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early retirement

Personal Finance 401

May 17, 2015 by Andrew Leave a Comment

School is almost out for the summer, but you should always be learning new things in life.  Today we’ll cover an advanced personal finance topic.  It may sound like goobly gook, but the payoff is worth it!  So break out the notebook and pay attention.

Roth Conversion Ladders

What if I told you that you could retire earlier or with substantially more money and you didn’t need to earn more or spend less.  Does that sound too good to be true?  Well, it is true thanks to a little strategy called roth conversion ladder.

What is it?

During your working years that you are saving up for retirement you have three options as to how you can save your money.

The first option is to use a traditional 401k or IRA (individual retirement account).  With this type of savings account, your contribution gets to grow tax free.  Then when you reach retirement age (59.5) any withdrawals that you make are taxed.

The second option is to use a Roth 401k or IRA.  Your contributions are taxed going in and then at retirement age you can withdrawal the principle and interest tax free.

The third option is to invest in a taxable account.  Generally the contributions to a taxable account are post tax and any gains (withdrawals) are also taxed.  It is kind of the worst of both worlds.  The one bonus is that you do not have to wait until retirement age to access the funds.

To sum it up, you can either pay the tax man when you retire, when you earn, or both.

A Roth conversion ladder is a strategy where you use a traditional IRA as your primary savings vehicle and then over time you convert the balance over to a Roth IRA.  In doing so, you get the best of both worlds.  Your initial contribution is tax free and can grow for many years and your eventual withdrawal is also tax free.  The tax man can be removed from the equation and the best part is that it is perfectly legal!

How does it work?

To start the process, upon retiring any traditional 401k funds will need to be rolled over to an IRA.  This is pretty straightforward and according to Vanguard, it involves 3 simple steps that should take you less than 30 minutes.

Now the real fun begins.  The IRS allows you to transfer IRA funds to a Roth IRA as long as the transferred money is considered income and taxed as such. Also transferred money is not accessible for a period of five years.  Uncle Sam gets his cut during the transfer and is happy.  You are also happy because you realize that being a newly retired individual your taxable income is basically whatever you transfer between accounts.  You also know that income tax doesn’t kick in until you cross a certain threshold (exemptions + standard or itemized deduction).  For example, since we are married and have one dependent we could convert up to $24,600 a year without paying a single penny in taxes.

$12,600 (standard deduction) + $12,000 (three times personal exemption of 4,000)

Obviously when Frugal Boy strikes out on his own, we will lose a dependent, but we would still be able to convert $20,600 a year tax free.

Roth Conversion Ladders are awesome because you get to grow money relatively tax free.

Perhaps the easiest way to understand the strategy is to see an example.  Thankfully, Root of Good, has already packaged together some easy to read tables that show how it works.

Screen Shot 2015-05-17 at 8.12.38 PM

[credit] http://rootofgood.com/roth-ira-conversion-ladder-early-retirement/

Root of Good also explains some intricacies nicely, such as how to handle inflation during the five year waiting period, how to best cover the five year gap, and their own personal conversion plan.

Why Bother?

If this sounds like a lot of work or is overly confusing you may be asking yourself why should I bother.  JL Collins, an early retirement advocate, crunched the numbers and determined that by using this strategy to minimize taxes, the test case individual could retire two years earlier than just sticking to the conventional script.  You don’t have to earn more or spend less, just plan ahead and you can retire sooner!

When should I consider it?

Roth conversion ladders are best suited to those planning on an early retirement.  The conversion takes time (the more time you have, the less taxes you’ll have to pay).

In Summary

If you are just starting out and the prospect of early retirement is appealing to you then you should utilize a traditional 401k and/or IRA.  Having some money in a taxable account will help you cover the first five years of converting, but your primary goal should be to stuff as much money as possible into the tax advantaged retirement account.  Later on in life, you can figure out the specifics of how you are going to access that money in a tax minimal way.

Posted in: Finance, Savings Tagged: 401k, conversion ladder, early retirement, retirement, roth

Planning for (Early) Retirement

April 30, 2015 by Andrew Leave a Comment

You may have noticed an addition to the sidebar.  It is this little chart graphic that I try to update once a month.

pf goals 5-1

May 2015

It is our yard stick for two major financial goals in life.  The first is to pay off our mortgage and be completely debt free.  The second is to have enough interest earning assets socked away to be able to live indefinitely without having to work (aka retirement).

We currently have 62% of our mortgage paid off.  Our extra payments help to chip away about 3% every month.

The retirement bar rises more slowly and could even decrease if the stock market goes down.  We are currently at 12.3% of our retirement goal, but what is the goal number?  More importantly, how do you find out your own goal number?

Planning for Retirement

There are only a couple of numbers that you need to know in order to plan for retirement.  The most important number is your annual expenses.  Ya, ya, I know what you are thinking.  All of those retirement calculators and financial gurus on the internet talk about retirement in terms of income.  “You need to be able to replace 80% of your working income in order to retire.”  Let me tell you, that’s a load of crap.

What you really need, is to be able to cover 100% of your expenses.  You track those, right?  If not, now’s a great time to get started with Mint.

The great thing about basing your retirement goal off your expenses is that if you want to retire sooner, you just have to lower your expenses!  Man, I knew this frugal thing was going to pay off.  🙂

Before you rush off to figure out your annual expenses keep in mind that they should be adjusted for retirement.  If you are going to be mortgage free before you retire, you can drop those mortgage payments from your total.  The same goes for items such as daycare, estimated income tax (you’ll be retired), and any debts that you have paid off (student loans, credit card, car, etc…).

Okay, so do you have your annual expenses number?  Let’s use $30,000 as an example.

4% Rule

Here comes the second number.  If you guessed 4 you’re wrong.  The second number is 25.  Multiple your annual expenses by 25.

$30,000 x 25 = $750,000

There you go, that is how much money you need to save in interest earning assets (like stocks and bonds) in order to retire.  Do you see what I did there.  I said “retire”, I didn’t say “retire at 67”.  That’s right, once you have your nest egg you should be able to retire at any age and live indefinitely off your nest egg.

Suuuurre… say the skeptics.

Don’t believe me?  Let’s start with exhibit A, the Trinity Study.  The study, done by a group of professors in the 90s, and later updated with recent historical data, looked at rolling 30 year periods to see how stock portfolios (50/50 stocks to bonds) would have fared since as early as 1926.  The authors concluded that given a withdrawal rate of 4% per year, the likelihood of a portfolio surviving for 30 years was 96%.

It’s at this point that you look over to your SO, if you’re single you can skip this step, and you find out who among you is the more cautious.  The cautious partner will probably say that number is too small, and want to use a 3% withdrawal rate just to be safe.  So we really have two retirement numbers, the 4% and the ‘rock solid’.

If you’d like to read more about the Trinity Study and the 4% rule, Go Curry Cracker has a great write up on the topic.

Going back to our example, 4% of $750,000 is $30,000.  Yay, the math works!

But $750,000 is SOO much money.  Who could ever save up that amount of dough.

If you are close to the ‘normal’ retirement age, you may not have to.  Social Security and any pensions may be able to subsidize your annual expenses.  Instead of needing 30,000 from your portfolio a year, you may only need $10,000.  That shaves off a cool half million right there.  If you are still young and want to pursue early retirement then Social Security and pensions are too far away to be much of a serious help.  Instead you’ll have to focus on two things, cutting expenses and raising income.

Early Retirement

Mr Money Moustache (MMM), an avid early retirement blogger, has put together a simple table to correlate savings rate to years till retirement.

Savings Percent Years of Work

Saving 10-15% of your income for retirement will put you on track for retiring in your 60s or 70s, assuming you start in your early 20s.  We are currently putting aside 25% of our income, and even that amount of savings only puts us on track for late 50s.  Our goal is to increase our savings percent to 40 or 50 so we can retire early.  Preferably before we turn 40.  That may be possible if we are disciplined enough to pay off our mortgage early and save that freed up cash flow instead of spending it on lifestyle creep.

Some Final Thoughts

I use the word retirement, but what we are actually pursuing is early partial retirement.  The flexibility of working when, where, and on what we want is incredibly appealing.  It may not be necessary to reach 100% of our retirement number if we offset our annual expenses with partial working income.

The second thought, is that no where in here have I mentioned financial windfalls.  That could include  winning a lottery, or receiving an inheritance.  The reason for their omission is simple, you shouldn’t count on them or rely on them.

Finally, the 4% rule has been getting a lot of flak in the past few years saying it is obsolete and no longer valid. The arguments generally go that bond rates have plummeted in recent history and yield close to zero.  The 2008 crash and subsequent depression hit close to home and rattled a lot of 401k holders.  The 4% rule works if you remain flexible.  Should you buy a new car the year that the stock market drops 50%?  Probably not, maybe you can make do with what you have until your portfolio recovers in a year or two.  Is the market up 15% this year?  Maybe you should withdraw more than 4% to build up cash reserves for down years.

Posted in: Finance, Savings Tagged: early retirement, mortgage

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