Last week, I wrote about My Biggest Money Mistake. It was not a money mistake that most people can identify with. I over-optimized and put too much into retirement accounts. It’s great if we are looking to maximize our net worth. It’s very poor if the plan is to use the money to pay expenses now – 15 years before traditional retirement age. As I mentioned in my previous article, this is a “good problem” to have. We’ve been extremely lucky that most of our personal finance plans have worked out well.
Overall, around 90% of our money is in real estate equity or a retirement account. Half of the real estate equity is our primary residence. The other half is in rental properties. We’re a few years away from owning our primary residence which will largely eliminate our biggest expense. The mortgages on the rental properties will be paid off in a few years as well, giving us a supplemental income. The rental property equity simply looks like a big number on
paper a screen.
Getting the money out of the rental properties is straightforward. We could sell one to pay off the other two and get a smaller income stream now. We could sell off all three and invest the money in an index fund. If we did that, we may get around $10,000 a year in dividends. However, if we stay the course, I estimate we’ll get $30,000 a year in rents after all expenses once the mortgages are paid off. I don’t like the idea of selling the properties at this time.
Getting the money out of the retirement accounts early is a little more complicated. Actually, it can be easy if you are okay with paying penalties. However, the whole reason why I put the money in a retirement account was to maximize the growth and the amount available after taxes.
When we look at retirement accounts there are two basic types – those that are invested with pre-tax money and those that are invested with after-tax money. Pre-tax retirement accounts include 401ks, traditional IRAs, and government TSP plans. After-tax retirement accounts include things like Roth IRAs, Roth 401ks, and Roth TSP plans. With the after-tax Roth accounts, you’ve already paid tax, so you don’t need to pay tax again. For this reason, the only thing we need to think about with Roth IRAs is being old enough (age 59.5) that we don’t get penalized.
However, with the pre-tax retirement accounts, we have to pay regular income taxes on all the money we take out. Right now, that actually isn’t too bad. If we earn up to $80,250, we’ll pay only about 12% of taxes. If we earn less than $171,050 we’ll be in the 22% tax bracket. If we earn less than $326,600 we’ll be in the 24% bracket. That’s a ton of income, so I it’s not worth look at the 32% tax on incomes over $326,601. This almost guarantees that our effective tax rate would be less than 20%. (If you didn’t know, you pay all the taxes as you move up in the bracket, landing in a high tax bracket doesn’t mean all your income is suddenly taxed at that number.)
It’s hard to imagine we’d make over $326,000 in retirement, but it isn’t impossible. My wife may get a $60,000 pension that’s indexed for inflation. We might have income of $45,000 from rental properties (which will naturally adjust for inflation). We have a few other income sources (blogging, my dog sitting, etc.) that could add up to around another $50,000. My wife may continue to work that brings home an income. That would be around $150,000 before we account for withdrawing money from the IRAs. There’s not much room left in the 22% bracket, but still plenty of room in the 24% bracket.
So we wouldn’t pay too much more than the expected 20% in taxes except for two possible scenarios:
1. The brackets get lowered over time. I think there’s a strong possibility that this happens. We can imagine that at some point we want to fix the national debt and one way to do that is to raise taxes by lowering the bracket thresholds. If the $326,000 bracket gets dropped to $200,000, we might risk running into the 32% bracket easier. Alternatively, the tax rate may go up, which would conceivably be the same thing.
2. At age 70-something, we might have to pay Required Minimum Distributions (RMDs). I write “70-something” because the RMD age has changed recently and there’s legislation for it to potentially change again. In any likely scenario we’d be forced to take a percentage of our nest egg as regular income at age 70 or later. Since my wife and I are 45 years old, we may have 25 years of compound interest. With that much time, our pre-tax retirement accounts could be a big number, leading to taking a big distribution in our 70s. Social Security will still exist (in some form) and some simulations say that will be another $60,000 of income.
Some combination of #1 and #2 will likely happen. It’s always difficult to plan for “what ifs” in the future, but it never hurts to be prepared.
I’ve been writing a ton about taxes, but having access to money earlier rather than waiting until age 59.5 would be ideal. Fortunately, it’s possible to get access to the money early, while also potentially limiting high tax brackets in the future.
There are two ways we can access our IRAs early:
1. We can take Substantially Equal Periodic Payment (SEPP). That means that we commit to taking an amount of money out of our IRAs as determined by an IRS formula. We’d have to continue it until age 59.5 or face big penalties… with interest. It’s not a bad plan, but I don’t like to have to withdraw money based on what an IRS formula says we should. I also don’t like to be locked into 10-15 year decisions.
2. We can use a Roth IRA conversion ladder to move money from our pre-tax IRA to a Roth IRA. We’ll have to pay the taxes on the income immediately, but that sets up two very good scenarios. First, we can withdraw the money, tax-free, after 5 years. Second, we can let the money grow while not having to worry about taxes. The first scenario would give us access to money, penalty-free. The second scenario gives us the flexibility to decide not to take the money if we don’t need it.
I’m 90% sure that the Roth IRA conversion is the way to go. Getting access to money tax-free in 5 years is about as good as we could hope for.
There’s one small problem with a Roth IRA conversion. Paying taxes up-front can be tough. If we were to convert $50,000, we’d have to pay $10,000 in taxes (and we can’t use that $50,000). When you are trying to get through 5 years because you don’t have access to that retirement money, it’s not easy to come up with $10,000. That’s when I had an idea. Since you can take out Roth IRA contributions at any time, we could use our previous Roth IRA contributions to pay off the taxes on our IRAs. Under normal circumstances, you won’t want to pull those Roth IRA contributions out. However, pulling $10,000 out means putting $50,000 in, so I’m sure the personal finance experts won’t mind.
At the end of the day, all this essentially guarantees us paying around a low 20-ish% marginal tax rate, while giving us access to money in five years. Locking in that tax rate now is valuable, because I feel that taxes will rise in the future. Of course, I’ve felt this way for a long time and it doesn’t happen. Politicians don’t like the idea of raising taxes as it’s unpopular with almost all voters. At some point, I think we’ll simply need to do it.