471 | Mailbag: Inflation and FI, ACA Subsidies, Roth vs. Trad and More | Cody Garrett

0:00Hello and welcome to Chooseify. Today on the show we have a mailbag episode where we're answering your questions that you've sent in through my email newsletter and through our feedback at chooseify. dot com email address. And I have my good friend Cody Garrett to help give an expert opinion on this. Cody is a CFP and the founder of Measure Twice Money. He joined us back in episode 352, and he is quite possibly the person that I referenced the most in my newsletter. And he's just putting out incredibly helpful content every single week on Twitter and Facebook. And I'm just so happy to have him here.

0:35And we're going to talk through a bunch of questions, including inflation and financial independence, ACA subsidies and early retirement, tech stock over concentration, capital gains taxability, and Roth 401k versus Roth IRA. This is going to be a really wonderful episode. And with that, welcome to ChooseFI.

1:01Cody, thank you for being here. I am so excited for this. Yeah, it's so nice to be here. Again, the Chooseify community is like, I wish that was my neighborhood. These are my people. So I'm really excited to be here. Oh, I love that. I love that. And it's funny because in 2024 and beyond, I'm actually really focusing on our Chooseify local groups. So to hear that this is my community, this is who I want to live near in essence, right? Be part of my life. That's something I'm really working on in 2024. So all right, Cody, let's get right to it. We have five questions, ideally, that we'd like to get to.

1:33So the first one came in from Wilson and Wilson said something that seems to come up a bit in the Facebook group is the concept of how inflation affects your FI number, especially if you're a long way from achieving that number or determining when you're close FI. You always discuss this by using a 7 % return rate because that is a real rate of return already subtracting out inflation. I think some people get confused and think that you also need to inflate your annual spending to get your true costs, say 30 years from now. My understanding is that if you use six or 7%, you basically are projecting what would be the same spending power in the future, as opposed to the actual dollar value.

2:11This might be something to clarify on the podcast sometime. So, okay, Cody, this is the time to clarify. Let's go through Wilson's question. And I guess, how would you quick hit respond to this? Like any thoughts or anything that jumps out to you that you'd love to kind of correct the record on? Yeah, so this is a great question. I mean, just mad respect for the people writing in because they ask great questions that we should be asking, but we aren't often. So this is a great observation, actually, for two reasons. Number one, so as you mentioned, Wilson, although the US stock market, we typically focus on VTSAX and some of these broad market index funds, that's historically achieved average annualized total returns over 10%.

2:52You hear people say all the time, oh, the market does 10%, right? But the average annualized inflation adjusted return, as you mentioned, the real return has actually been 7%. So you can see a big difference there. And as you know, over long periods of time, that difference can make a big difference. So we want to ensure that we can maintain purchasing power. And we know that compounding effect of those small percentages over many decades. And the second reason your observation is fantastic is that that 4 % rule, that 25 times expenses that we often use within our community to calculate our FI number, that accounts for inflation adjustments, but only once retirement distributions begin, not between now and retirement.

3:31So we need to account for inflation on the path to retirement, not just through retirement. So many DIY investors within our community, we're assuming that our FI number will be 25 times our current expenses, not our future expenses. And we don't want to be unpleasantly surprised if we realize that we're behind because we haven't accounted for that 2 % to 3 % annualized inflation rate. So Wilson, I think your understanding is correct, but I actually want to do some clarification. You know, without getting too deep into the numbers, there are actually three calculations required to determine if you've reached Coast FI adjusted for inflation.

4:05And by the way, I actually have a Coast FI inflation adjusted calculator we can put in the show notes if people want to nerd out a little bit. Okay, awesome. We will definitely have that in the show notes. So you can always find that on choose to buy.com or just on the show notes on whatever podcast player you're listening to this on. Yeah. So the calculations that go into it, there are three calculations and you know, the calculator, of course, will do it for you. But I think it's important for us to understand where does inflation come into the calculation? Because I think what you're mentioning, Wilson, is a lot of people, they consider inflation three times.

4:36Like they overcompensate because they're maybe they're worried about inflation. So they keep adding inflation to the calculation, even though it's already in there, right? So the first calculation is simply to understand the future value of your current expenses adjusted for inflation. So let's say I needed to distribute$75 ,000 a year, right in today's purchasing power, but in retirement 15 years from now. So the first calculation I have to do is what is$75 ,000 of purchasing power 15 years from now, I would actually need to distribute over$113 ,000 and the first year of retirement 15 years from now, assuming a 2.8 annualized inflation rate.

5:14Okay. So Cody, just real quick for anybody, obviously they can go to your calculator, but if they had just like a regular calculator or Microsoft Excel, is that just the 75 ,000 basically times 15 years raised to 1.028? Right. And it's actually even easier in Excel because you can do a, it's called a future value calculation. Nice. Okay. Very cool. So if we wanted$75 ,000 of purchasing power 15 years from now, we might actually have to distribute$113 ,000, not even including taxes or things like that. So the first calculation is saying, what is my annual spend inflation adjusted for when I want to retire multiple years from now?

5:51The second calculation, you need to calculate the portfolio balance that you need to have in your first year retirement. So that's like your FI number, but it's actually your FI number when you retire, not as of today. So the investment return variable is adjusted for inflation again in this calculation, since inflation also affects your purchasing power throughout retirement, not just between now and when you retire. So these first two calculations say, okay, inflation on the path to retirement and inflation all the way through retirement. And then the third calculation is that you need to calculate your Coast FI number, right?

6:25How much you need in your investment portfolio today to not need to make any additional contributions. Since the previous calculations to and through retirement already included the inflation adjustment, you don't have to do it again. So the calculator we'll share in the show notes, we'll do all that for you. But I want to let you know that we want to make sure that we don't add inflation to that final calculation, because that would actually make you seem like you need more money than you actually need to. Okay. That is very, very interesting. There's a lot, a lot in there, obviously. So we could say it in a different way too.

6:57Yeah. Well, yeah. And let's try that. So as I think about inflation and your FI number, you always hear it in two different ways. And again, this, I would love your clarification on, are we overthinking this? Are we being too conservative? Are we basically building it in multiple times? So the ways that you generally hear about inflation is like you said, the total return is probably closer to 10%, but the inflation adjusted real return is probably closer to 7%, maybe a little bit higher. So generally, when you are trying to figure out your compounding using, let's say the rule of 72 or something, if you said, okay, I'm going to get a 7 % real return, your money would basically double every approximately 10 years, a little bit more than 10 years, just 72 divided by seven.

7:44So as I'm understanding this, inflation is built into that already because now you've reduced it to get down to real return. So, okay, that's how I think about it in one, but then you also hear people talking about, okay, well, my return is actually going to be seven or 8%, but I'm only withdrawing three or 4%, the safe withdrawal rate, whatever you decide that is. And since we've been talking about 25 times, we'll say 4 % rule of thumb. So 4 % withdrawal rate. Most people say, all right, you're only doing 4 % because you're building in some cushion for inflation between your total return of 7 % or 8 % and your withdrawal rate of 4%.

8:25Now, Cody, as I'm hearing you describe over the last five minutes, I'm wondering if, are we baking in this in twice? Maybe this comes back to a confusion a little bit about the 4 % rule. I think understanding that the first of all, the 4 % rule is inflation adjusted in its white paper, right? But at the same time, the 4 % rule also is a different portfolio. We've effectively in the FI community use it as a rule of thumb for just saying, are we going in the right direction? So our 25 times expense is the 4 % rule. It's just a place to start. And actually, this is a great point. I know this is a little sidebar, but it's really important that we don't ignore other future income sources when calculating your COST-FI number, because your safe withdrawal rate might actually be much higher than 4 % in early retirement and then decrease much lower.

9:12For example, social security, right? I would just tell everybody here that the 4 % number is just giving you general guidance of how to think about, do I have enough? But no, it's probably not a good idea to try to go strictly with the 4 % rule through the end of life. Right. Yeah, it's interesting. I think a lot of people in the FI community basically completely discount Social Security as if it's not going to be there. And I think, obviously, we can never fortune tell what the future is going to be. But it seems even if it goes, quote unquote, bankrupt, it seems highly, highly, highly likely, at minimum, we're going to get 70 % of what we expect as of today.

9:48Again, not prognosticating, you can't know what the political future, that's not a game I play. But many, many experts suggest that that's essentially a worst case scenario, barring some catastrophe. So I think most people in the FI community that I talked to, Cody, counted as zero in their projections, which is kind of ludicrous. Yeah, I think you're right that social security, I always call it the, you know, it's the gravy on the mashed potatoes, right? It's not the main course. So, you know, I've always said, you know, it's a nice thing to have. And the taxes that come along with it are a nice problem to have, you know, kind of closing this conversation about inflation adjusted returns.

10:23Keep in mind that, that 7 % average, average doesn't mean it happens every year. There's been a lot of content around this of averages versus annualized returns and things and ranges. But for example, the S &P 500, that US stock market index, the average has been 7 % real return, inflation adjusted, but the range of annualized returns over 35 year periods has been between 5 % and 10 % real return. So seven is like everybody kind of does the middle number, the seven. But I mean, when you're playing around with a calculator, like why not look at what happens more conservatively, right? Say what happens if it's 5 % real return?

10:58What if it's 10, right? So create a range for yourself and start to think, hey, if I did get 5 % instead of seven, how could I adjust my life to maintain my early retirement objective? And Brad, to come back to your question about 4 % versus 7%, 7%, we think about this as an average, but in retirement, when you're taking distributions in retirement, you have to be worried about this thing called sequence of returns risk. So that difference between the 4 % and 7 % is really helping with the variability of returns, especially in the first decade of early retirement. Okay, awesome. Cody, that's really, really helpful.

11:30I think we answered Wilson's question. And who knows? I'll go to Steve next time. Yeah, well, yeah, you never know. There might be follow-ups. I suspect there might be. So it's a really important thing. It certainly is. So, okay, let's move on to question number two. This came in from Jennifer. Jennifer said, I'd really appreciate if you could outline how an early retiree should approach planning for strategic withdrawals while considering the potential benefit of ACA subsidies. I'm sure that the advice will need to consider what is available in the pre-tax, post-tax, Roth buckets, but let's assume there is enough in all three buckets.

12:02So, okay, Cody, we're talking ACA subsidies, so basically for healthcare premiums. I know a lot of people who are in their working years and basically have to pay their own premiums are looking at$1 ,500 a month for families. And obviously, this is a massive, massive line item in people's budgets. But with the potential for having lower dramatically reduced income, there's a potential for significant subsidies bringing that down close to zero. But like Jennifer is saying, you don't want to mess it up, right? So there's a lot to consider here. Yeah. So the ACA health insurance subsidy, technically, this is called the premium tax credit, the PTC.

12:42You'll see that on the IRS tax forms and things. So your eligibility for this credit is based on your family size, your age, your income, and where you live. So we'll talk about some of those variables a little bit. But keep in mind, this is a credit. So a credit, a tax credit reduces your taxes owed dollar for dollar rather than a deduction, which just reduces the amount of income that's taxed. So with a credit that could be this substantial, it may be worth prioritizing this in early retirement. And I would say, yeah, most people, if they don't plan around this, this will be their highest expense.

13:14I've met many families where their monthly premiums exceed their mortgage payment. And they didn't expect that. They always expected housing and transportation to be up there. But really, if you don't have a plan, the plan will hit you over the head. So individuals and families can actually save over$10 ,000 per year on their health insurance premiums through the health insurance marketplace. So that's the place where you go shop in the public. Some people call it the exchange. By having control, you have to have control over what's called your modified adjusted gross income. For most retirees, this is just a fancy way of saying your adjusted gross income.

13:49And most people aren't going to have tax-exempt municipal bond interest or social security because they're in early retirement. And sometimes they're controlling income that they don't need municipal bonds necessarily. So effectively, your income plays a huge role in this because your income currently has to be between 100 % and$400 percent, the federal poverty level to receive an ACA subsidy. And right now there's actually no ceiling on that 400%. So you can get a little bit higher than that. But let's assume, like you said, you have a nice balance of pre-tax, taxable and tax free buckets, which is the, you know, everybody wishes they had that in early retirement.

14:25Hopefully you do. So here's what I call the standard distribution order of operations for maximizing those credits. So, you know, you kind to do this in the order of what has the least amount of tax impact first. So first, you're going to start by distributing the ability to maintain your desired lifestyle and living expenses by just taking money out of your savings account, your checking account, and your taxable brokerage account, possibly using tax harvesting or really trying to take the most amount of money with the least amount of tax consequence first out of those taxable brokerage accounts.

14:56If you need more money to maintain your living expenses, which is the most important thing right here, right? Living in retirement is more important than saving some taxes. Of course. So the next step after savings checking tax or brokerage accounts is taking money out of those pre-tax retirement accounts, assuming you have access. Some of those ways to access an early retirement, rule of 55, substantial equal periodic payments. If you have a 457B, there are some options there that I'm sure, Brad, you probably covered on a lot of other podcast episodes. You know, and by the way, the third would be Roth accounts, Roth accounts, and also your HSAs, your health savings accounts.

15:32But that's a last resort. Most early retirees are able to maintain their lifestyle with just checking savings, taxable brokerage, and pre-tax accounts if necessary. So once you've met your living expenses that you need, then you say, okay, where does my income sit? You need to include your interest and dividend income for your taxable brokerage accounts and things. But once you figure out where you sit, you can go to healthcare.gov forward slash C dash plans. C like S-E-E, Cody? Yeah, C. I can see it. I can see it in the future. So you can actually research the cost of the health plans and also your healthcare subsidies year round, not just during open enrollment.

16:10So if like in the middle of March, you can go kind of estimate what it might be for the year. So once you've met your living expenses, then you can figure out, okay, sometimes you actually might need more income to get above that 100 % of the poverty level for your family size. So that might mean doing some Roth conversions or selling more stocks in your taxable brokerage account with unrealized capital gain. So you always prioritize your lifestyle. And then you say, how else do I need income? Or by the way, you might've already hit where you're like adding more income would reduce your credit.

16:41So maybe you don't want to do more. So effectively, it's get enough to live and then figure out how much more income you need, whether from Roth conversions or selling more stocks with appreciation. Yeah, very, very interesting. And there's an interplay here with a future question we're going to tackle on this podcast. Maybe we'll just do it next. That's coming in from Josh. So I like how you set this up where you're talking about taking from the certain buckets first before maybe doing a Roth IRA conversion or creating a taxable event from a pre-tax account. I think that's one of the most important clarifications here is when you pull money out of a traditional IRA or 401k, the money that you pull out of that, the entirety of that is a taxable event.

17:25So that is taxable income, 100 % of it, as opposed to when you, let's say, sell from a regular brokerage account, the only taxable event is the capital gains, which is basically the selling price less your basis, which is what you bought it for. So it's a much smaller amount. And potentially if they're long-term cap gains and it can be either 0%, 15%, or I guess 20 % is the highest. Anyway, there are a lot of considerations here, but just super quickly, let's go through, let's say somebody's expenses were$40 ,000 and you're telling them to pull out of certain accounts, but then you want to make sure you get over 100 % of the poverty level, right?

18:06So that would most likely mean you're pulling money out of a pre-tax account. So just quickly talk through that. Yeah. So let's say somebody is just retired. They need$40 ,000 in their first year of early retirement. They most likely have that much money just in savings, checking, and taxable brokerage accounts, maybe without even having to sell anything. So effectively, you're pulling money out of the accounts that don't have any tax consequence to begin with. You aren't taxed on the money you take out. You're only taxed on the things that you sell and the dividends and interest income that you receive.

18:37So let's say that you had to sell things in your taxable brokerage account to get access to that$40 ,000 to maintain your lifestyle. So you'd sell that. I mean, you might have some tax harvesting opportunities to sell some things at losses and some things at gains. But effectively, the goal here is not to do anything tax fancy. It's just saying, how do I get access to the money I need to live as tax efficiently as possible? In your example, Brad, let's say that you only, by pulling 40 ,000 out of these accounts, you ended up having taxable income of$5 ,000. Okay. And that would be capital gains on selling something from brokerage, hypothetically, right?

19:11Right. And yeah, let's say that you have$5 ,000 from that. So that's going to show up as income for these ACA tax credits. But let's say that to get over the 100 % poverty level as an individual, a single, I actually need to have modified adjusted gross income of$20 ,000 to get the maximum premium tax credit without dropping in the Medicaid area. So I have$5 ,000 of income that I took to get my money that I needed for my lifestyle. Now I need$15 ,000 of income from another place to get to that$20 ,000 level that I need to get that premium tax credit. So I'm immediately going to say, okay, how am I going to get$15 ,000?

19:47Usually in early retirement, you're actually going to do this by doing a Roth conversion. So I might do a$15 ,000 Roth conversion from a pre-tax account to a Roth account, withhold 0 % because I don't want to pay the 10 % penalty on even the taxes that are withheld from a conversion before 59 and a half. So with all that said, now I have income of$20 ,000. And this scenario, by the way, I'm single. I've got a standard deduction in 2024 of$14 ,600. I practically have no income tax, right? But not only do I have like no income tax, but I also am getting my health insurance practically free in 2024 rather than paying$20 ,000 for it.

20:29Yeah, that's amazing. And so right, the AGI is before you take the standard or itemized deductions, right? So that's why you started with that amount of saying, hey, it's the 5 ,000 of capital gains plus this extra amount that I need to take out to get over that threshold. I guess the other follow-up question, and we will move on to the other related question, is let's say you mess something up and you're over 400 % of the federal poverty level. Is there like a cliff where it goes to zero and you basically shot yourself in the foot or how does that work? They've eliminated the cliff for now, but the best way to do it, the best way to answer that question, you know, going back to that healthcare.gov forward slash C dash plans is just, you can actually just keep typing in numbers to say, like, you can just, you know, push back and then assume your income and then see what the premium tax credit will be.

21:19And then, you know, just go back and forth and see, I actually make charts. Maybe I can share this as well. Like I effectively make a chart to show like, where is your cliff? Because everybody's cliff is going to be different. It's worth going on the website to just estimate yourself even before you retire to see what might it be like, you know, in a few years when I retire. Cool. All right. I love that. This is really important, everybody. So this is some homework that's actually really worth your time because we're talking, like Cody said, this is potentially a five figure per year issue that you could get these subsidies.

21:50So this is really important to get right. So, all right, Cody, I think we answered that. And let's move on to Josh's question, which really does line up here nicely right after this. So a question I've been struggling to answer is how do I accurately calculate my future retirement tax liability when factoring in multiple sources of income that differ in taxability. Let me explain. When I retire in my early fifties, hopefully, I'll have income from a military pension, rental property, and a taxable brokerage account. I would like to figure out what is considered taxable income in that case. Married, filing jointly, a couple can draw$94 ,050 in 2024 from long-term capital gains without paying a penny in taxes?

22:29How does that change when adding in income from a pension, rental property, and later in life, Roth and traditional accounts? Behind the scenes, I'm trying to figure out if I should be maxing on my Roth or traditional accounts instead. So, all right, Cody, this is yet another really important one. How would you tackle this? Yeah, I think we have to start actually with this important note that taxable income is actually a technical IRS term. So taxable income, a lot of us think of taxable income as income that could be taxable. But in reality, taxable income is not the same as gross income. So we've talked a little bit about these standard deductions.

23:03So when you calculate your taxes in retirement, you start by adding up your various income sources. Then you subtract what are called adjustments to income. In early retirement, usually the only thing you might have is an HSA deduction, a health savings account deduction. Then by subtracting out the adjustment to income, you've arrived at AGI, that adjusted gross income. But then you reduce AGI even further by subtracting the standard or itemized deductions, finally arriving at taxable income. So first, just to clarify that term, taxable income is really important here because taxable income is not the same number as the amount of money that you receive from those various sources.

23:41So the easiest way, if you want to follow along and you're a visual person, the easiest way to understand the taxability of these various income sources is to walk through a federal tax return, a form 1040 line by line. You know, sounds intimidating, but thankfully it's only two pages and maybe we can put in the show notes. I actually have a video just showing literally line by line how I how I do it. Oh, nice. That's brilliant. So you can go ahead and just share that with the community. So I'll walk through that. But to simplify this for you and your situation. So wages from a job, you know, a military pension, net rental income, Roth conversion amounts, those are all included in taxable income.