Inflation, Taxes, Healthcare
There is no dignity quite so impressive, and no one independence quite so important, as living within your means.
— Calvin Coolidge
The FIRE movement has been picking up steam lately, with thousands of bloggers and Youtube channels dedicated to teaching you how to save enough to escape the rat race well before the “normal” retirement age. By now everyone has heard of the famous 4% rule —if you can live on 4% or less of your savings per year, your money should outlast you.
Take the advice with a grain of salt — this simple rule glosses over important details you should keep in mind when planning your retirement:
- inflation will increase your living costs every year
- withdrawals from retirement accounts are subject to income taxes
- your healthcare costs will go up with age, especially in the United States
I’ll try to explain each one of these in a bit more detail below.
1. Inflation
To be able to live on 4% of your savings, you must have saved up 25 times your yearly expenses — usually called the 25x rule. As explained in this article, the rule assumes a retirement period of 30 years.
Let’s say your current living expenses are $50,000 per year. So according to the 25x rule, saving 25x50,000 = $1,250,000 should be enough to retire. Let’s also assume it takes you 10 years to save that much money.
If you account for an inflation rate of 3% (about the US long-term average), you will need $67,196 in 2030 to keep the same living standards you have today for $50,000.
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So in reality, 25 years of living expenses should not be calculated as 25 times your living expenses today, but 25 times the living expenses on the year you plan to retire — 25x67,196 = $1,679,900 if you retire in 2030. That’s a 35% increase on the original savings target. If you instead take 20 years to save enough money, you’ll need $2.25 million!
2. Taxes
The amount you need for living expenses each year must be after taxes, since the money you pay the government doesn’t go into covering your living costs.
Most people who save for retirement in the US will use 401(k) accounts because contributions to those accounts come out of pre-tax income. But, you’ll still need to pay income taxes on that money when you start withdrawing it.
Here are the current tax rates that apply to 401(k) withdrawals:
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Let’s use the $50,000 amount from before and assume the IRS raises the limits on those tax brackets in line with inflation, otherwise the numbers look even worse. If you want to have $50,000 left over after taxes, you’re in the 25% tax bracket and need to withdraw $62,500.
Even ignoring the inflation point above, you still need 25 times the pre-tax income for retirement — $62,500 instead of $50,000 — which makes the retirement target $1,562,500 instead of $1,250,000.
And that 25% tax rate isn’t even that high — in most of Europe the tax rate for an income of $62,500 per year would be way higher — in Scandinavia, where I live, I would end up paying over 40%. On the flip side, my healthcare costs would be a lot lower.
3. Healthcare
As a young person, you’re probably not spending too much on healthcare right now, but you should expect that to change as you get older — it happens to all of us.
If you live in the US, you can only get Medicare benefits once you reach 65, so if you plan to retire earlier than that, you have to make sure you leave room in your budget for healthcare costs. Aside from a financial crisis wiping out your savings, unexpected healthcare expenses are the biggest threat to your early retirement dreams.
According to the California Health Care Foundation, the average American will spend $11,500 per year on their health in 2019 — and you can see that number grows every year by about 8%, faster than inflation, and probably faster than your savings grow in the stock market.
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This article is not meant to discourage anyone from following their dreams and saving for early retirement, but to highlight some costs that are often ignored in FIRE discussions.
If you think I missed something important, please feel free to leave a comment below. Good luck on the road to financial freedom!
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions