Eat your cake now or when you are 59.5? Addressing the conundrum

Note: My idea presented in this blog post appears to be fairly original and has received some recent attention in a popular finance podcast; learn more here.

My generation just rejects the idea of putting your head to the grindstone so you can golf and have a luxury hospital bed when you are old. We say: no. We want to enjoy life now. This means being frugal and investing, so we can develop a current stream of income now, and use that stream of income to pay bills, so we can work less. It’s a pretty simple formula, actually.

Except, there is one large obstacle which has been tormenting me lately: the issue of IRA’s (individual retirement accounts). These are accounts where you save money for retirement, but there are penalties for accessing the money prior to age 59.5.

So, you might ask, why not simply avoid putting the money in retirement accounts, since it hides that money away until old age? Well, there are huge tax advantages to putting money in an IRA. So huge, in fact, that depending on your tax bracket, you just have to do it in many cases.

For example, let’s say at the end of the year, I was able to save an extra $10,000 in my savings account. Well, if I keep that money out of my IRA, I’ll only get to keep about $6500 of it after taxes. But if I put it in my IRA, I get to keep all of it. That’s right, I don’t pay any tax. Until I withdraw it later – then I pay tax.

Digging Deeper in the math

So why not just pay the tax now and get it over with? Because, inside an IRA, the earnings also grow tax free until I withdraw them. So that means if my $10,000 sitting in my IRA is earning 10%, I get to keep that $1,000 per year income in the IRA, and keep re-investing it, year after year. So, an IRA with $10,000 in it earning 10% yields an income of $1,000/year tax free.

On the other hand, if I kept that money out of the IRA, remember – I’d only have $6,500 after taxes. And if I invested that in the same investment making 10%, I’d have $650/year in income. BUT I’d also pay tax on that income, and assuming the same tax bracket, I would only get to keep…………. drum roll………… $422.50.

Yes, that’s right. Not only does my $6500 get to be $10,000 inside the IRA, but the income from this chunk of money also gets to be $1,000 instead of $422.50 inside the IRA. That’s more than Double!

I’ll pay tax eventually when I withdraw from the IRA, but I’m operating under the assumption that in my 60’s, I’ll have a much lower living expense and won’t need to withdraw as much as I need to live on now when I have a mortgage and am raising kids. You only get taxed on what you withdraw post-60, not on the whole thing.

So an IRA is starting to look like a pretty sweet thing, isn’t it? Yes, absolutely, except for the fact that I can’t touch the income til I’m 60. If all goes well, that’s fine, but it sure would be nice to use it now if I need to, right?

THE MAGIC MATH: It’s OK to use IRA income now!

So if you do the math, you know what? We can have our cake and eat it too. This has been such a fantastic realization for me. Here’s a real life example.

Let’s say my company is having a bad year and I’m faced with the horror of having to get a “real job.” Will I regret putting all that money in my IRA? Actually, no.

Withdrawing money from the IRA early comes with a 10% penalty. But as you will see, paying this penalty still leaves me ahead compared with not contributing to the IRA at all. Let’s go back to our above example. The $6500 yields $650 if I’m invested at 10%. Assuming now I’m in a lower tax bracket because my business is struggling, let’s use a tax rate of only 20% (fed+state). That $650 becomes $520 after taxes. So if I had kept the $6500 out of the IRA it would be paying me $520 after taxes per year.

EUREKA!

On the other hand, let’s say I do the unthinkable and start living off the income my IRA is generating. I withdraw the $1000/year in income ($10,000 x 10%). I have to pay $200 in taxes (20%) and another $100 penalty (the IRS 10% early withdrawal penalty). That leaves me with $700/yr in income, AFTER TAXES! Hooray!!!

See what happened here? A bit of magic. My IRA can produce better pre-retirement income than an after-tax investment!!! This single piece of information is fantastically comforting.

But the picture gets even better. If there are months or years where I don’t  need the IRA income, it just keeps growing in my account, tax free. So it’s like a faucet I can turn on or off as needed. On the other hand, after-tax income is ALWAYS taxed even if I don’t spend it. It’s ALWAYS taxed. Did you hear me? IRA income is ONLY taxed when I need it. This right here can be the difference (when you take into account compounding) of a HUGE SUM over 30 years.

So this is my big secret for this blog post today: you can have your cake and eat it too. You can take the passive income NOW, if you need it, and still come out ahead compared to not using the IRA. But you can also WAIT and defer that income until later if you don’t need it now, hence allowing it to grow tax-free for decades.

Also, notice something else that’s a bit subtle. My principal that’s earning the income, in my after-tax scenario, is only $6500, whereas it is $10,000 in my IRA. So by using the IRA – even for current income – I’m also sustaining a massive increase in the size of my principal.  This compounds enormously over a 30 year period with tax-free returns.

What about a ROTH IRA?

A ROTH IRA works the other way around: you pay tax now and then never have to pay tax again. ROTH’s are great except they have one big problem. You pay tax now. The traditional IRA allows you to avoid tax as long as possible, allowing your money to go tax free, and saving current tax. I have a finance degree and money now is better than money later. Now, this is a long discussion and one that is beyond the scope of this post. Whether you do better with a ROTH or traditional IRA depends on many factors, including but not limited to: your lifespan, rate of return on investments, how much you want to withdraw in retirement, how risky your investment preference, and several other variables. A big factor is your personal life philosophy. So we don’t get derailed here, I’ll just end this discussion by saying the following: both vehicles are wonderful tools and have their time and place.

The naysayers

OK, back to our discussion (using the traditional IRA model). Many people have told me they absolutely hate my model here. Why? Because of the 10% IRS penalty that must be paid. But these people are making a fatal mistake, in my opinion. They are assuming that more money is always better – even if it means working longer and postponing the enjoyment of life. This is where those on the road less traveled diverge from those on the beaten path. For me, it’s not about maximizing wealth. Think about it. If that was my goal, I would be working 3 jobs right now, I wouldn’t be letting my kids take dance or karate lessons, and I’d be eating beans instead of meat and greek yogurt. See, it’s not all about money. It’s about life. Our lives will end, and we don’t know when that moment will come. Paying the 10% IRS penalty to get at my income now is still more lucrative than foregoing the IRA all together (as you can see above), and so the 10% penalty is just part of the cost of living a good life… just like other costs we choose to pay, like eating healthy food or paying for our kids to do certain activities.

The saddest thing to me is that the “Old school” people who disagree with me have never even asked themselves the hard questions, like: why is more money better, if it means working harder, longer? What makes us happy in life – money/wealth, or our time? How much is enough to be happy?

I love the parallel conclusion drawn by Tim Ferris, one of my favorite financial philosophers. In this free podcast interview (which I highly recommend), Tim made the point that he is really good at stock market investing but intentionally chooses less lucrative investments because they are less stressful. Huh? I thought more money is the meaning of life! (cynicism intended 🙂  Tim makes the point that investing isn’t just about making money, it’s about making your life better. And so it is with my IRA philosophy.

So, am I actually using this strategy?

No, I’m not; I don’t need to. At this point in time there’s no reason for me to pay the 10% IRS penalty, and I hope I never have to cross that bridge. So, why it so important then? Because there’s a secret sauce formula in life which can lead to sleeping much better at night. It goes like this:

“Burn rate” (how much you need to live on) – passive income = active income needs

All this says is simply that, if it costs me $50,000/year to live, and I have $25,000 in passive investment income, it means I only need to work a job to provide $25,000 per year ($25k + $25k = $50k).

The fact that I could intelligently and with mathematical soundness  use my IRA income if needed, means my active income requirements in life are less. This gives me peace of mind – if bad things happened in my business, instead of sending my wife back to work or myself going and working a job I don’t like, I’d have that nice buffer of IRA income. Now, I hope I never need it. But knowing it’s there is a huge blessing.

Am I the only one unplugging from the Matrix?

I find it so fascinating that the information in this blog post was never taught to me in my 4 years getting a finance degree at Cal Poly. Never once. Okay, okay, even if the naysayers disagree with me, howcome they never at least want to have the conversation, to at least talk about the pros and cons? It bewilders me how this kind of useful information is only stumbled upon after years of learning and exploration all by myself, a lone ranger. I just don’t understand why this type of analysis isn’t used more in real life to help people live better now instead of later. What if later never comes? And even if it does come, what if my kids are grown?  (this last sentence is a blatant plagiarizing of a blog post my friend wrote, which I’ve read at least 15 times).

After you’ve done enough research and number crunching, financial stuff is really less about math and more about life philosophy. That’s why I find it so fascinating. You can look at two households that have the same income and adults with the same IQ’s, and you’ll see two incredibly different pictures.

I hope my blog has helped you to decide for yourself what it means to live in the moment, for today’s joys, because …

From Luke Chapter 12:

The Parable of the Rich Fool

16 Then He spoke a parable to them, saying: “The ground of a certain rich man yielded plentifully. 17 And he thought within himself, saying, ‘What shall I do, since I have no room to store my crops?’ 18 So he said, ‘I will do this: I will pull down my barns and build greater, and there I will store all my crops and my goods. 19 And I will say to my soul, “Soul, you have many goods laid up for many years; take your ease; eat, drink, and be merry.”’ 20 But God said to him, ‘Fool! This night your soul will be required of you; then whose will those things be which you have provided?’

21 “So is he who lays up treasure for himself, and is not rich toward God.”

I find it so interesting that financial truths align closely with biblical truths. In this case, we learn two things from the story: First, tomorrow may never come. Second, we should be aiming to serve God.

Personally, I believe I can serve God better by living in the moment, not storing up for a day that may or may not come decades from now.

So, to the IRS, I say: here’s your 10% penalty. It’s worth it.