue chip stocks untouched but you do withdraw the dividends to support your expenses at least for the first ten years.
- Social Security benefits will be marginally higher: In today’s dollars, your estimated FRA benefits go up to $1,250 and your husband’s to $2,300, before the haircut.
- Wow! You’ll grow your net worth to $4m+ (in today’s dollars!!!) by the time you reach age 70. One could argue that this is too conservative. You could increase your spending quite substantially! Or maybe you want to retire and you have your husband work for three more years?
- By the time you can make the 401k distributions penalty-free you still have a close to $100k allocation of your mutual funds and two years in expenses in the CDs/bonds, in addition to the $640k reserve of individual stocks.
- Also, notice the impressive growth of the Roth IRA which is never even used for any withdrawals. That’s a nice size extra cushion in case of health expenses. Or for sending the kids to medical school, all expenses paid!
- One little fly in the ointment: You have a pretty massive stash in the 401k. Even when using the 401k for funding your expenses after 2028, you will have a $1m+ 401k. It looks like you keep the withdrawals high enough to satisfy the RMD rules, but depending on the actual asset returns, you have to monitor this and make sure you make the necessary RMDs. If you have to withdraw more than you need simply invest the money in the taxable account or keep a bigger cash cushion. Too much money in a 401k, it’s a good problem to have, isn’t it?
Social Security Hacking?
Currently, I assume you both retire at age 67 at your full retirement age. Considering that you’re a bit younger and your husband has substantially higher expected Social Security benefits you could do what we are likely going to do in the ERN household. If that’s still permitted in the future:
- The wife takes benefits at age 62, or whatever is the earliest possible date. Benefits are 30% lower than under FRA.
- The husband waits until age 70 and takes the maximum benefits, to boost benefits by 24% over the FRA.
- If the husband dies before the wife, then the wife has the option to receive her husband’s benefit (though, reduced if taken before her own full retirement age). This would be substantially higher than your own benefits.
BTW, one big reason why I think it would be best to leave our investments in the taxable account to our children or charity is because it would let me avoid doing tax accounting on all those individual sales. We invest monthly in our mutual funds and select stocks. Those monthly amounts are small ($100-$300), so you can imagine how many transactions we have.
I have already answered that via email: This is not something to worry about. I do the lot identification and never had any problems with it. I can pick which lots I want to sell (highest cost first or lowest cost first, depending on how my tax situation looks that year). You have to list each sales transaction. But to the extent that each sale is a combination of multiple purchase tax lots you don’t have to drill further into the origin of the individual lots. As long as they are all long-term, you simply list the purchase date as “various.” My brokers (Fidelity and Interactive Brokers) are both pretty good in providing the itemized transactions that go straight to IRS form 8949.
We both max out 401k’s and Roth IRA’s (via backdoor). My husband’s workplace also offers a Roth 401k, but I think that it’s not a good option for him considering our income tax bracket. Do you agree?
Agree. Considering your current and likely future tax bracket it’s best to invest into the regular 401k. For as long as your husband works, max out his regular 401k, contribute to the regular IRA (for both of you, even if you’re already retired!) and do the backdoor Roth.
I wonder if it would be a good idea to increase our Umbrella Insurance ($1M) or even temporary life insurance on my husband. One policy ($500K) will terminate in 10 years and another ($250k) in 15 years. The insurance through his employer will cease once he leaves the company.
Once your husband draws Social Security benefits there is the risk that if he passes away you lose a big chunk of the guaranteed CPI-adjusted income. But by then the life insurance term has expired. My suspicion is that it would be too expensive to extend the term life insurance to age 70+. Use the massive stash of money in the Roth and maybe the Social Security hacking (see above) to deal with that scenario.
$1m umbrella insurance sounds good to me!
What if the husband works until 55?
If say my husband really wants to work until 55, I will not try to change his mind. So, in this case, due to the separation from the company at 55, wouldn’t it be better to start using his 401k for our living expenses for a few years at least in order to bring its balance down (and allow taxable accounts to grow)?
Yes! There is this nice exception to the 59.5 age limit. Normally you can withdraw penalty-free at age 59.5 but if the husband stays in his job until 55 then you’re good to go with penalty-free withdrawals from his 401k. Our blogging buddy Fritz over at The Retirement Manifesto plans a similar route!
If you go this route, the Roth Conversion ladder is out the window for the next 6 years. You simply let the Roth and the two taxable accounts grow on their own and take all the money you need out of the 401k after age 55. If that’s the plan then you (Mrs. Greece) can most definitely retire now. I don’t provide the full numbers here but your net worth will accumulate even more than under the “3 more years scenario!”
Added 9/8/2017: Fill out the 15% bracket for further Roth Conversions?
You might also consider what I proposed in the case study for Rene three weeks ago: Do Roth conversions to fill out the entire(!) 15% tax bracket, see the section “A Roth Conversion Ladder?” in that post. This will be less useful if you know for sure that you’ll be in the 15% tax bracket once the RMDs start, but as a hedge against higher future tax rates and/or the risk of slipping into the 25% federal bracket, the additional Roth Conversions should be worthwhile!
Do you have an estate plan?
One thing occurred to me: With a multi-million-dollar portfolio and young children in the household, what are your plans for when the unimaginable happens: both of you pass away. My wife and I have a similar problem with a three-year-old at home. We are not comfortable with our daughter getting access to a seven figure fortune when she turns 18. A revocable trust, which will become irrevocable once the parents die, can specify that the kids will get financial support from the proceeds of the portfolio but can’t access the principal until a later age.
Well, it looks like you’re in an extremely good spot to retire early. Even if you were to retire at the end of the year (or today, for that matter) you should be able to sustain a pretty comfortable retirement. It sounds like you’re financially prepared to pull the plug anytime between now and certainly in three years. Go on, read more Early Retirement blogs and find the inspiration and the courage to finally pull the plug! Best of luck!