A Tax Deferred is a Tax Avoided?
Updated: Mar 7, 2019
There are a lot of tax deferred retirement plans available, but in order to participate, your employer has to offer them. Money put into tax deferred retirement plans is not taxed when it is earned and any investment gains are not taxed either. When you look at those retirement plan statements, it is easy to think the money is all yours. However, a tax deferred is not a tax avoided. It is merely a tax not paid yet. Once you start withdrawing the money, the withdrawals will be taxed at ordinary income tax rates. The good news is that withdrawals will not be subject to FICA taxes.
In general, it is a good idea to save as much as possible in tax deferred plans. $1 in a tax deferred plan that gains 8% every year would be worth $4.66 after 20 years. If you then paid a 25% tax on it, you would be left with about $3.50. $1 in a taxable account that gains 8% every year would really gain 6% every year if you had an effective tax rate of 25%. After 20 years, the taxable account would be worth about $3.21. For most savers, it is highly likely that their withdrawal rate will be lower than their working salary, so their effective tax rate in retirement should be lower than their effective tax rate while working. Of course, the Government could always enact a large tax increase just as you are set to retire.
The problem for FIRE savers is that the goal is to retire before age 55. The earliest one can access tax deferred retirement money without restriction is at age 55 and even then, only if you are still employed by the plan sponsor when you turn 55. Otherwise, you have to wait until you are 59 ½. If you want to start withdrawing your money earlier, you will either pay a 10% penalty or you will have to withdraw money according to 1 of 3 preset formulas that most likely will not align with your desired withdrawal rate.
So, if your goal is to retire before the age of 55, you should save in a tax deferred retirement account and in a taxable account. The money in the taxable account will need to last from retirement until age 59 ½, and then the money in the tax deferred account can be used to take you the rest of the way. There are financial drawdown calculators such as https://financialmentor.com/calculator/retirement-withdrawal-calculator that can help you find the right balance.
Consider the following: you want a spend rate of $50,000 per year (because you are depleting savings, your income tax will be negligible), you found a real estate investment trust that pays 7% (like https://www.richuncles.com/), inflation is 3%, you want to retire at age 50, and you expect to live to age 95. The calculator tells you that you will need to have saved a bit less than $425,000 in your taxable account to last you from age 50 to age 60. At this point, the after tax savings would need to generate $59,000 of income because this money would all be taxable. So, now at age 60, you would need a bit over $1.5 million (as calculated in future inflated dollars) to last you until the age of 95. If you started collecting $1000 per month in social security at age 62, you would only need a bit over $1.25 million (as calculated in future inflated dollars).