Mad Fientist

Retire Even Earlier Without Earning More or Spending Less

After finishing the Lab Rat and Assumptions post, I was anxious to start experimenting with the example scenario so I decided to apply some of the optimizations described in a few of my previous articles to see how they affected the lab rat’s journey to financial independence.

Triple Value of Income

In the Triple Value of Income article, I showed how to dramatically increase the value of your earnings by utilizing various tax-advantaged accounts and retirement incentives.

Let’s assume after reading this article, the lab rat decides to take advantage of his employer’s 5% 401(k) match. He knows he should contribute more than 5% though so he decides to fully max out his 401(k). This results in an annual contribution of $20,500 ($3,000 from his 5% employer match and $17,500 from his own pre-tax contributions).

Traditional IRA vs. Roth IRA – The Final Battle

Let’s also assume he decides to max out his IRA during his working years. Using what he learned in the Traditional IRA vs. Roth IRA article, he decides to fund a Traditional IRA, rather than a Roth IRA, because he knows he can convert the Traditional IRA to a Roth IRA after FI, tax free. Smart guy.

Ultimate Retirement Account

After reading the Ultimate Retirement Account article, he realizes that a Health Savings Account (HSA) is the Clark Kent of retirement accounts (it’s actually a super IRA, in disguise) so he decides to contribute the maximum of $3,250 to his HSA every year as well.

Graph

The following graph shows how these optimizations affect his path to financial independence. The green line in the graph is constructed using the unaltered data of the Lab Rat and Assumptions post, the bars in the graph are constructed with the updated data described in this article, and the dashed red line represents the amount he needs to achieve FI.

Financial Independence Graph

Retire Earlier

As you can see, it’s possible to retire over two years earlier, simply by taking advantage of common retirement incentives and tax-advantaged accounts! It’s pretty amazing that he can take years off of an already short working career without earning more, spending less, or taking on any additional risk!

Taxes

The reason these seemingly subtle changes have such a big impact is because they decrease the amount of money spent on taxes and therefore, increase the amount of money invested.

When we look at the graph representing the amount of tax paid in each of his working years, we can see he is paying nearly $5,700 less per year in the updated scenario than he was in the original scenario.

1-Year Tax

Combining these tax savings with his employer’s 401(k) match, the lab rat is able to invest almost $8,700 more per year than he did in the unoptimized scenario.

1-Year Investments

Eventual Taxation?

I can hear you ask, “Since most of his money is in tax-deferred retirement accounts, won’t that money be taxed eventually?”

No, actually.

Based on his living expenses and the fact that he won’t be earning any more money from employment after he reaches FI, he’ll be able to slowly convert his tax-deferred accounts (401(k) and Traditional IRA) into a Roth IRA, without paying any tax on the conversion (see the Traditional IRA vs. Roth IRA post for more information on this conversion). Based on the amount he will need for living expenses and the current tax laws, he would be able to convert over $9,750 per year, tax free.

Early Withdrawal Penalties?

Since most of his money in the updated scenario is in tax-advantaged retirement accounts, you may wonder if he will be forced to pay early-withdrawal penalties when he withdraws money from these accounts before standard retirement age.

No again!

Roth IRA Conversion Ladder

To access the money in the retirement accounts prior to standard retirement age without paying any penalties on the distributions, he can create something called a Roth IRA conversion ladder.

Thanks to the way Traditional IRA to Roth IRA conversions work, you are able to withdraw converted money five years after the conversion date, tax and penalty free. So in this example, assume that he converts his entire 401(k) to a Traditional IRA when he achieves FI and then, every year after that, he moves $9,750 from his Traditional IRA into his Roth IRA. He would only need to do this for five years before he could then start withdrawing $9,750 per year, tax and penalty free!

Since his taxable accounts will provide enough income to sustain his first five years of early retirement and the Roth IRA conversion ladder distributions will help ensure that he has enough money to live off of until standard retirement age, there’s no reason he shouldn’t max out all of the available retirement accounts and retire over two years earlier!

Surprised?

I don’t know about you but I was actually a bit surprised to see how much of an impact these changes had on this hypothetical scenario. I know tax-advantaged accounts can really help supercharge your retirement savings, which is why I’ve been maxing out mine for years, but I didn’t expect the strategies described in the various articles to take over two years off of an already extremely short working career.

I’m looking forward to experimenting with more optimizations in future articles, in an effort to make the lab rat’s career even shorter (and hopefully yours and mine as well).

Were you surprised by the impact of these optimizations? Will it make you think twice about taking full advantage of retirement accounts in the future?

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Posted by The Mad Fientist in Optimizing 9

One of my primary goals as the Mad Fientist is to discover interesting and innovative ways to reach financial independence sooner. Since a lot of the strategies and tactics I describe are best supported with examples, I usually find myself writing the same example setup and discussing some of the same assumptions over and over again. Rather than do that with every article, I would rather have a single post to refer to instead.

Having a single post would also allow you to challenge and discuss the assumptions in a place where future readers would be more likely to see it. For example, on the Shortest Path to Financial Independence post, people quite rightly challenged my assumption that 4% is a safe withdrawal rate for retirement accounts. When writing a new article that references the 4% withdrawal rate again, it would be beneficial if those types of comments were visible to future readers instead of being buried deep in the comments of another post.

I also think it’s important to have a consistent example scenario to work with. If I use the same scenario in each post, I will be able to quantitatively compare the benefits of the various strategies I describe.

This post will serve as a summary of all the assumptions I use in my examples and will also describe the example scenario itself. I will continue to add to this post and update it, as necessary.

Your feedback is very important so please let me know if you disagree with any of my assumptions or can think of any reasons to change the example.

Assumptions

Withdrawal Rate

The first assumption I’ll discuss is the 4% safe withdrawal rate. This tends to be one that is frequently contested so I’d like to reference some arguments for and against the 4% rule.

For
- The Trinity Study
- Mr. Money Mustache
- JLCollinsNH

Against
- Financial Mentor
- Schof

I agree with both MMM and Jim that the 4% figure is actually quite conservative for early retirees (see articles above for reasons why) so I am happy to assume a 4% withdrawal rate.

Rate of Return

In all of my examples, I assume an after-inflation portfolio return of 5%. By using the real rate of return, I don’t have to factor another figure into my calculations to account for inflation. By picking a reasonably conservative figure of 5%, I can also assume this figure accounts for fees and transaction costs, without having to explicitly factor those values into the calculations.

Example

Age

Our lab rat is a 30-year-old male who is going to live to be 90, lucky guy.

Income

He is currently working and makes $60,000 a year. I chose $60K mainly because 60 is a highly composite number that is evenly divisible by many other numbers (i.e. 1, 2, 3, 4, 5, 6, 10, 12, 15, 20, 30, 60) so it will work nicely with percentages.

Taxes

If we assume that he is single with no children, he should be taxed $8,600 per year on his wages, for a marginal federal tax rate of 25%.

Based on his income, he will also need to pay $4,600 per year in FICA tax for Social Security and Medicare.

To make things simple, assume he lives in a state that does not collect state income tax.

Spending

He is able to happily live off of $1,400 per month, or $16,800 per year. This level of spending corresponds to a before-tax savings rate of 50% and an after-tax savings rate of around 64%.

Investing

After spending and taxes, he invests the entire surplus of $30,000 per year into a portfolio consisting of 75% stocks and 25% bonds. To limit transaction costs and management fees, he invests in a total stock market index fund and a total bond market index fund to obtain the 75/25 balance.

All investments are in taxable investment accounts.

FI

He is starting from scratch on his path to FI at age 30 so he has no savings but no debts either. Using the assumptions described above, here is a graph* illustrating his path to FI:

It’s pretty amazing that even starting from scratch on his 30th birthday, he should be able to reach FI before he turns 41 and will leave over a million of today’s dollars to his heirs after he’s gone.

I’m looking forward to applying some of the optimizations I’ve already written about to this example scenario to see how much sooner he could reach FI.

Let me know what you think.

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* The graph represents a simplified example of portfolio growth. In reality, a mixture of stocks and bonds would not produce consistent 5% growth, year after year. To see how this portfolio would have actually performed over multiple 50-year historical periods, click this link to FireCalc and then press the Submit button to generate realistic graphs using the parameters described in the article.

Image: SMercury98

Posted by The Mad Fientist in Planning 27

Afford Anything – Dive Into Real Estate Investing

Paula from AffordAnything.com joined me for an episode of the Mad Fientist Financial Independence Podcast to talk about how she’s investing in residential real estate in order to achieve early financial independence.

Paula describes how she got started in real estate and highlights the importance of taking action when opportunities arise. She also discusses some of the mistakes she’s made and offers advice for people thinking about investing in real estate.

Our conversation really changed my mindset about real estate investing (and seizing opportunities in general) so I hope you find it as interesting and inspiring as I did!

Click here to listen now!