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