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

Rainbow layer cake on a cake standNote: 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.


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.

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  • Joshua Sheats

    Bryan, I’m so glad you brought this to my attention. I’ve just published episode #314 of Radical Personal Finance which publicizes this idea. http://traffic.libsyn.com/radicalpersonalfinance/RPF0314-Use_an_IRA_for_Early_Retirement_Even_with_the_Penalty.mp3

    • Thanks, Joshua! I actually got a lot out of your podcast even though it was like listening to myself talk. You brought up a bunch of stuff I hadn’t considered before, like using money to invest in businesses outside of IRA’s instead of typical publicly traded securities – you have got a good point. Maybe instead of shoveling all this cash into my IRA, I should be using it to start or grow businesses.

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  • Justin
    • Cool, Justin! I think MMM should do a real blog post on this topic. It is so important for us early retirees.

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  • Catherine

    If you know you will need income from your IRA for at least 5 years, you can use substantially equal payments and avoid the 10% penalty entirely. https://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Substantially-Equal-Periodic-Payments

    • Yes, but I need a tool more flexible than that. I don’t want to take income in my IRA for 5 years. I want to use it to supplement income ONLY IF NEEDED on a per-year basis. But yes, you are right…

      • Catherine

        Ok, then.

  • Sam Lord

    A couple things. First, I just found your blog (from madfientist) and I’m really liking it.

    I agree with your numbers, but only if you make some favorable assumptions. You need a very high rate of return (e.g. the 10% return you used) and/or a long time for the TIRA+penalty to win over taxable. Also, you assume in your example that your taxable returns are taxed as ordinary income instead of long-term capital gains. Assuming LTCG rates on the taxable account, I need numbers of 10% growth rate and 20 years before the TIRA+penalty wins. If I could get 10% for 20 years, I’d be very very happy!

    That said, even when the TIRA+penalty loses, it doesn’t lose by a devastating amount. So I agree with your conclusion that one should contribute to their 401k or TIRA (unless they are in a very low tax bracket, and then the Roth might be better).

    OK, and I have to admit that I’ve made some unfair assumptions in the other direction. I’ve assumed the growth is only price growth, and not from annual dividends. If part of your growth is in dividends or interest, you need to pay at least LTCG rates (e.g. 15%) on the dividends in the taxable account every year, and I think the TIRA starts pulling ahead even faster!

    • Hi Sam, thanks for commenting and reading my stuff. It’s only a hobby, but I love talking about this stuff.

      Yes, there are many variables to consider. I admit that the TIRA doesn’t win under every scenario. One thing I like about it is the flexibility. I PROBABLY won’t need to live on my investment income before retirement. I think you’d agree that if we are talking a 20-30 year time horizon with NO early withdrawals and no penalty, the IRA will always win – whether a ROTH or a TIRA. Therefore, if all goes well in my life, the TIRA won’t be touched until retirement anyway. However, if I do need to live on the passive income now (in order to avoid getting an ugly job), then it’s at least exciting to see that it beats, breaks even with, or in some cases lags closely behind, the taxable account. So I win under both scenarios (using income now vs. not needing it til retirement). Hence the title, “have your cake and eat it too.

      I do need to go back and play with it a bit more and make some charts which show how rate of return and tax bracket affect this. These are the two major variables as far as I’m concerned.

      And regarding long term capital gains – That is not my favorite income strategy for obvious reasons. I’d prefer slow growth stocks like REITs that spit out predictable dividends, and even preferred stocks, for income. I also do a lot of hard money lending in my IRA’s.

      My strategy as illustrated in this post is admittedly experimental and has a lot of info to be fleshed out. I’m open to anyone and everyone who wants to contribute to make this a more refined hypothesis! Love the discussion.

    • By the way I just ran the numbers even for qualified dividends with ZERO TAX compared to ordinary income coming out of the TIRA, and the TIRA still breaks even! So incredible.

    • Sam Lord

      OK, so help me better understand your approach. Are you only calculating the first year’s after-tax income earned on a portfolio inside and outside a TIRA? You’re not comparing the remaining principle or how many years either account would last at the calculated income-withdrawn rate?

      • Yes, I’m looking at income only, because my strategy is to NOT spend any principal until after I retire. But the principal balance still wins in the TIRA because it is not taxed when you put it in. So, if I’m in 35% state/fed tax bracket, and I save $10,000 at the end of each year, that $10,000 principal doesn’t lose any value in my IRA whereas it becomes $6500 in the taxable account.

        Also, if I don’t need the income, the income compounds TAX FREE in the IRA. So on the principal front, the IRA always wins. IRA’s are always better, EXCEPT my question in this blog post was – are they still better if you need some income now? Turns out yes, they are still better under that scenario too.

        I haven’t run the numbers out past one year, but the improvement would keep compounding and become more in favor of the TIRA, not less. There are a number of un-knowable variables of course – will tax rates in 20 years when I retire be vastly different than they are now? Will I be richer or poorer in retirement and what will my income needs be? Etc.

        If you start taking out PRINCIPAL from the TIRA, it doesn’t win out over the taxable account, so yes, that’s a very important distinction, sorry I didn’t make that.

        If I were to run a few scenarios – and I may do this when I have a bit more time – they would look something like this.

        Scenario 1: Taxable vs. TIRA where I DO need the income now for a few years.

        Scenario 2: Taxable vs. TIRA where I DON’T need the income and it compounds in my IRA.

        And in both scenarios, how do things look in retirement 20 years down the road (this is the more tricky calculation because of so many unknowns both in my personal life / spending, as well as government tax policy.)

        However, I’d be extremely surprised if the TIRA doesn’t win out in all these scenarios. The TIRA, in the “don’t need the money” compounding scenario, will be like rocket fuel to the compounding effect compared to the taxable.

        And in the “need the money now” scenario, the TIRA will win in most normal situations, for a number of reasons… TIRA contributions are generally made in HIGH earning years, hence bigger tax savings, and withdrawals are made in LOWER earning years, because you wouldn’t use TIRA income unless you really needed it. All of my examples in the actual blog post are pretty conservative and don’t even account for that disparity.

        And you have some other advantages too, like student loans for the kids supposedly don’t take into account IRA assets, so my family might qualify for more financial aid, etc.

        I think the TIRA wins in 90% of scenarios, the question is, what are those 10% scenarios and how likely am I to end up in those.

        Lastly, it depends also on your tax bracket. If you aren’t paying any taxes because you have a lot of write offs or don’t make much money, then a ROTH would almost always be a better choice. The TIRA assumes you are paying substantial income taxes.

        I can flesh out the scenarios if you want me to.

        Here’s a quick scenario where TIRA wins *even when* you could get 0% qualfiied dividend tax rates in the taxable!

        End of year savings: $10,000. Invested at 5%. Income needed now. 30% tax bracket (fed/state) when put money in, 25% when take money out as ordinary income).

        Taxable: $7,000 investable after taxes. @ 5%, total income for the year is $350. Pay no taxes because qualified dividends.

        TIRA: $10,000 investiable @ 5% is $500 in income. Pay 25% tax and 10% penalty. Total income = $350 in income!

        Same DISPOSABLE AFTER TAX income in both scenarios. But principal in Taxable is $7k, and in TIRA is $10k, so TIRA wins on principal and ties on income.

        Year after year, I don’t see how the scenario would ever change from year 1. It will just compound and become more pronounced, years out.

        And in the 2nd scenario when you DON’T need the income, the TIRA rockets ahead with no taxes and tax free compounding.

        What if the Government raises the penalty from 10% to 20%? That would be horrible and would ruin everything. So again, it’s not all cut and dry.

      • Sam Lord

        Got it. But let’s look at to your last pair of scenarios.

        First, a drop in tax rate from 35% to 25% is big and that is what makes the TIRA such a big winner: choosing when to pay your taxes. This assumption makes sense, because you’ll probably be a lower tax bracket if you end up needing income from your TIRA.

        But make the spread smaller. Go from a 33% to a 28% tax bracket and a 15% LTCG rate. Assume 6% growth of the $10,000.

        TIRA income = $372 after taxes and penalty
        taxable account income = $331.50 after taxes and LTCG

        So you earn $40.50 more income from the TIRA. But to get that higher income, you’ve needed to drain $260 of your TIRA’s effective principle (the balance of the principle after taxes and penalty). You’ve effectively paid $260 to gain $40.50.

        I think ignoring the value of the principle throws off the math.

        Of course, if you let the TIRA grow for a few years before you touch it, or your marginal tax rate really does drop a huge amount I agree with you that you win overall with the TIRA. So I 100% agree with you that folks should not shy away from a TIRA, even if they plan to retire early. But I think some of your math was a little too optimistic and left out a big aspect (the final value of the principle).

        I also agree with you that TIRAs are wonderful and basically magic. My favorite part is that one ends up paying a lot MORE tax to the government, but still ends up with more after-tax money than if the funds had been in a taxable account all along. It’s a win-win! 🙂

        EDIT: One more thing. If you take out the income one year, but then leave the principle in the account until retirement, that 10% penalty goes away on the remaining principle, and now you’re back in the scenario of the TIRA winning in both income and principle. So maybe my math was just too pessimistic. OK, you win. 🙂

      • Hi – so to summarize your point – you are saying that by taking the income from the TIRA I am sacrificing more principal. But your argument here is flawed, because you have to do the comparison RELATIVE TO the taxable account. Don’t forget that to enjoy the taxable account, I have to pay a huge tax bill on it right off the bat, so for $10k at 30% tax rate, I am left with only $7k in taxable account but keep the $10k in my TIRA. So I’m already ahead $3k in the TIRA. So your argument of draining $260 of principal pales in comparison with the $3k tax savings.

        Also, it isn’t really principal that’s being drained. It’s income. The TIRA produces MORE income because it’s producing it from a larger principal chunk. So what’s really being drained isn’t the principal, it’s the income. And we still end up with more income after the drain.

        Think of it this way. If we do the scenario where we need the income one year, the start of the year and the end of the year, the principal balances in both taxable and tIRA don’t change. They remain the same at year start and year end. It’s not principal that’s being drained, it’s income only.

      • Sam Lord

        I only compared final principle values, after all taxes are paid. I agree with you that you have to compare apples to apples. The principle that matters is the amount that you could actually use to purchase things. Saying that the TIRA has $10k and the taxable has $7k isn’t fair, either, because you have to pay taxes on that $10k before you can spend it. That’s why I called it “effective” principle.

        You’ll see in my edit above that I do agree with your analysis if you can leave the principle untouched at least until the early-deferral penalty goes away. 🙂

        I think splitting income and principle and ignoring the latter is not the way to go. The real question is how many years can I keep this up until I’m out of money (and therefore out of income)? But I have come to agree with your math for the narrow circumstances you laid out.

      • You are right – if you need to spend the $10k principal before 59.5 years old and incur the penalty, you lose. In order to have your cake and eat it too, you need to walk this narrow path. It’s a path that allows you to pay some living expenses now and at the same time preserve principal for retirement.

        But even if I were in dire straights and needed to take the principal out, chances are, my tax bracket would be much lower and the tax savings would offset some of the penalty.

        In my own finances, I’ve run the scenarios with more specificity – almost all my T-IRA contributions are going into the account at 35% fed/state, and they would come out only if I were in 25% fed/state, so realistically the tax offset would pay the penalty for me. So even the principal before retirement age would not be worse off than a taxable account.

        Hopefully though, the income-only from the IRA would be enough to pay my bills.

        The reason I’d never use the principal anyway, unless it was a dire emergency, is that I am very committed to the idea that in a bad year, I will never draw down my principal, I will only use the income, otherwise it is back-peddling big time. I would rather: move to a smaller house, send the wife back to work, cut expenses, work a bit more in my side hustles, etc — before ever touching principal. If you think there’s a good chance you’ll need the principal, then for sure don’t put it in the IRA.

        But this whole philosophy isn’t for everyone. I’m a student of MMM, Brave New Life, and a few others who believe in: living on low expenses, living frugally, enjoying life now, etc. It doesn’t work for everyone.

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