In order to reach financial independence, one of the fundamental ideas is that you need to save up and invest at least 25x your yearly spending. If you spend about $40,000 a year, you’ll need at least $1,000,000 to be set for life.
While there are no sure things, this is a good baseline. It’s unlikely you’ll be set for life if your savings are below this number. How much higher it should be depends on a bunch of things: your future expenses, health & healthcare, your life goals – and most importantly how flexible you want to be with your spending.
I’ve always thought of the 4% rule / 25x rule as the bare minimum needed to reach financial independence. There’s a kicker to this though: that’s 4% in your pocket after taxes!
In other words, if you withdraw $80,000 a year from an IRA, even in a state with no income tax, you’ll end up with about $73,810 (in 2021). Because of that, you actually need to withdraw a lot more each year to cover taxes.
Let’s figure out how much more we really need.
A California vs A Washington State Retiree
Let’s look at two people. They both live out on the west coast of the US, enjoy similar weather, and somewhat similar politics. They’ll pay the same amount of federal taxes, but their state taxes will be wildly different. Washington state has a 0% income tax, while California’s marginal tax bracket goes up to 13.3%!
State and federal taxes in retirement will impact your FIRE number. How much depends on which state you live in and which accounts you’re withdrawing money from.
Let’s look at an example retiree couple in these two states to see how much they’d pay.
- Yearly spending: $80,000 for a married couple.
- Which accounts: All of it is coming from a 401(k) accessed early using a Roth IRA Ladder.
How much do they need to retire in each state? If taxes weren’t a thing, the math would be easy: $2 million ($80k x 25).
|Tax-Deferred Yearly Withdrawal||$93,210||$87,022|
|4% / 25x Amount Needed||$2,330,269||$2,175,550|
Adam Says: This is assuming a married couple takes the $25,100 standard federal deduction and the $9,202 California standard deduction.
In order to spend $80k a year from your IRA in California, a married couple would need to take out a little over $93k. That’s a lot higher! In fact, it’s about 16% higher for California and 9% higher for Washington.
These calculations are tricky. You need to adjust the amount you’re withdrawing up so you can take out money for taxes. But increasing the amount also increases state and federal taxes – driving the numbers up a bit more.
Luckily all tax brackets are marginal. There’s no point where raising your withdrawal amount triggers more taxes on the money you’ve already taken out. It’s marginal, so you’ll only pay tax on the next dollar after that.
What If: They Retired with 25x Spending?
Not taking into account taxes would have a catastrophic impact on both retirees. For the California retiree to withdraw $93,210 a year, that would be a withdrawal rate of 4.6% based on a $2m portfolio. It’s closer to 4.2% for the Washington retiree.
According to cFIREsim, that gives only a historical 91.74% chance of success for our Washington retiree, but only an 80.99% chance for the California retiree. This assumes a 30-year time horizon.
I don’t know about you, but a 20% chance of failure is WAY too higher. That’s worse odds than rolling a 6 on a 6-sided die.
You can increase your odds in both cases by saving up more money. If the California retiree saved up $2,330,269 and the Washington retiree saved up $2,175,550, they’d both get to a 95+% success rate over a 30-year period.
Calculate Your Tax-Adjusted FI Number
Knowing how taxes work, you might be wondering: what is my REAL FI number taking into account taxes? And how much less would I need in different states? Well, it’s time to find out! Just answer a few questions to get your tax-adjusted FI number.
What’s Not Covered With this Calculator?
Taxes are complicated. Two people making the exact same income could have wildly different tax rates. This calculator is very naive in what it takes into account – mostly because recreating a calculator that works for every state is beyond even what the government offers. 😅 There are some known edge cases not covered here, and many unknown edge cases. Here are some of the know edges cases not covered:
No Alternative Minimum Tax – The AMT is a minimum tax for higher income earners who manage to lower their taxes.
No state tax deductions – The state tax doesn’t take into account any deductions. This could result in a lower state tax bill.
No federal deductions beyond the standard deduction – This calculator assumes only the standard deduction for the federal level. No child deductions, charity deductions, mortgage interest deductions, or anything else.
No SALT deduction for state and local taxes – This doesn’t include deducting state tax – which would only make sense if your state tax is above the standard deduction and you itemize your deductions at a federal level. This is more common in states with high property taxes.
Tennessee capital gains and dividends tax – Tennessee charges a 1% tax on capital gains, interest, and dividends. This calculator WILL calculate tax on capital gains, but not dividends or interest.
How Can You Lower Your Taxes for FI?
Let’s get this out of the way first: there’s nothing wrong with trying to lower your taxes. There’s a difference between tax avoidance (illegally not paying taxes) and tax reduction (taking advantage of the tax code). It makes sense for everyone to lower their taxes. It’s more money in your pocket, and less you have to save!
So how do you do it? I’ve documented my approach to spend $80,000 a year and pay no taxes as one route. Another approach is to understand tax tiers and be money in multiple account types.
For example, let’s say you (filing as a married couple) wants to spend $80,000 a year and pay no taxes. Here’s one way to do it:
- $0 – $25,100 – Keep your IRA withdrawals, 401(k) withdrawals and unqualified dividends in this range. With the federal standard deduction, that’ll ensure you pay no taxes.
- $25,101 – $105,901 ($80,801 + $25,101) – The next $80,801 you can withdraw from a taxable brokerage account and pay no long-term capital gains. In other words, any investments you’ve held for longer than a year, can be sold tax-free up to this amount.
- Anything else – If you don’t have this much in a taxable account, you can also use Roth IRA.
This involves having a LOT of money in a taxable brokerage account, which isn’t always the case. If that’s not your situation, you can raise your tax-deferred withdraws and pay some tax, but use your Roth IRA to slightly lower the amount you need (and the taxes you pay).
One way to lower your capital gains basis is to take advantage of tax-gain harvesting each year after you retire. This works by selling stock then immediately rebuying it. You pay taxes on the gains and reset your cost basis. The trick, if you call it that, is to sell long-term capital gains while you’re in the 0% tax brackets for long-term capital gains. This results in resetting your cost basis and allows you to withdraw more in future years while paying fewer taxes. And it’s all completely above-board.
What’s Your FI Number?
Depending on how you’re funding your retirement, your number may change by up to 25%. If going through this calculator raise your FI number higher than you previously thought, I’m sorry to be the bearer of bad news. It’s still going to be better than leaving your job and running out of money.
The good news is that the last few percent growth in your investments gets to benefit from all of the growth up to that point! Compound interest is your best friend in this situation.