The below post was written in May of 2016 and found on my computer recently, so this is kind of like a director’s cut/cutting room floor edition. I have since written in detail about my distribution strategy, which can be found here and provided a one year later update. Some details in this post have changed, such as I went back to work in 2017 for maybe a year and I did a prorated 72(t) distribution in 2016 of 4 out of 12 months, but the other figures look pretty spot on. I figure this might be a good resource for someone searching the world wide web for doing withdrawals in early retirement. For more on Reg 72(t), read this and this. Enjoy…

 

My Withdrawal Strategy in Early Retirement

A lot of attention is given to the asset accumulation stage of life to achieve early retirement. But there is another important stage to think about as well, the withdrawal stage. When I left my employer, one of the last things I told the manager was “Building up some money is the easy part. Making it last for 50 years is the hard part”-Me. That statement is probably a little more dramatic than it needs to be. I’ve given a lot of thought to my withdrawal strategy to ensure not running out of money, so I’d like to go over that today.

Some Things to Do Before Retirement

A few important things to mention first: Budget. If you are flying blind and don’t know what you’re spending, start now. Without tracking your spending, you don’t know how much money you need accumulated to retire. Second, Margin of Safety. If something unexpected can happen, it probably will, so it’s good to allow for one off occurrences. Third, inflation is a bitch. Cost of goods and services go up over time, don’t ignore it. Low inflation is also much better than experiencing deflation (nightmare for the economy). Building up to retirement, you really need to start tracking your spending, unless you’re just filthy stinkin’ rich. It’s also a good idea to see if, on paper, your figures work out and do a test drive. Also, if you have some upcoming large expenses (like a home repair) coming up, it would be best to pay for that while still working or set aside some cash for it. I also started to set aside a little cash as opposed to investing every dollar I earned.

Stage One-The First Year

I left my job at the start of the calendar year (2016). The timing was key as I had some bonus money and over 200 hours of vacation I would get paid for leaving on/after January 1. If I left December 31, I would be losing out (so be sure you know you’re company’s policy). So there was some good money on the table and I put up with the job a few more months. I also deferred 100% of my paycheck into my retirement plan, the idea being I’m trying to stay in the lowest tax bracket this year (there was one problem with this) I theoretically can still live off that bonus and vacation money for the rest of the year, but I’m building in a margin of safety.

From January thru May, I’ve been living off of that bonus/vacation money. Beginning in June, I am turning off the dividend reinvestment on my brokerage account (not the ROTH or Traditional IRA though). This will provide enough monthly income to live off the rest of the year and allow a small monthly buffer.

When I was trying to project my budget in retirement, my bare bones expense to cover my essentials worked out to a little over $5500 for 2016 (I moved to a different area and actually over estimated some cost). Let’s just round that up to $500 per month in essential expenses. My dividends from my brokerage account kick out about $6200 for the year. So the dividends from my brokerage account cover the essential living expenses. Like I said, nothing fancy this year, but I am living comfortably believe it or not at that expense level, I can also sell some of my individual non-dividend paying stocks should the need arise and have some cash on the sideline.

So why keep my income low this year? Basically I’m keeping my ordinary income low for one reason: taxes. If I started taking PENALTY FREE 72(t) Distributions from my IRA, I would get bumped into a higher tax bracket. I would then owe taxes on my dividends and the withdrawals from my IRA. However, as it stands, when I am filing my taxes for 2016, I will only have ordinary income from the bonus and vacation payout and qualified dividend income. Since I will be in a low ordinary income tax bracket, I WILL NOT owe taxes on my dividends, but also will be getting a refund of about $2000 from the taxes taken out of the bonus money (I’ll owe approximately $327 in state taxes). So why take out money from the IRA when you don’t need it, but also the dividends in the IRA are reinvested creating extra future income for next year.

 

Sidenote: I don’t have insurance. I pay cash for dental cleanings and eye exams (Walmart is super cheap for vision) and fortunately I am very healthy. I have not been to a doctor’s office since the age of 17 and that was to have my balls squeezed for a physical for high school sports (now, turn your head and cough). Yes, I would be able to qualify for basically free insurance through the Affordable Care Act, but I have a strong opposition to all things socialistic (ask anyone that’s worked with me-stupid Wednesday breakfast), so I won’t be freeloading off the American Tax payer. There are also a bunch of holes in the coverage with the plans when leaving your state or even finding a doctor that accepts the plan, so I figure why bother. Eventually when I get older, this will be a concern and I’ll buy some coverage, but for the next few years I’m good and willing to take the risk. And no I’m not paying the stupid penalty.

I also do these things to avoid having high expenses and, also I, in general, have everything I want and need. Also, I have not mortgage, credit card, or car payments, so I have absolutely no debt payments. I am completely liquid and debt free.

Stage Two-Year 2017 thru ???

So this is where it gets interesting. I like to assume a 4% inflation rate long term. Yes, we are currently well below that for now, but I want to be conservative. This would make my essential expenses go up to $6240 (let’s just round to an even $6300).

Dividend Income from my brokerage account next year should be around $6300-6400+ in 2017 (I’ll get a better feel after all dividend increases have been announced this year). I am mainly focused on a dividend growth strategy, so this dividend income rises slowly but surely every year. I’ll also get a tax refund of approx. $1600 (netting out federal and state)

Basically my qualified dividend income will cover my living expenses. End of story, right? Not quite.

Next year I will be doing what is called Reg 72(t) distributions from my Traditional IRA. This little known IRS rule allows for someone under the age of 59 ½ to take out Substantially Equal Periodic Payments (SEPP) from an IRA and avoid paying the 10% penalty for early distributions, you just have to follow all the rules. I’ve already gone into some details here about Reg 72(t), so no need to rehash the story.

I will initially be going with the Annuitization Method for my SEPP and stop reinvesting the dividends in this account. I will also be setting up the payments based on an interest rate that is just below the published 120% Mid Term Rate that you cannot go over, intentionally being conservative. This will provide $10,000 in income from the IRA account, without paying the early distribution penalty of 10%. Here’s the beautiful thing (and why it’s conservative), I’m not even touching all the dividends in that account. I’ll be pulling out less than the dividends being generated from the account. This strategy provides a cushion down the road if any of my stock holdings needs to cut their dividend, as extra cash will accumulate (and eventually be reinvested). So in theory, I will never touch the principal in this account or sell a stock. I will be taking $10,000 from this account for the forseeable future to stay within the rules of Reg 72(t).

A few other beautiful things: That $10,000 is basically all extra disposable income. Yes, I’ll try to spend some on things and stuff, but largely, it is just extra money and some will most likely find its way back over to my brokerage account being invested in more dividend paying stocks (increasing my qualified dividend income) or just building cash for emergencies down the road.

So why even take out the money from the IRA? Simple…taxes. In Stage 1, I’m delaying doing 72(t) because I would be unnecessarily paying taxes on money I don’t need. The opposite is true in Stage 2. In 2017, I won’t have any ordinary income from working. The $10,000 that I pull out of the IRA will be my only “ordinary” income. The thing to notice, I will be in the low income tax bracket. After the standard deduction and exemption, I won’t be paying any federal income tax on those IRA withdrawals. Because I’ll be in the lowest ordinary income tax bracket, my qualified dividends from the individual account will be tax free at the federal level (of the approx. $16,000 of income, I pay a few hundred bucks in taxes). So while I was working I saved a nice amount by tax sheltering money into my retirement plan, and now that I am retired (and because of my low expenses) I am able to basically pull that money out almost tax free. The government sees me as poor, because we are taxed on income, not on assets.

But what about taxes on your brokerage account? I control taxes on my brokerage account. I invest only in individual stocks. I don’t pay taxes unless I sell or one of my positions is acquired for cash and stock. I don’t have some fund manager running an actively managed mutual fund racking up short and long term gains, creating an adverse tax bill for me each year. Another beautiful thing about our tax code, since I’ll be in the lowest tax bracket, I can sell some of my long term holdings in my brokerage account little by little every year and buy back into the shares and not pay capital gains tax. Essentially adjusting up my cost basis on stocks, this is called tax gain harvesting. This helps protect against changes in the tax code down the road.

The tax code is funny. There are a bunch of tax breaks for low income earners. The reality is low income earners are not able to take advantage of them. If you earn $16,000 and have to pay rent and all the other cost of living, you have nothing left to invest, let alone get tax credits for contributing to an IRA. So when politicians talk about that crap being good for that demographic, the reality is that it doesn’t benefit them. It benefits people like me, able to use the rules in their favor.

Getting back on track, in 2017, I will have approx. $800 monthly in absolute disposable income each month. Frugality has allowed me a lot of flexibility.

At this stage, I am not even touching the ROTH IRA. This account is left alone, dividends being reinvested and all. This account is currently triggering about $4500 in dividends.

Stage 3- Approximately Year 2027 thru 2038

This is really a stab in the dark, and will be adjusted accordingly. At this stage in life, I will hit age 47 and cost of living will be up considerably.

The major change at this point will be looking for insurance.

At this point in life, I will take advantage of the allowed one-time modification to my SEPP. I will switch over to the RMD method under Reg 72(t). Under the RMD rule through Reg 72(t), you take your account balance and divide by your life expectancy. From here until age 59 ½ my income from the IRA will vary every year. The thing to not ignore however, my IRA balance should theoretically be higher 10 years from now, so the distribution will be higher than the $10,000 I was previously taking. I’m hoping to get to near doubling my Traditional IRA account balance at that time.

Also, my qualified dividend income from the individual account should be realistically doubled (around $13,000)

Also, by this time, my ROTH IRA dividend income should be around $9000. This account will not be touched at this stage either.

Total dividends across all accounts should be approx. $42,000 and essential expenses about $11,000 (not factoring in insurance cost)

Stage 4- Year 2039

This is the year that I turn 59 ½. It is the year I am finally able to stop the SEPP distributions and have avoided the 10% early distribution penalty for 22 years.

Dividends from the Traditional IRA should be around $40,000.

Dividends from the ROTH IRA should be approximately $18,000

Qualified dividends from the individual account near $26,000.

At this point, all bets are off. I no longer have to follow the Reg 72(t) distributions and can take out whatever I want from the Traditional IRA. I will most likely just touch the Traditional IRA account, trying to tax efficiently draw down some of the balance. Also, I want to draw from the Traditional IRA, because not too far down the road at age 70 ½ I will have the Required Minimum Distribution (RMD) on this account. RMDs do not apply to Roth accounts (yet, at least) or brokerage accounts, so I can leave those account to grow until later down the road. Overall, if I just wanted to touch the dividends in the various accounts, they will provide more than enough to life off.

There you have it, my withdrawal strategy for the rest of my life.

 

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