Fast-forward a few years and imagine you’re on the final glide path to retire early, meaning you are close to making work optional. By now you’ve mastered what’s in this book and more, and your finances are on point. You’ve been diligently saving 50 percent or more of your income for the past four years and investing it wisely. Based on your calculations, if the stock market doesn’t drop by double digits in the next three years, you’re going to be on track to be able to retire in five years or less.
As you get closer to early retirement you’ll have a much better handle on your monthly expenses, which by now you’ll have worked hard to optimize so you’re spending enough money to be happy and have everything you need. You’ll have used your optimized expense projections to update your number and you’ll be on track to reach it. At this point you’ll start crafting your exit strategy and seriously planning three things:
Your cash flow strategy (aka how you will cover your monthly expenses), using any income streams, investment withdrawals, and cash
How to ensure you can live off your investments for the rest of your life
What you’re going to do next (aka whatever you want!)
The number one goal with your investment withdrawal strategy is this: you want your money to last for the rest of your life. If you end up making a mistake, you may need to go back to work, which is easier to do when you are forty-five than when you are seventy-five. Just like calculating your number, living off your investments for the rest of your life is by no means an exact science, and your strategy will evolve over time. But there are a number of principles and strategies that can significantly increase the odds that your money will last for the rest of your life. The key is to get as close as you can. This is not a process you go through once. Remember that you should be recalculating your number quarterly (four times per year) as part of your regular routine (don’t worry—it takes only about five minutes).
It’s never too early to start planning your investment withdrawal strategy so you can minimize any early withdrawal penalties (for withdrawing your money from your tax-advantaged accounts before you are 59½) and the impact of taxes from your taxable accounts. Knowing how to best withdraw your money in the future will undoubtedly make you a better investor today.
While I haven’t retired yet, I’ve been planning how I could for the past few years. Here are the best withdrawal strategies being used today, but as you get closer to early retirement or the necessity to live off your investments, it will be worth taking some time to research new early retirement withdrawal strategies that are likely to develop as tax laws change, as well as loopholes identified by the financial independence community (if there is a new loophole, it will be found!). This chapter is by no means the definitive early retirement withdrawal strategy, but it will introduce you to the framework you will need to customize to your needs as you get closer to living off your investment income.
As you get closer, you’ll want to start planning how you’re going to cover your monthly expenses. Your strategy should depend largely on how much money you need and whether you need to immediately start withdrawing your investments, or if you can rely on a dependable income stream, like rental income. If you are going to need to withdraw money from your investments to cover your expenses, you’ll likely want to shift your investments to a more conservative stock/bond allocation so you can rely on bonds or some other type of fixed-income asset.
A common asset allocation for early retirees is 60 percent stocks/40 percent bonds or 40 percent stocks/60 percent bonds. These allocations both allow you to participate in stock market growth over time but have fixed income from bonds that you can withdraw and live on. With a more conservative allocation, if you are living off fixed-income assets you can leave your stock investments alone and let them keep growing and compounding. Although other early retirees who can withdraw less than 3 to 4 percent of their portfolio to cover their monthly expenses leave their money in 100 percent stocks to maximize its long-term growth potential, it’s up to you to determine the level of risk you are willing to take and if you would prefer to live off fixed guaranteed income. One nice feature of bonds is that you know exactly how your bond investments will grow each year, so the income is guaranteed.
If possible, use money you make from real estate rental income, side-hustle income, or sources of passive income to cover your monthly expenses before dipping into your investment gains.
While we covered this when you calculated your number, it’s worth revisiting, because any income will reduce the amount of money you need to withdraw from your investments. For example, if you make an extra $2,000 a month off rental income and need $5,000 a month to cover your living expenses, that $2,000 a month in relatively passive income reduces the amount you need to withdraw from your investments to $3,000, a 40 percent decrease. Because of just $2,000 a month in rental income, you can leave an additional $24,000 a year in your investment accounts to continue to grow. And if you can get your side income to cover your monthly expenses, you could live off that income for the rest of your life and never have to touch your investments. This is easily one of the biggest benefits of building income streams outside of your full-time job.
As you learned earlier in the book, if you have at least 25 to 30 times of your expected annual expenses invested, then based on the existing research, a safe withdrawal rate of between 3 and 4 percent (with annual adjustments for inflation) is going to significantly increase the odds that your money is going to last for the rest of your life. Now, it’s important to mention that what constitutes safe withdrawal rates is a hotly contested debate within early retirement circles, so it’s worth reading up more as you get closer to wanting to retire. By the time you are ready to live off your investments for the rest of your life there might be new research and withdrawal recommendations, but based on all of the research released I’ve reviewed, the 3 to 4 percent range is a conservative estimate for not only preserving your principal, but ensuring future growth.
No matter what, you should plan to take out as little money as you need to live on and keep as much of your money invested and compounding as possible. Due to what’s known as a sequence-of-returns risk, your investment performance of the first five to ten years of retirement has an impact on how long your money could potentially last. For example, if you retire right before a 30 percent stock market drop and all of your investments are in stocks, you’ll be starting retirement with 30 percent less money and potentially less than your target number. The goal is to make it through the first five to ten years with your investment principal intact.
If the stock market drops that much in the first few years after you retire, it is extremely likely you will recover the losses over the next ten-year period, and research shows that even after the worst stock market declines in history, the 3 to 4 percent (plus adjustments for inflation) withdrawal rate with the right asset allocation led to a successful outcome (money lasting for the rest of your life) a vast majority of the time. If the stock market has dropped significantly over the past year, it might also be worth delaying retirement a year or two or growing your side-hustle income to offset the money you would need to withdraw. However, you always want to withdraw as little money from your investments as possible to support as much compounding growth as possible. Even if the stock market is up 23 percent one year, you should still stick to as little money as you need and leave the rest in to grow.
You can also minimize the sequence-of-returns risk with the right withdrawal strategy, which might include moving some of your investments into fixed income (bonds) that you can live off during your first five to ten years of retirement, while leaving the rest of your money in stocks to continue growing. This way you would guarantee income that’s not impacted by the performance of the stock market.
You should try to live off cash and your fixed-income investments and supplement them with your stock market withdrawals; this way you are always keeping as much money growing in the stock market during both down years and up years. During the years when the stock market is down, you should live off your fixed income and cash, and when it’s up, you can live off your stock returns if you need more money.
A 3 to 4 percent withdrawal rate is an extremely conservative withdrawal strategy, and as long as you are reasonable during your first five to ten years of retirement, after that period your investment portfolio could easily double, triple, or quadruple in size over the subsequent years, making it possible for you to easily increase your expenses and spend more money if you want. For example, if your expected annual expenses are $50,000, you had $1,250,000 invested before you retired, and you plan to live off 3 to 4 percent withdrawals, your portfolio could very realistically grow to $5,000,000 or more over the next thirty-plus years, making it possible for you to take much larger withdrawals than $50,000 as your money grows and to start spending more as you get older. After all, 4 percent of $5,000,000 is a $200,000 withdrawal! But since you want your money to last for the rest of your life, withdraw only what you need.
While this can vary depending on your personal financial situation, based on the current tax laws, if you need to live off your investment gains before you are 59½, then it is better to withdraw from your accounts in the following order. First, take withdrawals from accounts that have no early withdrawal penalties. Also, you should withdraw only a percentage of your investment gains, not your principal, because you want to keep as much of your gains and your original investments growing.
The three big benefits of withdrawing from your taxable accounts are that there are no early withdrawal penalties so you can withdraw the money whenever you want, you pay taxes only on your investment gains, and your investment gains on investments you’ve held for at least one year are taxed at the capital gains tax rates, which are significantly lower than regular income tax rates. Using your gains in your taxable accounts first will let your tax-advantaged accounts keep growing, which ultimately gives you more tax benefits.
If you’re married, you and your spouse could withdraw any money you have in taxable accounts tax-free up to $77,200! Even if you withdraw more than $77,200, you are taxed at only a 15 percent capital gains rate up to $479,000 for a married couple filing jointly. Many early retirees have annual expenses that are less than $77,200, and they take advantage of the 0 percent capital gains rate to pay no taxes.
One caveat with your taxable account is if you’ve built a portfolio specifically to generate consistent stock dividend income that you plan to withdraw to live on. If you’ve built a dividend portfolio that completely covers your monthly expenses, then you can easily keep the portfolio intact and live off it forever!
After completely exhausting the gains on your taxable accounts, you can start withdrawing your principal before touching your tax-advantaged accounts. After you’ve exhausted your taxable investments, then you can start withdrawing from your tax-advantaged accounts using the following withdrawal strategy.
U.S. Federal Tax Brackets and Long-Term Capital Gains (2018)
|
Tax Bracket |
Single Taxpayers |
Married Filing Jointly |
Head of Household |
|
10% |
$0–$9,525 |
$0–$19,050 |
$0–$13,600 |
|
12% |
$9,526–$38,700 |
$19,051–$77,400 |
$13,600–$51,800 |
|
22% |
$38,701–$82,500 |
$77,401–$165,000 |
$51,800–$82,500 |
|
24% |
$82,501–$157,500 |
$165,001–$315,000 |
$82,500–$157,500 |
|
32% |
$157,501–$200,000 |
$315,001–$400,000 |
$157,500–$200,000 |
|
35% |
$200,000–$500,000 |
$400,001–$600,000 |
$200,000–$500,000 |
|
37% |
over $500,000 |
over $600,000 |
over $500,000 |
|
Long-Term Capital Gains Rate |
Single Taxpayers |
Married Filing Jointly |
Head of Household |
|
0% |
$0–$38,600 |
$0–$77,200 |
$0–$51,700 |
|
15% |
$38,600–$425,800 |
$77,200–$479,000 |
$51,700–$452,400 |
|
20% |
over $425,800 |
over $479,000 |
over $452,400 |
DATA SOURCE: Internal Revenue Service
Here’s the order you should start withdrawing from your tax-advantaged accounts:
Traditional 401(k) or 403(b)
Traditional IRA
HSA
457(b)
Roth IRA
Roth 401(k)
No matter what, you should take withdrawals from your Roth accounts last because the investment gains are growing tax-free. If you need the money before you are 59½, the nice thing about a Roth IRA is that you can withdraw your contributions anytime without penalty and you can withdraw them first, letting your investment gains continue to grow. If you can hold out on your Roth IRA until you are 59½, when you can withdraw from it penalty-free, you will be able to maximize its remarkable tax benefits. Even if you have to withdraw from it earlier than that, you should withdraw from it only as a last resort.
If you invested in a Roth 401(k), then you should convert your Roth 401(k) to a Roth IRA before taking any withdrawals, because with a Roth 401(k) you have to withdraw a percentage of your contributions and gains, so you are taxed if you take early withdrawals and are subject to a 10 percent early withdrawal penalty.
When you withdraw money from a tax-advantaged non-Roth account, you pay taxes on your principal investment as well as on any gains you’ve earned based on your tax bracket at the time of withdrawal. Since your tax bracket is based on your level of income, the lower your income when you retire, the less in taxes you will pay on these withdrawals.
If your only income is from your investments and you withdraw less than $77,400 after your deductions (remember you can still get the standard tax deductions even as an early retiree!) and you are married filing jointly, then your 401(k) withdrawals would be taxed at 12 percent. However, if you withdraw just one dollar more, $77,401, you would need to pay 22 percent. If you withdraw this money before you are 59½, you will also be subject to the 10 percent early withdrawal penalty on top of any taxes, all of which reduces the amount of money you can leave to grow in your investment accounts.
However, there is an amazing way to avoid the 10 percent early withdrawal penalty on your tax-advantaged accounts, but you have to get a little creative.
Let me introduce you to one of most valuable early retirement withdrawal strategies: the Roth IRA conversion ladder. Here’s how it works. Because of a specific bit of magic hidden within the U.S. tax code, any money that’s been converted from a 401(k) to Traditional IRA to a Roth IRA or just Traditional IRA to a Roth IRA can be withdrawn without the 10 percent early withdrawal penalty exactly five years after the conversion. Note: As is true with all tax strategies, the Roth IRA conversion ladder could change with a future tax law update. So definitely check if it’s still possible when you are reading this in the future.
This is how the Roth IRA conversion ladder works:
First convert the money in your 401(k) or 403(b) into a Traditional IRA.
Next convert your Traditional IRA into a Roth IRA. You’ll need to pay taxes here, so convert only as much as you’ll need. It will be easier for you to determine how much you might need to withdraw to cover your living expenses as you get closer to retirement.
In five years you can withdraw the money you converted from your Roth IRA penalty-free.
The reason it’s called a ladder is that every year you will want to convert another portion of your Traditional IRA to a Roth IRA so that you are building a ladder: at each step you have to wait five years after the conversion to withdraw the money tax-free. A popular strategy is to live off your taxable investments for the first five years of early retirement, during which time you start building your Roth IRA conversion ladder so you can minimize the taxes you pay on the conversions.
By the time you retire or you need to live off your tax-advantaged money, you will have already staggered your annual Traditional IRA to Roth IRA conversions over the past five years so you can start withdrawing the money tax-free and penalty-free right away.
With any conversion of a Traditional IRA to a Roth IRA, you will be paying taxes at your income tax level on that portion of the converted amount you previously did not pay taxes on, as well as on the investment gains included in the conversion. While you can set up your ladder whenever you want, in order to minimize the taxes, you should start building the ladder after you’ve already retired or when your income is low, so you can minimize the taxes you pay on the conversions. This is why it’s important to live off your taxable investments first.
You will owe the taxes on the conversion when you do your taxes for the year the conversion happened, so the earlier in the year you convert, the longer you can delay paying taxes on the conversion. For example, if you do the conversion on January 2, you don’t have to pay taxes on the conversion until the following April, when your taxes for the previous year are due. Always pay your Roth IRA conversion taxes with money from outside your Roth IRA, so you can leave more money invested and compounding tax-free! Money growing money!
While this might sound like a lot of work to eliminate the 10 percent withdrawal penalty, it’s like getting a 10 percent return on your money! You don’t want to lose that 10 percent, especially since the more money you can keep invested, the longer it can continue to compound. You can also convert any amount of money (there are no limits). For example, if you convert $100,000 from your Traditional IRA to a Roth IRA in 2018, then exactly five years and one day later in 2023, you can withdraw the money completely free with no penalty.
While this is pretty easy to set up on your own, if you need help, you can call the company that holds your investments or hire a fee-only tax or financial advisor who specializes in early retirement to help you. Some financial advisors will have no clue what a Roth IRA conversion ladder even is, but it’s important you do it correctly so you don’t get stuck with a huge tax bill. This is why it’s always best to build your ladder after you’ve retired, when your income, and thus your tax rate, is low.
The lower your income, the less tax you’ll pay on your investment gains, and you might even be able to pay $0 in taxes if you manage your income to stay below the minimum income tax and capital gains tax thresholds. Once you do decide to live off your investments, it’s essential that you limit your income from all sources to only what you need in order to keep your taxes as low as possible. While this might sound like a lot of work, it’s not, and by the time you’ve determined you’re close to reaching financial independence, you can learn more about how to pace your investment withdrawals monthly to keep your annual taxes as low as possible. The lower your expenses, the lower your tax burden will be and the further your money will go—yet another benefit of trying to live on less!
Tax deductions can also significantly reduce (and in some cases completely eliminate) the taxes you have to pay on your investment withdrawals. As of this writing the standard tax deduction for a married couple filing jointly is $24,000, and you can also take deductions for many other things like children, qualified stock dividends, medical expenses, business expenses, and more. It’s worth learning as much as you can about tax optimization and/or hiring an accountant by the hour who knows about early retirement strategies to teach you the ins and outs of tax optimization. While tax optimization might sound boring, the better you are (or your accountant is) at doing your taxes, the more you can reduce your tax bill and the more money you can keep invested, so the more it can grow and the longer it can last. Just like the rest of money management, tax optimization also gets easier over time.
If you do plan to retire early, you’ll want to have a plan for how you are going to spend your time. Definitely take some time to chill out, but it’s healthy for humans to work in some capacity. However, the definition of “work” is completely open and can mean taking a part-time job doing something you love; pursuing a passion project or new business venture; engaging in a personal mission or community service; traveling the world; getting in shape; or anything you’ve always wanted to do. Remember, “retirement” can mean whatever you want it to mean. That’s freedom.
There are many stories of early retirees who worked hard and strategically to retire early only to be met with a feeling of “okay, what do I do now?” on the other side. When you’ve spent your whole working life trying to attain this goal, you’ll need somewhere to put that energy once you reach it. Whether your identity was wrapped up in your job title, salary, and professional status or not, you should prepare for the transition.
A bunch of factors—for example, your personality, how you make money, how you reached financial independence, and whether you liked your job—will likely determine how easy the transition actually is for you. Once you do decide to make the transition, you can either ease into it or jump right in. Plan the best you can and do what feels right to you. Do what you’ve always wanted to do and take the time to discover new things. Let yourself grow and change. I can’t even imagine where I’ll be in five, ten, twenty, or thirty years.
Freedom is open and uncertain. But life is infinitely rich when you are open to it.