NOTE: We know people like to hear about beaches and travel and dogs etc. but we have to pay for all that somehow. This is the last one! of a mini-series of posts on the financial side of retirement. Like many bloggers and most people, I'm not going to share our actual numbers because it's pretty personal, and it may not be safe in the modern world. But I will give you what I think are important foundational points. I also want to say I'm not your financial advisor! I'm our financial advisor, and I'm only that until I tire of it and hire a professional. So if you're taking financial advice from me, well I really urge you to hire a professional!
I have broken down my retirement planning into three main areas: calculating/estimating income needs (spending), income generation (paying for it all), and closing the loop (comparing spending and income, and making adjustments).
In previous posts, we talked about setting yourself up for success with pre-planning, how to get to a spending number, and all the possible sources of retirement income. In this post, we'll be closing the loop, connecting spending with the funding, the tools you can use to help with it all, the order of spending your retirement funds, tax strategies, etc. It's a lot, but I think it's worth it to go through all this.
Before we dig in, I offer my apologies to our readers outside of the United States. I know this is all very USA specific, but retiring in the USA is my experience - I don't think it would be fair to be blogging about that which I don't know! But those of you in the 31 other countries that are reading this blog (Yay, I love this, and thank you for following us!) have probably realized by now that most of these concepts are universal, and the topics that are USA-centric may be extrapolated to your country and your situation. I certainly hope that is the case.
We're attempting to figure out how much money is “enough” in order to retire. Now that you've figured out your spending needs & determined where the funds are coming from, it's time to close the loop on this admittedly basic retirement planning process. There are layers upon layers to retirement planning, but you have to start somewhere and this is a pretty good somewhere, so let's forge ahead. We're going to talk about what you have and what you need, making adjustments, making new plans, and coming back periodically to see how you're doing.
As mentioned in the previous post, there are some challenges if you are retiring before a certain age that the government has determined for you. I'll lay out some of the magic ages for retirement planning:
- Any age – you can withdraw your Roth IRA contributions, but not any earnings or interest. I recommend this only in an emergency, because you are killing the goose that laid the golden egg. Roth money has already been taxed, and will never be taxed again, so it should really be spent last in your retirement, not first.
- 55 – you can withdraw tax-advantaged money, without penalty, from your current 401K, but only your current 401K.
- 59 ½
- From this point forward you can withdraw, without penalty, from your Traditional 401Ks and IRAs.
- Roth accounts all have a 5-year-rule, but the IRA and 401K versions of this rule are slightly different.
- With a Roth IRA, you must have an account, any Roth IRA account, for 5 tax years prior to the withdrawal.
- With a Roth 401K, it is per account, so that each account on it's own must have been around for 5 years prior to taking money from it.
- 62 – This is the first year that Social Security is available to you as a retiree, but at a reduced payment vs. the benefit you would receive at your full retirement age. It's all explained in more detail in this blog post.
- 65 - You are eligible for Medicare
- 66 - if you were born between 1943 & 1954, this is your Full Retirement Age for Social Security
- 67 - if you were born in 1960 or later (that's Deb and I!), this is your Full Retirement Age for Social Security
- 70 – this is the age when you will get the maximum Social Security benefit. After age 70, you are giving money away to the US Government. In other words, file for SS benefits by this age!
- 70 ½
- Required Minimum Distributions start for Traditional IRA, 401K, 403B, etc. accounts. This is the government's way of finally getting some taxes on those dollars you've been accumulating, tax advantaged, your whole life.
- Roth accounts do NOT have an RMD requirement, so let them grow.
Disclaimer: this is not legal or financial advice, this is only my personal understanding and opinions on what to do at these ages. Please discuss with your spouse/partner, do your own research, and/or ask your financial planner about these things.
Comparing Spending vs. Funding - Closing the Loop
We started this process by determining how much money we would need to spend in retirement. We followed that by going through our funding sources. Now, we need to compare the two and see where we are in terms of retirement readiness. Because I'm a fan, and because it's valuable, I'm going to borrow a few terms from Jim Otar. When you compare your money to your spending plan, you will fall into one of three zones: red, gray, or green.
The first possibility, the Red Zone is pretty obvious. It sounds pretty ominous but it's not the end of the world. It does mean your money isn't likely to stand the test of time, you are quite likely to outlive the money if you retire today. In this case, it's back to work, but with a renewed focus on earning more, spending less, saving more, and investing better. Map out a plan and work to make it happen. This is not a terrible thing, it's a challenge to overcome and when you do it, the feeling is indescribable!
The other obvious scenario is called The Green Zone. If you do the math, and you know you can be happy with a spending level that allows for significant monies to be passed on to your heirs (this extra money is also your backup plan if all things financial go bonkers), then you are done. If you look at it carefully, considering all the downside risks to the portfolio, and you determine that you should have retired 5 years ago, well this is easy. Go talk to your boss on Monday morning and give her the good news!
It's the middle zone, the Gray Zone of “I'm still not sure” where things get interesting, and a bit more difficult. The contingency options are many, from working longer, working part-time during retirement, finding ways to spend less in retirement, or possibly annuitizing a portion of the portfolio. I'm far from an expert with annuities but they are an option for creating a steady income stream in retirement, and can be used to create an “income floor” where you know you'll always have a certain number of dollars the rest of your life. If you think about it, Social Security is an annuity – you pay in (it's not as if you have a choice) early on, and draw a guaranteed income stream later.
With this knowledge and a good plan, you can play “what-if” scenarios and start to converge on the best one for you. Maybe the answer is simply to delay retirement while you continue to grow your portfolio, etc. But during this time, I urge you to revisit the planning steps every six months to a year. This does two things: it helps you become more comfortable with the idea of retiring (this is no small thing!), while you refine your estimates and watch your plan take shape.
Now I will say that I couldn't have gotten comfortable with the plan to retire without looking at multiple retirement calculators. This link from Darrow Kirkpatrick (another engineer who retired early) lays out a nice list of them. It's a great place to start even though it is a few years old, he does update it from time to time. He presents a lot of information in a nice easy table, showing the types of calculators and how much detail (his word “fidelity”) goes into them. I started out with Vanguard's Retirement Nest Egg calculator, a dead simple (really, overly simple) retirement calculator. But that's a start, and that's important. I graduated to FireCalc, which is less simple, but much more useful. This is always the case BTW, you get out of these calculators what you put into them. Finally I ended up with Laurence Kotlikoff's ESPlanner and Jim Otar's Retirement Calculator.
I have a few thoughts about how these retirement calculators operate. There are three common methods for calculating your future money: Average, Monte Carlo, and Historical.
Average calculators do a disservice in my opinion, because they literally assume average numbers forever. But reality is not average! Jim Otar, among others, has proven that the order of investment returns is critical to the outcome. It's absolutely critical! Two portfolios with the same annual % returns on the money will give dramatically different results, if one got the higher returns early vs. the other one with the lower returns early. So those average calculators IMO are well below average! Monte Carlo simulators throw a distribution of numbers at the problem, a range of values for each variable, and calculate the likely results repeatedly, coming up with best/worst/typical numbers. This is better, and many tools use this method.
Historical calculators use past history to find the best, worst, and typical retirement years over the last 100 years or so. They scale everything to today's dollars but use historical real-world values in their calculations. We've been told our entire financial lives that past history doesn't guarantee future results, but honestly, nothing guarantees future results, and I do mean nothing. So my primary tool is Otar's history-based calculator with Kotlikoff's Monte Carlo simulator as a sanity check.
Regarding the Otar Retirement Calculator – I do use it religiously in my planning, because his approach to the problem and his presentation style really suit me. It provides for inputting income needs and adjusting them for the future, all sorts of assets and income sources, and then uses what he calls “aft-casting” to see how the portfolio would have done had you retired at any point in the last 100 years. This covered the Great Depression, two World Wars and several smaller ones, Presidential assassinations, dozens of bull/bear market swings, countries leaving the gold standard, all sorts of big events that would affect the markets. Nothing says this will predict the future, but it gives me the feeling that I'm not too far off what might actually affect my money in the future.
What I learned from Jim Otar is that spending is the number one killer of portfolios, the most important factor as to how long the portfolio will last. It's obvious, if you spend too much, especially early on in retirement, the portfolio will die an early death. The second most important factor is the sequence of returns (what Otar simply calls “luck”). As mentioned above, this is the idea that if your portfolio takes a big hit early on, it is very difficult to recover (really bad luck). If the same drop happens later in retirement, the impact is not nearly as bad (not nearly as bad luck). The flip side is that if the markets go big early on, then you may be set up for a long and prosperous retirement (good luck!).
I always have to say that if you feel you're not up to the task of doing your own planning, you should definitely go to a professional. Some people aren't interested in this stuff, or don't have the skills or the time to do it themselves (Remember Know Yourself?). Or maybe there is just enough uncertainty considering the high stakes that you just don't want to go it alone. Or maybe, like us, you want to do this for a while and take it to a professional later, that's fine too. I will say I don't think you should ever pay more than 1% of your portfolio as a fee to a professional, and even 1% is a lot! In retirement you may only average 4% on the money. So that 1% is one-quarter of your income, and in a bad year when you lose money, guess what? The professional stills gets 1%, driving your losses lower. So keep an eye on the fees, for your own sake.
Regarding spending, some people (like us) expect the spending to be all over the spreadsheet, which is OK as long as it is all accounted for. This is intertwined with the contingency/risk planning that we do. For example, we plan to spend much less in our early years, based on the idea that the Caribbean adventure is the fun part. We don't have to hang out in resorts with swimming pools and fancy restaurants. We don't need a big boat, because then we'd need something to pull it, and stuff to put in it! We're living island life on island time, and we think that is fun in itself, and it's somewhat inexpensive as long as we're careful.
We also expect to adjust our spending based on investment market conditions - in the next crash, and we all know there's another "next crash", we'll cut our spending plans and just play it safe for a while. Will that be easy? Nope. It's just another challenge for us, different from the day to day challenges of the working life, but we're up for it and we'll try to make it fun.
When it comes to withdrawing money to live on, there are myriad ways to do this. The sources of possible income were discussed in detail in the previous post, but I'm focusing here on our situation which involves mostly a portfolio of stock and bond investments (in mutual funds & ETFs). I'm sure many others have similar situations with some other sources likely as well. Some people set themselves up with stocks and bonds that pay dividends and try to live off those dividends as much as possible. But usually you have to sell some securities over time, drawing down your portfolio, in order to live your retirement life.
But spending is still the key, which brings me to the “4% Rule”. Four Percent is your limit on spending. That's what they all say, that's what they've said for many years. The “4% Rule” is based on historical research done by some university professors many years back now. It says for a 30 year retirement (we're planning ours for ~35 years), you can withdraw no more than 4% from your portfolio in the first year (and adjust it for inflation every year after that). If you exceed this amount, you run a higher risk of running out of money before you run out of time. It's a “rule of thumb” and you know by now I'm not a big fan of those, but think of it more as a starting point. Smart investors and advisors don't always use this figure, but they almost always use it as a starting point. Engineers are big on changing the numbers to make the math easy, so let's say you have a $1 Million nest egg; you can spend $40,000 the first year and adjust it for inflation in the subsequent years.
Our personal plan is more variable than a rigid 4%, as we are currently trying to keep our spending very low early on while we still have our fun and adventures. There'll be more spending later as we get less mobile, maybe want a bit more luxury, and probably have more medical costs, etc. For example, we'll have bicycles and an “island beater” car for now, but maybe one day we'd like a vehicle with air conditioning! 🙂 We ride bikes from our small house to the beach now, but later on maybe we want a condo instead, with a water view of course.
When it comes to spending though, how do you do it in the right order? We have bank accounts, taxable investment accounts, and tax-advantaged retirement accounts. We're planning to spend them down in this order:
- Bank Accounts (partial). Right now we are living off part of the proceeds of the home we sold in Colorado, which is in an online bank account that pays decent interest. This does two things: first it keeps us from worrying about the market swings, we don't have to sell stocks during a down market just to pay the rent. It also bridges us to the age of 59 ½ (see magic ages above). The drawback is that this money only made us 1.4% in the last year (and this was a good rate!) when the markets were up over 25%.
- Taxable Accounts. We will sell these next because the gains on these are fully taxable. Our tax bracket is low too, so it won't hurt much.
- Traditional IRAs. These are next because another magic age will approach, which is 70 ½, when we will be required to take taxable distributions from them (Required Minimum Distributions – RMDs). So we will draw these accounts down somewhat before 70 ½ to reduce the tax impact at that time. (The less you have in your Traditional IRAs the smaller your RMD will be.)
- Roth IRAs. These are last because they are funded with after tax money, and will never be taxed again (just ignore the fact that Congress can change the laws whenever they want!). So we will let these grow as long as we can.
Wrapping it up with the Taxman
Finally, I will say that without a daily job I have time to do these things, including reading and learning. Much of that learning lately is around managing (minimizing) my taxes, especially now as Tax Day approaches. Once you're not earning money, I think the best thing you can do is to work on not giving too much of it away in taxes. So for example, I try to keep only stocks in our taxable accounts because long term capital gains typically are taxed lower (they are more tax efficient) than bonds. Bonds are in my IRAs because their dividends would be taxed at the higher ordinary income rate (if they weren't in a tax-advantaged account). And I plan to convert as much money as I can from traditional IRAs to Roth IRAs while my tax bracket is so low. We can literally move thousands into a “never taxed again” Roth account for only a 10-12% tax burden. And this also reduces our RMDs as mentioned above. My future self will thank me!
So that's it for this mini-series of basic retirement planning. We've laid the foundation starting with preparing yourselves emotionally and with the knowledge you need. We talked about the spending part of retirement and how to figure out how much you will need and want. Then we discussed the possible forms of income, how to pay for it all. And in this post, we tried to pull it all together and close the loop. And if all this financial business is not interesting to you, we've suggested the professional advisor approach. I also know much of this is very basic for many of you, but I hope it has been somewhat useful. Even if only one little nugget was golden for you, I consider it worthwhile.
I'd love to hear about your retirement planning in the comments below, or to be more private, from the Contact Us page. I will also add some of our favorite retirement planning sites to the Fave Links page. Our wish for you all is a great plan that you can take into retirement happy and relaxed. Stick with us, the next post will be about beaches and travel and dogs, or uh, something like that - I promise!
TODAY'S SPECIAL: "Taxman", by the Beatles. "If you drive a car, I'll tax the street...If you take a walk, I’ll tax your feet."