I promised you a post on TAX MATH — specifically, the math involved in my deciding whether to continue putting money into tax-advantaged retirement savings vehicles — and then I realized that any math involved was going to be fairly easy to break down.
As a self-employed individual, I pay 15.3% tax on all net business income (profit minus expenses). This means that I don’t have to factor self-employment tax into this decision; it gets taken out regardless. Off the top, if you prefer.
From there, I calculate my adjusted gross income (AGI) based on my total income earned minus any above-the-line deductions (the “employer half” of my self-employment tax counts as an above-the-line deduction, btw). This is where traditional and SEP IRA contributions could come into play, reducing my AGI and lowering the tax I owe for that year.
However, I will have to pay tax on those IRA contributions eventually — as well as tax on any investment returns associated with those contributions. If I choose to withdraw money from my IRA before I turn 59 1/2, I’ll have to pay not only tax but also a 10% early withdrawal penalty.
If I wanted to keep as much of my earnings as possible, I would have to bank on the idea that any money put into an IRA would A) remain there until I was at least 59 1/2 and B) withdraw at a lower tax rate than what I’m paying currently.
Otherwise, I’d be better off paying the taxes now and putting the money into the bank.
Let’s look at the second point first:
Right now, I’m earning too much money to take the entire IRA deduction. This means that I am both maxing out my traditional/SEP IRA and paying tax on a portion of the money I’m putting away.
This is suboptimal.
Not because I’m having to pay tax on this money — remember, I’ll have to pay tax on it eventually — but because I am locking up money in a vehicle that will charge me 10 percent if I want to unlock it early, and I’m not even getting the full tax break.
If I had not taken any IRA deduction in 2020, my AGI would have increased by $22,208. However, my taxable income would have remained in the 22% tax bracket, meaning I might have owed an additional $4,885.76.
I mean, that’s not nothing.
If I could guarantee that I wouldn’t need to withdraw any of my retirement savings before I turned 59 1/2, then it could be a cost-saving measure to stash them away.
If I do withdraw some of that money in the next 30 years, paying both taxes and the 10% penalty, I automatically lose.
If I withdraw more than the standard deduction every year after age 59 1/2, I could also lose — especially if the tax rate for that level of withdrawal is higher than 22%.
That’s an unlikely loss, but it’s worth considering.
Of greater consideration is what I plan to do with the next 19 1/2 years of my life.
If I do end up hitting $1M cash net worth by 50 (current cash net worth: $232,591.19), I am very likely going to want to use some of that money. Call it FIRE or LeanFIRE or PartialFIRE or “this is probably the period of my life in which I will be doing more teaching and/or caregiving” or what have you — and keep in mind that I am no longer invested in the market, so I will be spending down my actual cash reserves instead of trying to live off dividends.
At $25,000 a year, that gives me 40 years of potential runway plus the skills to earn more money as I need it (and I understand that I will need to front-load that money-earning, since my capacity to earn money is likely to be greater at 50 than it will be at 80).
Let’s say this costs me an extra $5K in taxes every year — that’s exactly $100,000, between now and age 59 1/2.
(Ten percent of a million, coincidentally enough.)
Is it worth it? That number feels like “too much” to pay, but I’m always going to have to pay something.
It’s also worth asking myself whether I’d have enough income left over, if I put $25,000 of my pretax income into retirement accounts every year, to thrive financially without having to withdraw any of the money until age 59 1/2.
Let’s say I did stick to my plan of increasing my cash net worth by $6,638 every month until I turned 50 (which is what I’d need to do to have $1M in cash on my 50th birthday). That comes out to $79,656 per year, of which ~$25,000 would go into traditional and SEP IRAs and the remaining ~$54,656 would go into savings accounts.
Keep in mind that I’d actually need to earn ~$130,000 to make this work, because ~$25,000 would go towards that year’s cost of living and another ~$25,000 would go towards taxes.
Basically, the math looks like this:
For every year of gross earnings,
— one year’s worth of expenses goes towards expenses
— one year’s worth of expenses goes towards taxes
— one year’s worth of expenses goes towards tax-advantaged retirement accounts
— two years’ worth of expenses goes towards saving for the future.
By the time I turn 50, I should have 22 years of expenses in savings accounts and 19 years of expenses in retirement accounts (the aforementioned 40 years of runway, plus or minus $25,000), which should be fine at any withdrawal rate.
YES, OBVIOUSLY, SOMETHING COULD HAPPEN TO CHANGE THIS PLAN.
EXPENSES COULD GO UP, FOR STARTERS.
EARNINGS COULD ALSO GO DOWN.
But the math seems clear — keep putting money into those tax-advantaged accounts.
At this point I’d invite you to comment and tell me what I haven’t yet considered, but I turned off the comments so none of us would spend all day checking them.
Feel free to email me at firstname.lastname@example.org and let me know what you think I’m overlooking.
I’ll even publish your response on the blog, if it’s worth sharing. ❤️