Money is a precious resource that must not be wasted. It isn’t easy to collect those dollars, so they should be saved, invested, and spent with maximum efficiency and thoughtfulness. Between investing and spending comes withdrawals. Since most of us have money tied up in multiple accounts, it makes sense to take money out strategically so your tax bill is minimized.
UPDATE: Comments on this post led to a sequel post. Read it here.
My life as a worker bee is long over and Mindy’s will be over soon. At that time, we’ll pivot from saving to cashing in our investments.
This is a thought exercise about our situation, but I hope it helps you too. Our goal is to withdraw money in the most tax-efficient way possible. More money for me, less money for Uncle Sam.
- Mindy no longer works: We’ll have no income besides social security which we’d take at age 70.
- Tax rates will go up: Politicians in the United States have been cutting a lot of taxes lately, but not cutting spending. What could possibly go wrong?
Our Money Situation
Currently, here is where our money sits:
- Post-tax: $1,050,000, These are mostly stocks that I purchased before I learned about index funds. Thanks JL!
- Pre-tax: $1,215,000, This is money in 401(k)s.
- Roth IRA and HSA: $160,000
(We also have some real estate holdings but to keep it simple, I’m going to ignore those.)
Here is how each of these categories shakes out tax-wise:
For a married couple, long-term capital gains are taxed at 15%, but only at income over $80,001. Below that, it’s 0! That’s right; nada, nothing, NO taxes!
If you also consider that a married couple has a standard deduction of $24,000, gains aren’t taxed until you hit $104,001 in income. Since we wouldn’t be working (no income), we could easily live off stock sales and pay no capital gains/taxes. This is amazing:
If your spending is reasonable and you don’t have other income, post-tax holdings are very similar to a Roth type of investment.
And, you avoid the age constraints of a Roth investment. If you happen to need the money earlier, you can get at it all.
401(k) withdrawals are taxed as ordinary income, just like money that you’d earn from a job. Remember that you paid zero-taxes on the money when it was invested. Now, Uncle Sam wants his cut.
To complicate matters, once you hit 72, Uncle Sam forces you withdraw from your 401(k) whether you need the moolah or not. This is called a Required Minimum Distribution. (Uncle Sam really wants his money).
If you have a significant amount of money in your 401(k), you’re going to be asked to withdraw significant amounts. If you’re a frugal fart like me and strive to live on small amounts of money, this is annoying.
For example, if you have $2,000,000 in your 401(k), you’ll have to withdraw $87,781 at age 72. What if you don’t need the money? Too bad. Take it and pay up!
Now that you know about RMDs, your goal should be to minimize them. Luckily, this isn’t hard. I’ll get to that a little later.
Roth accounts are magical in that you’ve already paid the taxes, so these investments grow tax-free. If you go nuts at 75 and decide you want to buy a yacht for $800,000, if you have $800,000 in your Roth account, you can buy it!
Side-note: Just invite me for a cruise. And I’d appreciate it if you could buy a yacht with a helicopter pad and transport me to the ship in your flying machine. Not that I’m demanding or anything…
Our Withdrawal Strategy
Now, it’s time to talk about how we’re going to withdraw our money. For the sake of tax efficiency, our strategy is split this into 3 time periods:
- Before age 59.5: The only accounts I can access here without penalty are post-tax accounts.
- 59.5 to 72: We can withdraw from everything now including 401(k) and Roth accounts.
- 72: This is the age those nasty, no good, very bad RMDs kick in.
Before age 59.5
We will live off of our post-tax investments (stocks and index funds) and all of the money will be tax-free. Again, this is because long-term capital gains for a married couple don’t start until $80,001 ($104,001 when accounting for the standard deduction!). And remember, that tax is just on the gains. Consider this example:
I buy ACME stock for $20,000 and it goes up to $100,000. I’ve made $80,000 in gains, so if I have no other income, I could sell all $100,000 of my stock and pay nothing in taxes. And, I’m not even accounting for any deductions which make the deal even sweeter.
Capital Gains Harvesting
At the start of every year, we will sell the maximum that we can without paying taxes. We probably won’t need the full amount, so we would then just put the rest back into the markets for withdrawal at a future date. This resets the cost basis, minimizing taxes in the future. For further explanation, see my article on capital gains harvesting.
We have 14 years until we hit 59.5. If Mindy quit work today, the $1,050,000 should easily carry us to 59.5 If the world really went to hell though, we could withdraw principal from our Roth IRAs to supplement our income.
Age 59.5 to 72
At this point, we pivot to withdrawing from the 401(k)s. There is a simple reason for this, RMDs…
RMD WMDs (Weapons Of Mass Depletion)
My goal in drawing down our 401(k) accounts at age 59.5 is to reduce the hit from RMDs which again, start at 72.
If our 401(k) balances appreciate at a measly 6%, we’ll have $5,500,000 by the time we’re 72. Under current RMD rules, spouses have to calculate RMDs for their own accounts, not combined. Assuming our 401(k) balances are similar, Mindy and I would each have to withdraw about $100,000 per year. Since 401(k) balances are treated as ordinary income, this money is subject to taxes. To avoid the pain of RMDs, our goal is to draw down the account before we turn 72. If we take $70,000 out for 12 years, that’s $840,000 we’ve reduced our account balances by.
So, starting at 59.5, we’d start withdrawing money exclusively from our 401(k)s. If our 401(k) balances are sky-high, we may take a little out more than we need and just invest the rest in post-tax accounts.
Oof. Age 72 is hard to think about. I hope that I still have a sound mind (sh*t, is it sound now?!??) and body. I hope that I don’t turn into one of those cranky old bastards who swills booze all day while watching cable news channels in between yelling at kids on the lawn. But I digress…
At age 72, we’ll start paying a lot in taxes again. We’ll be collecting money from social security, some of which is taxed as ordinary income. Our 401(k)s will most likely still be worth millions, so RMDs will add to our tax burden. But, the withdrawal strategy is also simple.
After we get paid from social security and take our RMD withdrawal, if we still need money, we’ll use our Roth or HSA accounts. At this point, the account of last resort is our post-tax account because those gains would all be taxed. Yes, I plan on having a shitload of money at this point in life.
However, these are very good “problems” to have. No complaints here.
At 46 we have a little over $3,000,000 in the
piggy dinosaur banks.
Well, not actually in those dinosaurs. I’m talking about the antiquated institutions where people save and invest their money.
Side note: Why are there still brick and mortar banks?!??
It’s not unreasonable to consider that our nest egg could double every 10 years. This would leave us with a positively thrilling chunk of change:
- 46: $3,000,000
- 56: $6,000,000
- 66: $12,000,000
- 76: $24,000,000
- 86: $48,000,000
Mindy and I don’t want a bigger house or a boat or even a helicopter. (Well, I could actually go for a helicopter, but that sounds expensive and I’d probably crash it into the neighbor’s house. The insurance company would not be happy and there would be a big mess.) Helicopter aside, we’re pretty happy with our life is right now. When the girls have left the nest, we’ll downsize. No other big changes planned.
I don’t believe in leaving vast amounts of wealth to children or relatives. I also think it’s a good idea for the world to be a better place because you lived in it. At some point, we’ll figure out how we’re going to give most of our money away to good causes. But that is a topic for another day.
- Retirement to 59.5: Withdraw money tax-free from post-tax accounts.
- 59.5 to 72: Withdraw from 401(k) to minimize RMD hit.
- 72+: Live off of RMDs. Supplement with Roth accounts as needed. Yell at children on the lawn.
- Kick the bucket: Leave a little to the kids and a lot to worthy causes.
What do you think? What did I miss? What would you do? When are you getting that sweet yacht and helicopter?!??
For more on this topic, read Part 2 here.
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