Courtesy of Fritz Cartoons
At some point, if you have been following the Simple Path to Wealth described in these posts, you will be able to choose to have your assets pay the bills rather than your labor.
How quickly you reach this point will have much to do with your saving rate and how much cash flow you require. In any event, your assets will have reached the point where by providing ~4% they can cover all your financial needs. Or said another way, your assets now equal 25-times your annual spending.
Having left your employment, you will have rolled any employer based retirement plans, such as a 401k, into your IRA, and the investments themselves, will be split between stocks and bonds held in the allocation that best matches your personal risk profile. Ideally, these will be in Vanguard’s low-cost index funds: VTSAX for the stocks and VBTLX for the bonds.
As we discussed in The 401k, 403(b), IRA and Roth Buckets post, these two funds will be in your tax-advantaged and ordinary (taxable) buckets. By this time you will have pared these down to just three: IRA, Roth IRA and taxable. My suggestion — and personal portfolio — is to hold them as follows:
- VBTLX in the IRA, as it is tax-inefficient.
- VTSAX in the Roth IRA, because this is the last money I would spend and the money most likely to be left to my heirs. Roths are an attractive asset leave upon your death and, since this is my most long-term money, the growth prospects of VTSAX make it the preferred investment here.
- VTSAX also goes into the taxable account as of the two funds, it is the more tax-efficient.
- VTSAX is also held in our regular IRAs, as even it can benefit from tax-deferral.
As you can see, if you are single, you will actually have four fund accounts. VBTLX in your IRA and VTSAX held in all three places: Roth, IRA and taxable. If you are married, your allocation might look something like ours.
- VTSAX in my Roth and in my regular IRA.
- Our entire bond allocation in VBTLX in my regular IRA.
My wife holds: VTSAX in her Roth and in her regular IRA.
Jointly we hold: VTSAX in our taxable account and minimal cash for spending needs in our savings and checking accounts.
So together we have two Roths, two IRAs and one taxable account. Across these we have one investment in VBTLX and five in VTSAX. Our allocation is 75/25, VTSAX/VBTLX.
It is also very possible that, even if you’ve embraced this Simple Path, you still have other investments. If these are in your tax-advantaged accounts you’ve likely rolled them tax-free into Vanguard. But if they are in taxable accounts, the prospect of a hefty capital gains tax might have persuaded you to hold on to them. When I retired, we also had some of these “cats and dogs”, mostly in the form of individual stocks I had yet to break the habit of playing with.
At this point the discussion risks becoming a bit complex. There is almost an endless array of ways you might withdraw the ~4% you’ll be spending from your investments. So, let’s start with the mechanics of how this works and then I’ll share with you some guiding principles and exactly what we are doing and why. From there you should have the tools you need to form your own strategies.
If you hold your assets with Vanguard, or any similar firm, the mechanics of withdrawing your money could not be easier. With a phone call or a few clicks online, you can instruct them to:
- Transfer a set amount of money from any of your investments on whatever schedule you chose: Weekly, monthly, quarterly or annually.
- Transfer any capital gains distributions and/or dividends and interest as they are paid.
- You can log on their website and transfer money with a few clicks anytime.
- Or any combination of these.
This money can be transferred to your checking account or anywhere else you choose. A phone call to Vanguard, and most any other firm, will get you friendly and helpful assistance in walking though it all the first time.
Next, let’s look at some of the guiding principles behind the approach we use and which I am about to share.
First, notice that in constructing our 75/25 allocation, we look at all of our funds combined, regardless of where they are held.
Second, we have all dividends, interest and capital gains distributions re-invested. I am not captivated by the idea of “living only off the income” as many are. Rather, I look toward drawing the ~4% the research has shown a portfolio like mine can support.
Third, I want to let my tax-advantaged investments grow tax-deferred as long as possible.
Fourth, as I am within ten years of age 70 1/2, I want to move as much as I can from our regular IRAs to our Roths, consistent with remaining in the 15% tax bracket. This strategy is described in detail in the post on RMDs (required minimum distributions).
Fifth, once we hit age 70 1/2 and are faced with RMDs, these withdrawals will replace those we had been taking from our taxable account.
Pulling the 4% in action
1. First we think about the non-investment income we still have coming in. Even once you are “retired,” if you are actively engaged in life you might well also be actively engaged in things that create some cash flow. We are no longer in a savings mode, but this earned money is what gets spent first. And to the extent it does, it allows us to draw less from our investments and in turn allows them still more time to grow.
2. Remember those “cats & dogs” I had left over in our taxable accounts? Upon entering retirement, those were the first assets we spent down. We started with the ugliest ones first. While you may or may not chose to follow the rest of our plan, if you have such remnants left in your own portfolio, I strongly suggest this is how you off-load them. Do it slowly, as needed, to minimize the capital gains taxes. Of course, if you have a capital loss in any of them, you can dump them immediately. You can then also sell some of your winners, using this capital loss to offset those gains. Any tax loss you can’t use, you can carry forward for use in future years. You can also use up to $3000 per year of these loses to offset your earned income.
3. Once those were exhausted, we shifted to drawing on our taxable VTSAX account. We will continue to draw on this account until we reach 70 1/2 and those pesky RMDs.
4. Since the taxable VTSAX account is only a part of our total, the amounts we now withdraw each year far exceed 4% of the amount in it. The key is to look at the withdrawals not in terms of the percent they represent of this one account, but rather in the context of the whole portfolio.
5. We could set up regular transfers from the taxable VTSAX as described above, but we haven’t. Instead my wife (who handles all our day-to-day finances) simply logs on to Vanguard and transfers whatever she needs whenever she notices the checking account getting low.
6. This withdrawal approach may seem a bit haphazard, and I guess it is. But as explained in this post, we don’t feel the need to obsess over staying precisely within the 4% rule.
7. Instead, we keep a simple spreadsheet and login our expenses by category as they occur. This allows us to see where the money is going and to think about where we might cut should the market plunge and the need arise.
8. Each year I calculate what income we have and, consistent with remaining in the 15% tax bracket, I shift as much as I can from our regular IRAs to our Roths. This is in preparation for the RMDs coming at age 70 1/2. When that time comes, I want our regular IRA balances to be as low as possible. This is the calculator tool I use.
9. Once we reach age 70 1/2, we will stop withdrawing from our taxable account and let it alone again to grow once more. Instead, we will start living on the RMDs that now must be pulled from our IRAs under the threat of a 50% penalty.
10. While I’m fairly certain the money in our taxable account will last until we reach 70 1/2, if it were to run out we’d simply begin drawing money from our IRAs ahead of the RMDs. In essence, this would be the money I had been shifting into the Roths. And, again, I’d strive to keep what we withdrew consistent with staying in the 15% tax bracket.
11. Despite my efforts to lower the amounts in our regular IRAs, the RMDs, once we are both forced to take them, will likely exceed our spending needs. At this point we will reinvest the excess in VTSAX in our taxable account.
There you have it. While you could, you don’t have to follow this exactly. You are free to adapt what works best for your situation and temperament.
- Transfer all your dividends, interest and capital gain distributions into your checking account as they are paid.
- Since all these together will likely total less than that ~4% level, should the need arise, you could occasionally log on and simply transfer some more money by instructing that a few shares be sold.
- Or have your dividends, interest and capital gains transferred as they are paid and schedule transfers from your taxable account on a regular basis to bring the total up to ~4%.
For example, if you had $1,000,000 in your portfolio allocated 75/25 stocks and bonds:
- At 4% your withdrawals equal $40,000
- Your $750,000 in VTSAX earns ~2% dividend, or $15,000
- Your $250,000 in VBTLX earns ~3% interest, or $7,500
- That totals $22,500 and if that’s all you need, you’re done.
- But if you want the full $40,000, the remaining $17,500 you’d withdraw from your taxable account. Taken monthly it would be ~$1498.
This seems overly cumbersome to me and I present it only to illustrate how someone focused on living on only their investment income might approach things.
Here’s what I would Not do
I would not set up a 4% annual withdrawal plan and forget about it.
As we saw in this post, the Trinity Study set out to determine how much of a portfolio one could spend over decades and still have it survive. Adjusting each year for inflation, withdrawals of 4% annually were found to have a 96% success rate. This became the 4% Rule designed to survive the vast majority of stock downturns so you wouldn’t have to worry about market fluctuations in your retirement.
It made for a great academic study and it is heartening that in all but a couple of cases the portfolios survived just fine for 30 years. In fact, most of the time they grew enormously even with the withdrawals taking place. Setting aside that in a couple of the scenarios this approach would leave you penniless, in the vast majority of cases it produced vast fortunes. Assuming you neither want to be penniless or miss out on enjoying the extra bounty your assets will likely create, you’ll want to pay attention as the years roll by.
This is why I think it is nuts to just set up a 4% withdrawal schedule and let it run regardless of what happens in the real world. If markets plunge and cut my portfolio in half, you can bet I’ll be adjusting my spending. If I was working and got a 50% salary cut I would, of course, do the same. So would you.
By the same token, in good times, I might choose to spend a bit more than 4% knowing the market is climbing and that provides a strong wind at my back. Either way, once a year I’ll reassess. The ideal time is when we are adjusting our asset allocation to stay on track. For us, that’s on my wife’s birthday or whenever the market has had a 20%+ move, up or down.
True financial security, and enjoying the full potential of your wealth, can only be found in this flexibility. As the winds change, so will my withdrawals. I suggest the same for you.
Addendum 1: For a detailed look at how one early-retired couple in their 30s traveling internationally with a soon-to-be-born baby does it: Cash Flow Management in Early Retirement
Addendum 2: What is your retirement number — The 4% Rule, an extraordinarily good post on the subject from Go Curry Cracker.
Addendum 3: My other Stock Series post on the subject: The 4% Rule, withdrawal rates and how much can I spend anyway?
Addendum 4: Vanguard Retirement Nest Egg Calculator
Addendum 5: Also excellent, and laugh-out-loud funny, is this one by Mr. 1500: Why the 4% Rule Won’t Steal Your Spouse
Addendum 6: Safe Withdrawal Rate for Early Retirees another first class post from the Mad Fientist and a close look at how critical real returns during the first decade of retirement are.
Addendum 7: The Mad Fientist interviews Michael Kitces, who is one of the great researchers on the 4% rule and retirement strategy.
Addendum 8: Bigger Pockets — Early Retirement: Asset Allocation and Safe Withdrawal Rates with Michael Kitces