Cap'n Arbyte's


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Financing Early Retirement

How much money does it take to retire early? It's actually very expensive, because there are powerful tax incentives against it. Retirement accounts get preferential tax treatment, but have the drawback that your money is locked up until you're old. You can't use them if you retire early. You'll have to do it with regular taxable investments, instead, and any money already contributed to retirement accounts is basically unavailable.

I'm thinking about this because I realized I have enough liquid assets that I could pay off my mortgage if I wanted to. (I crossed the threshold last month but didn't realize it until I was looking at this month's numbers.) I won't do it, because I'm only paying 5% interest and I can easily earn that much in safe investments. The relevance is that the key enabler of retirement is that you have enough money to pay the bills, so the ability to get rid of my single largest monthly bill is an important milestone.

The typical retirement-planning fear, "will I outlive my money?", is more acute for people thinking about early retirement. Because they have a longer remaining lifespan, it's more dangerous for them to draw down their savings. It's preferable to live on the income generated by investments. But how much is needed?

I keep a lot of data on my monthly expenses, so I know with high confidence that I typically spend a little less than $1,000/month on bills, food, and gasoline. Assume another $250/month for transportation (using the nice round numbers of keeping a $30,000 car for 10 years). I like big, safe, round numbers so let's assume another $250/month each for housing maintenance, medical expenses, and entertainment/travel. So with generous padding, my lifestyle costs about $2,000/month.

Of course, inflation will cause my cost of living to rise over time. Let's be pessimistic and assume a 4% annual rate of inflation, and a reasonable 8% nominal rate of return from investments. That puts my real rate of return at 4%. To generate $2,000/month, or $24,000/year, I would need to have $600,000 in regular taxable accounts — after having my mortgage paid off.

Working out some crude projections strongly underscores how despicable the combination of inflation and taxes really is. Inflation creates paper (but taxable!) gains by increasing all prices. Taxes make no distinction between real and nominal earnings, so the portion of nominal earnings that was caused by inflation and does not affect your economic position is taxed just as if it were an ordinary gain.

Here's an example using interest income, which is taxed at the same rate as wage income. If you had $1,250 invested at 8%, it would return $100 over a year. If you were taxed at 37% (Federal 28% plus Oregon 9%) you would be able to keep $63 of that $100. But when you consider the 4% inflation, $1,250 the first year is equivalent to $1,300 the second year. After keeping $63, you have $1,313 the second year. Due to the combination of taxes and inflation, your true rate of return was only 1% — one eighth of what you thought you were making!

If your income was in the form of (long term) capital gains and dividends, taxed at 24% (Federal 15% plus Oregon 9%), you would have $1,326 the second year, for a 2% true rate of return — one fourth of what you thought you were making!

Congress and the Federal Reserve are extremely effective at screwing investors. If there were widespread education on this matter, I wonder how deafening the outrage and demands to go back on the gold standard would be?

Clearly "buy and hold" is a useful strategy, because it allows for a longer period of compounding before the government takes its cut.

I've made some extremely crude projections based on my actual savings rate over the past year with the 2% true rate of return, with the (poor) assumption that there would be no significant changes in my life. And by these projections I could afford to retire in 2016. I would have almost paid off my mortgage by this time, anyway — less than $10,000 remaining. If I stopped contributing to my 401(k) and put that money into a taxable account instead, I could return in early 2015. And if I also stopped contributing to my Roth IRA, it would be pulled in to late 2014. Withdrawing my old Roth contributions makes almost no impact.

How much impact does inflation have? You may be surprised. If inflation was only 3% rather than 4%, my "true" rate of return would increase to about 3% and I would only need to invest $480,000 to generate the necessary income. I project I could do that by the end of 2013 — a little more than two years earlier!

Tiny Island