The majority of workers today do not have a pension plan. Instead, we have either a retirement plan sponsored by our workplace (401k or 403b) or a plan on our own (IRA, Keogh, Roth IRA). In general, tapping into the money in any of these plans before we turn 59 ½ results in a 10% penalty payable to the United States Treasury. For most FIRE savers, 59 ½ is far beyond their goal for financial independence. As a result, it would be tempting to decide to forgo saving in any retirement plan and instead save in a taxable account that one could tap into freely at any time. However, the ability to invest money pre-tax really builds up over time. In addition, any gains in the taxable account would be taxed during the year of those gains. However, this penalty can be minimized by investing in an index fund and never selling until one needs a withdrawal. For example, the typical taxable gains on an S&P 500 index fund amount to about 2% of the value of the investment.
I created a spreadsheet calculating how much money would be saved with the following assumptions: 20 years of saving, an initial pre-tax savings of $10,000 that was increased by $500 per year afterwards and a 7% rate of return. This would have resulted in a present day total of $599,117. I then compared this with an after-tax savings scenario assuming an effective tax rate of 25%. Thus, each year of contributions was reduced by 25%. This would have resulted in a present day total of $449,338. Now, if one were to start withdrawing from these funds, the $599,117 would be taxed as regular income, while the $449,338 would have a taxable capital gain of $228,088. Some employees are lucky enough to receive an employer match in their retirement funds which is essentially free money. If we assume an employer match that caps at $2,000 per year, the same savings scenario would result in present day total of $686.848. So, saving in a tax deferred account can easily result in having 1.33 times as much money as saving in a taxable account. If one has an employer match, one could easily end up with 1.5 times as much money as saving in a taxable account.
Most people believe that capital gains are taxed at lower rates than regular income, and for the most part this is true. However, tax rates do not make up for the extra savings you can achieve in a retirement account. The following numbers are for single filers in 2018. For incomes between $0 - $38,600, the capital gains rate is 0%. For incomes between $38,601 - $425,000, the capital gains rate is 15%. For incomes over $425,000, the capital gains rate is 20%. The following numbers are for married, joint filers in 2018. For incomes between $0 - $77,200, the capital gains rate is 0%. For incomes between $77,201 - $479,000, the capital gains rate is 15%. For incomes over $479,000, the capital gains rate is 20%. The regular marginal income tax rate goes from 10% - 12% for single filers for incomes up to $38,700. The next bracket up to $82,500 is taxed at a marginal rate of 22%. For married, joint filers, the marginal income tax rate goes from 10% - 12% for incomes up to $77,400. The next bracket up to $165,000 is taxed at a marginal rate of 22%.
At these rates, most FIRE savers will pay a capital gains rate of 0%, while having a regular tax rate of around 12%. 88% of $599,177 still leaves $527,222 which is higher than 100% of $449,338. Even for Fat FIRE savers, their effective regular tax rate would would be about 20% while their capital gains tax rate would be 15% (although they would only owe this on about half their money). As we calculated above, one can reasonably end up with 1.33x - 1.5x the money in a tax deferred retirement account as in a taxable account. 80% of 1.33 is still 1.06. This means that after taxes, you would still end up with more money from a tax deferred retirement account than in a taxable account even if the taxable account had a capital gains tax rate of 0%.
But, what about the 10% penalty for early withdrawals? Well, it turns out there is an exception to this penalty called the “Substantially Equal Periodic Payment” (SEPP) program. For a FIRE saver under the age of 55, this would require one to choose one of 3 preset formulas for calculating an annual withdrawal rate and then keeping to this formula until one turned 59 ½. The three formulas are called the: amortization method, annuitization method, and required minimum distribution method. A really good explanation of the various SEPP methods and an illustration of their results can be found here: https://www.investopedia.com/articles/retirement/02/112602.asp. In general, the amortization method appears to generate the highest withdrawal rate, but only by a small margin. On the other hand, the required minimum distribution method results in a much lower withdrawal rate.
The important things to note are that the calculations are based upon the interest rate and life expectancy. The interest rate is the “federal mid-term” rate and is set by the IRS every month. However, one is allowed to choose an interest rate of up to 120% of this rate. For comparison, the SEPP example in the link above used an interest rate of 3.98%. For March 2019, 120% of the federal mid-term rate is 3.1%. So, anyone using the SEPP method today would have a lower withdrawal rate. The life expectancy is set by the IRS, updated once a year, and is found in appendix B of the following document: https://www.irs.gov/pub/irs-pdf/p590b.pdf.
If the amortization method does not generate a high enough withdrawal rate to satisfy your needs, you might be able to increase it slightly by eliminating your spouse as a beneficiary if your spouse is younger than you are. Otherwise, it means you have not reached financial independence. If the amortization method generates a higher withdrawal rate than what you need, you can split off whatever amount of your retirement funds you desire into a separate IRA account. You can then just generate SEPP withdrawals from this account. While it may take some calculation iterations, you should be able to fine tune your SEPP withdrawal rate to any level desired up to your maximum rate.