Consider this. You’re out hiking on a nice Saturday afternoon when you come across a magic genie. The genie appears and says he has a proposition for you. I know this game, you think to yourself. This fool grants me three wishes and on the first wish, I ask for 100 wishes. I’ve got this. Instead, the magic genie surprises you with a proposition. He says, “I will grant you three years of freedom today in exchange for $900,000 when you turn 60.” What the hell, you think. I finally come across a magic genie and this guy is trying to scam me. “No thanks magic genie,” you say. “Your price is way too steep for me.”
So what’s your price? At first glance, $900k for just 3 years is pretty steep. But all decisions are relative. If you believed you would have $1.5 million saved at age 60, then there’s no way you take the deal. Taking a 60% haircut for 3 years is not worth it. But what if you were on track to save $10 million by age 60. That changes everything. All of a sudden, $900k doesn’t seem like that steep of a price to pay for 3 years of additional freedom.
Trading Money for Time
The concept of trading money for time comes into play when building your investment portfolio. If you solely use tax deferred accounts as your vehicle for investing, you’re delaying retirement for more years in exchange for more money. Investing in a 401k allows you to stock away more money today. Assuming a 20% tax rate, it only costs $14,400 in after-tax dollars to max out your pre-tax 401k contributions at $18,000. If you only had $18,000 pre-tax dollars to invest each year, you can obviously generate a larger portfolio by investing in a tax-deferred account than an after-tax account. But at what cost? Time.
In order to retire early, you need to build a significant after-tax portfolio. This portfolio will bridge the gap between early retirement and accessing your tax-deferred accounts around the age of 60. How much money are you willing to give up in your golden years to add a few more years of freedom during your prime years?
I’ll use myself as the guinea pig. My wife and I both work and both have access to tax-deferred investment plans. My employer offers a 401k while my wife has access to a 403b plan (the public version of the 401k). Currently, I max out contributions to my 401k plan at $18,000 per year. We do not contribute to my wife’s 403b plan, which offers no match.
Instead of maxing out the 403b plan, we’re choosing to push more money into our after-tax portfolio. Many in the finance community would scoff at this approach. Not taking advantage of tax-deferred accounts is a sin in the personal finance world. I disagree. I’m merely trading money for additional time in this case.
Let’s have a look at the numbers. On our current plan, we will achieve our Current Standard of Living FI in 9 years when I reach the age of 44. As our effective tax rate is roughly 20% for state and federal income tax, we are missing out on $3,600 annually that we could be investing (20% of $18,000 = $3,600 going to pay taxes instead of invested in tax-deferred 403b account).
In this real life example we have two paths: A and B. If I take path A, I max out the 403b account with $18,000 annually. In path B I use this money to build my after-tax portfolio. Using the current balances in my tax-deferred and after-tax investment accounts as a starting point, here is where each path will take me. Results assume an 8% annual return.
Which Path Would You Choose?
Note that these balances differ from the Three Stages of FI post as I’m not incorporating increased earnings for simplicity purposes. By playing out the numbers further on Path A, it would take an additional 3 years for the after-tax portfolio balance in Path A to reach that of Path B. However, Path A results in an additional $913,000 in tax-deferred savings by the age of 60. Such is the power of time and tax-free compounding. So my decision is to effectively trade 3 years of freedom for $900,000 down the road. Sounds crazy right?
As I mentioned before, all decisions are relative. Although Path B provides $900,000 less in my tax-deferred account, it still ends up with a balance of $3,649,000. Not chump change at all. Using that number alone, a 3% withdrawal rate would allow us to live at Livin Large FI standards. When you add in social security and dividend income to the mix, our withdrawal rate on this nut would be closer to 1%.
Less Money, More Freedom
At some point, more money does not provide more utility. While $900,000 seems like a lot of money, it becomes meaningless by the time I can access it. I can already live at the highest standard of living that I want to when choosing Path B. Plus, it affords me three additional years of freedom. I’ll admit that it does give me a little bit of heartburn to give up nearly $1 million. For an analytical person like myself, it can be difficult to compare the tangible with the intangible.
But if I chose path A for the additional money, where does it stop? Maybe I get the urge to hit 8 figures. I can keep trading out more years of freedom for more money. But for what? More money doesn’t equate to increased happiness. Millionaires want to be multimillionaires. Multimillionaires want to be billionaires. And billionaires want to be the richest billionaire in the world. The sole purpose of accumulating money is the freedom it provides. Once you achieve that, each additional dollar becomes less valuable.
Readers, what are your thoughts on my analysis? Is this crazy? How much would you be willing to give up for additional years of freedom?