[Update in March 2021: I followed this strategy in 2019 and 2020. I’m including the minor tweaks I made in the last two years.]
We’re in the 4th quarter now. It’s time to plan for the next year. When I left my full-time job in April, I still earned enough to cover our expenses for the rest of the year. Next year will be the first full calendar year in which we will be 100% part-time self-employed. As things stand now, and for the foreseeable future, we don’t expect the self-employment income to be able to cover our expenses.
Spending more than we make is quite a change from living below our means. Unlike others who are able to cover their expenses by a pension, a spouse’s job, self-employment, or real estate rental, maybe supplemented by spending some dividends, we will actually start withdrawing from our investments.
Many say managing portfolio withdrawals is much more difficult than saving for retirement. I disagree. It’s just different, something you’re not used to, which requires some planning, a different setup, and some finetuning as you go along. Saving for retirement was also confusing for us in the beginning until we figured it out after some stumbles. Now we already have a lot more knowledge and years of experience in managing our money. Not everything is new.
After thinking for some time about how we will do it, I came up with a plan. I’m sharing our setup here. It’s not going to be the best for everyone. Only we are going with it. As you’ll see, it’s not hard at all, and many parts are still familiar.
Self-Employment Income To Roth Accounts
We will continue maxing out all eligible retirement account contributions from our self-employment income. Because we don’t make much from self-employment, nearly 100% of that income will go into our solo 401k and Roth IRAs. To the extent we can, we will make Roth contributions because we will be in a lower tax bracket. These Roth contributions will help fund our retirement in the future.
Because we have a choice between making traditional or Roth contributions, these contributions also become a lever we can use to make our taxable income higher or lower. If we want our AGI higher we’ll make Roth contributions. If we want it lower we’ll make some traditional contributions. For this reason, we will delay making our IRA contributions to between January 1 and April 15 in the following year when we’ll have a better picture of our income tax situation, whereas we used to make the IRA contributions early in the current year. It’s possible to go ahead with contributing to Roth IRAs early in the year and then recharacterize as needed, but it’s too much hassle for too little gain.
Retirement contributions will also possibly qualify us for the saver’s credit when our income is low enough to reach into its 10% tier (AGI $66,000 for married filing jointly in 2021). Coincidentally that number is very close to ACA’s 400% FPL number for a household of two in the lower 48 states.
[Update in 2021: 2019 retirement contributions went into Roth accounts. 2020 contributions went into Traditional accounts because we had a one-time capital gain from selling our house when we moved. The Traditional contributions lowered the capital gains tax. We qualified for the ACA health insurance tax credit in 2019. We didn’t qualify for it in 2020 due to the capital gain from selling our house.]
We will invest 100% of the retirement account contributions in bonds, for reasons that I will explain later in this post.
Other than delaying the IRA contributions to the following year, this part isn’t much different than before. Maxing out all eligible retirement account contributions is still the modus operandi. We were doing backdoor Roth before. Now we will make direct Roth contributions.
For those without employment income, this part can be replaced by Roth conversions to take advantage of lower tax brackets.
Spend From Cash Accounts
We will have a conceptual spending account for paying bills. This can be a combination of a checking account plus a savings account or a checking account plus a money market fund. Before the year starts, we will fill this up with the anticipated spending in the upcoming year. Money for spending later in the year will go to the savings account or the money market fund, or very short-term, 3-month or 6-month, Treasury bills or CDs (see Treasury Bills vs CD vs Money Market).
Interest and dividends from our taxable investments will also drop into the spending account. Any money left unspent at the end of the year will roll over to the following year. It will reduce the required fill-up for next year.
Other than filling-up once a year versus twice a month from paychecks, the spending part also isn’t that different than before. As an alternative, we can set up automatic withdrawals from our investments on a schedule once or twice a month to mimic the “paychecks” behavior. We choose not to do that because we think that’s too rigid for us. Filling up once a year should work just fine.
[Update in 2021: We used Treasury bills and a money market fund before their rates went to zero. Now we use a savings account that pays 0.5%.]
Variable Percentage Withdrawal (VPW)
“How much can you safely spend?” is a question with no precise answer, because we don’t know how the future will play out. We choose to follow the Variable Percentage Withdrawal (VPW) method collectively developed by a group of Bogleheads.
We like the adaptable nature of this method. Every year you take a look at the total portfolio value and then you multiply it by a percentage you look up in a table based on your age and your asset allocation. That’s the amount you can spend this year. When your portfolio value is up, the amount you can spend goes up. When it’s down, you spend less. You don’t automatically ratchet up your spending by inflation every year.
For instance a 40-year-old using an asset allocation of 70% stocks 30% bonds can spend 4.4% of the portfolio value next year. A 50-year-old using an asset allocation of 60% stocks 40% bonds can also spend 4.4% of the portfolio value next year. A 60-year-old using an asset allocation of 50% stocks 50% bonds can spend 4.5% of the portfolio value next year.
The tradeoff of this method is that the amount you can spend will fluctuate with the portfolio value. It can go down in consecutive years. It can also stay down for many years when your portfolio value stays down. We’re completely OK with this fluctuation. It’s intuitive when the portfolio performs poorly you should cut back. You just make your budget fit under the calculated amount. It’s like Living Below Your Means all over again.
Because we will spend the interest and dividends from our taxable investments, they count as part of the amount withdrawn.
Annual Fill-Up To Spending Account = Portfolio Value * VPW % – interest & dividends not reinvested – money left over from previous year
[Update in 2021: We’re still using this method. It helps that the portfolio value went up in both 2019 and 2020, which gave us a higher “allowed” spending.]
Withdraw From Bonds In Taxable Accounts
This part is new. Instead of putting money into taxable accounts, we will pull money out of taxable accounts.
We won’t take any money out of our retirement accounts. We won’t do any Roth conversion ladder (convert traditional to Roth, wait 5 years, withdraw from Roth) because we’d like to reserve the money in retirement accounts for years after 59-1/2. In my opinion, if you have to touch the retirement accounts money before 59-1/2, you don’t have enough money saved.
Our taxable investments will be in stock funds and Vanguard Short-Term Inflation-Protected Securities Index Fund (VTAPX, a short-term TIPS fund). Our existing CDs will go into the short-term TIPS fund when they mature. We will also redeem some low-rate I-bonds (0.0% – 0.3% fixed rate) and put the money into this fund. The short-term TIPS fund will be the source of the annual fill-up to the spending account.
We choose to use a short-term TIPS fund because we’d like to have inflation protection and the lower risk of a short-term bond fund. A ladder of Treasury notes or CDs or a different short-term bond fund can also be a good option. We choose a bond fund over a Treasury or CD ladder because our spending can vary greatly from year to year based on the Variable Percentage Withdrawal method. A ladder would only deliver a fixed amount. Of course we can also use a ladder plus a bond fund — the ladder for the basic needs and the bond fund for discretionary spending — but we choose the simplicity of just a bond fund. I don’t think this choice makes a big difference. If you are more comfortable with the predictability of a ladder over a fluctuating bond fund, go for it. If you prefer a different bond fund over a short-term TIPS fund, that works too.
The stock funds in our taxable accounts are for growth. Eventually, the short-term TIPS fund will be nearly exhausted after some years of draining. At that time we will sell shares from the stock funds to refill the short-term TIPS fund.
[Update in 2021: We’re still using this short-term TIPS fund to fill up the spending account, although some replenishments went to add-on CDs we locked in before interest rates went down.]
This setup can be described as a bucket strategy. Stock funds, a bond fund, and cash spending accounts form 3 buckets that cascade down. Although mathematically it can be shown that withdrawing only from bonds followed by rebalancing is equivalent to withdrawing proportionally from both stocks and bonds, withdrawing only from bonds in taxable accounts allows us to control the timing of realizing capital gains. If we withdraw proportionally from both stocks and bonds in the taxable accounts every year, we will have to realize capital gains every year.
Because we don’t have a series of guaranteed payments earmarked by a ladder of instruments such as TIPS, Treasuries, CDs, or annuities, our approach belongs to the probability-based school as opposed to the safety-first school. We choose the conventional probability-based approach because we are comfortable with variance in the amount we can spend. We are not too concerned about having a level of spending guaranteed to us.
Rebalance In Tax-Advantaged Accounts
Because we’re depleting bonds in our taxable accounts by the annual fill-ups to the spending account, we will invest 100% of our retirement account contributions in bonds to partially counter-balance it.
Just doing that isn’t enough. Under normal market conditions, as bonds are drawn down more than the retirement accounts contributions, and as stocks grow, the percentage of stocks in our portfolio will go up. We will rebalance by selling stocks and buying bonds in the tax-advantaged accounts.
This rebalancing part also isn’t much different than before.
[Update in 2021: We rebalanced in the retirement accounts as stocks went up. Instead of adding to bonds, we bought some fixed annuities (also known as MYGAs) because they had a higher yield.]
When Stocks Crash
Stocks don’t always go up. There will be stock market crashes. When that happens, we will sell stocks in the taxable accounts to buy bonds. Yes you read that right. Sell stocks when stocks are down.
Selling stocks when they’re down makes the realized capital gains lower. We will do the opposite in the retirement accounts: sell bonds to buy stocks. That will maintain our exposure to stocks.
This is just rebalancing. Other than the accelerated replenishment of the short-term TIPS fund, it’s also not that different than before.
[Update in 2021: We did this when the market crashed in 2020. Instead of adding to the short-term TIPS fund, we topped up the add-on CDs that we locked in before interest rates went down.]
Many parts of our portfolio withdrawals setup are familiar. There are a few new wrinkles here and there, but they are really not too complicated. A summary can easily fit on an index card:
- Continue maxing out all eligible retirement account contributions. Favor Roth over traditional. Fine-tune after the end of the year.
- Spend from cash. Fill up once a year by the Variable Percentage Withdrawal method. Count interest and dividends not reinvested as part of the withdrawal.
- Don’t touch retirement accounts before 59-1/2. Withdraw from bonds in taxable accounts. Replenish when low or when stocks crash.
- Rebalance in retirement accounts.