# Saving for Retirement

Submitted by Don Lloyd on Sat, 2004-04-17 08:20

You want to retire early at the age of 50. You have accumulated a total of $1M in your traditional IRA, which has an internal rate of return of 10% per year.

Assuming no inflation, and no increase in your overall marginal tax rate of 40%, Approximately how many years can you spend $40K per year before depleting your IRA? (this is a trick question)

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## This feels underspecified.

This feels underspecified. But it's a trick question, so I'm sure that's just part of the fun.

Looks like distributions need to be about $74K/yr assuming 10% penalty (early distribution) and 40% tax to get about $40K/yr left for spending. But at that rate the IRA balance will keep growing, just barely.

I haven't accounted for the eventual mandatory distributions. Is that why it's a trick question? But I don't know the out-of-IRA rate of return.

## perpetuity? (i'm assuming

perpetuity? (i'm assuming alan greenspam will never die, in my calculation.)

## quote: "You cannot make

quote: "You cannot make penalty free withdrawals until age 59 1/2 (with some exceptions)."

From here: http://www.cascadebank.com/personalbanking/roth_traditional.cfm

## All three comments are

All three comments are largely correct, although the Cap'n's numbers may reflect a different set of assumptions. The question turned out to be too tricky even for my excel spreadsheet, as it insisted in adding in inflation, placing the blame where it belongs. (-g-)

Changing the question, write an equation that relates the total withdrawal (WD) required for a given spending level (SL), to the marginal tax rate (MR) and the early distribution penalty rate (PR). Assume no deductions or required distributions, no estimated payments or late payment penalties, no withholding.

Regards, Don

## Don, I am confused as to

Don,

I am confused as to what the 40% tax rate applies to. If you are retired, it won't be towards income. Is this tax rate for capital gains from the IRA?

## Jonathan, "I am confused as

Jonathan,

"I am confused as to what the 40% tax rate applies to. If you are retired, it won?t be towards income. Is this tax rate for capital gains from the IRA?"

No, there are effectively no capital gains in an IRA, for tax purposes. Every dollar withdrawn from a traditional (tax deferred) IRA is taxed as ordinary income.

Regards, Don

## Don, No, there are

Don,

No, there are effectively no capital gains in an IRA, for tax purposes.Oh yeah, * slaps forehead *. (You can tell I don't have an IRA.)

Let me think about this some more.

## WD = SL / (1-MR) /

WD = SL / (1-MR) / (1-PR)

...where MR and PR are expressed as fraction.

This yields the same numbers as the Cap'n.

## So you generate $100K/year

So you generate $100K/year from the $1 million? Case closed.

You can withdraw $40/year indefinitely.

You never touch your principle while withdrawing $40k per year. A forty percent tax rate reduces your "take-home" to $60k/year, but so what? That's well above $40k.

The real trick is getting the 10% return, relatively risk free, each year. If you tell me how, I'll retire tomorrow at age 51.

## Jonathan, "... WD = SL /

Jonathan,

"...

WD = SL / (1-MR) / (1-PR)

?where MR and PR are expressed as fraction.

This yields the same numbers as the Cap?n.

..."

I get different numbers with

WD = SL/(1-(MR+PR)). but I could be wrong again.

Regards, Don

## Don, I (and maybe the Cap'n

Don,

I (and maybe the Cap'n too) was assuming wrongly, for whatever reason, that the taxes and penalty would be applied 'in sequence' rather than on the original amount of withdrawal.

It makes sense that both would be applied to the original amount of withdrawal. Your equation works.

## All, The key point is that

All,

The key point is that if all of your savings are in a tax deferred account, you have to deplete your account by twice the amount you spend (for a total tax and penalty rate of 50%).

If you want to spend n% of your account per year, it has to have an IRR of 2n% to hold its value.

The problem, of course, is that you are effectively paying taxes on taxes.

The answer to the problem is to always try to have enough non-tax-deferred savings in order to pay the taxes. This is the domain of the ROTH IRA, whose earnings grow tax free, at least until they change the law. Since there are income restrictions on being able to contribute to, or convert (most likely partially) to a ROTH IRA, it should be taken advantage of whenever possible.

If you have a 401(k), this usually eventually turns into a traditional IRA, so it applies to you too.

The ROTH IRA is especially useful when used in conjunction with a portfolio of highly speculative and volatile stocks in the traditional IRA.

In the first quarter of the year, partially convert your speculative stocks that have crashed into a ROTH. If they continue to fall or fail completely, re-characterize (undo the conversion)them back into the traditional IRA in the last quarter of the year. If they recover, you have paid tax on them when they were at a low level when you converted them. One stock that makes a 10X or 20X major recovery in the ROTH can make up for several that just go away. After a ROTH account has been opened for 5 years, the amount of the original conversions or contributions (exact details uncertain) can be withdrawn without tax or penalty even before age 59 1/2.

Regards, Don

## <blink, blink> They *tax*

<blink, blink> They *tax* the *penalty*? Bastards! This is why I don't do my own taxes, I just can't take it...