Personal finance: FIRE
2021 March
I’ve been obsessed with personal finance since starting full-time work last June. I’m going to cover FIRE here – but I plan on covering more topics in the future.
What are tax-advantaged accounts?
First, let’s establish that if you’re investing your money, it gets taxed twice. When you get your paycheck, it’s already been taxed by the government. Let’s say I deposit that into my preferred broker and buy some stocks. Eventually, when I sell those stocks, the profits get taxed once more.
As the name suggests, tax-advantaged accounts let you avoid one of the two taxations, either pre-tax (when you get your paycheck) or post-tax (when you sell your investments). It’s straightforward to conclude that investing in a tax-advantaged account is always better than investing in a regular account.
What accounts are tax-advantaged?
Unfortunately, for most Americans, only retirement accounts are tax-advantaged. Everyone can contribute up to $6,000 annually in an IRA, or if your employer has a 401k plan, an additional $19,500 annually.
The main reason younger people don’t contribute to these accounts is that the money isn’t accessible until you retire, or the old age of 65. This is completely false.
In addition, there’s plenty of ways to avoid penalties on early withdrawals. Not only that, long term capital gains tax (the least tax you can pay on your investments) is 15%, while the early withdrawal penalty is 10%.
To make this more concrete, let’s say I bought stocks on Robinhood and sell the next year. I’d be taxed 15%, whereas if I had bought those same stocks in an IRA, I would only be taxed 10% if I withdrew the profits.
This means that it never makes sense to invest through normal accounts if you haven’t hit the contribution limit for retirement accounts first, regardless of when you withdraw.
FIRE
The FIRE (Financial Independence, Retire Early) movement was eye-opening for me. Before learning about it, I assumed what everyone else does: we’ll be working for the next 30-40 years of our lives.
The movement isn’t just FI (Financial Independence), because FI+RE are intertwined. You can only truly be financially independent if you don’t need to work for money ever again, hence the “RE” part.
When I was in high school and I learned that index funds averaged 10% return, I realized that someone with 1 million dollars in the stock market could live off a salary of 100k a year indefinitely.
This is incorrect for a few different reasons, but FIRE is rooted in this basic idea: with X amount of capital, we can withdraw Y dollars indefinitely.
Okay, how much can I withdraw each year?
Clearly, it’s not safe to withdraw 10% each year. In the case of a recession, we’d run out of money before the market recovered.
We won’t dive too far into the math, but even accounting for the worst recessions in U.S. history, the “safe withdrawal rate” for early retirees is 4%. Feel free to research more, but yes, this means that you can live off of 4% of your investments indefinitely.
What does FIRE mean for me?
Given what we’ve learned, the formula for FIRE is simple.
annual-income = (total investments) * (safe-withdrawal-rate)
Let’s say you hypothetically want to live in NYC your whole life, and let’s assume you’ll rent a place for 2.5k a month. Allotting $30 for food each day (a bit extravagant) and $5000 for annual miscellaneous costs, we get:
(30 * 365) + (2500 * 12) + (5000) = 45,590
To achieve FIRE an annual income of 45,590, you would need 45,590 * 25 = 1,139,750 in investments. With that amount, you could live off 45,590 for the rest of your life and never have to work again!
How fast can I FIRE?
Here’s some projections for how fast someone could reach this with varying annual contributions, assuming a 8% stock market growth rate:
$30k: 18 years
$40k: 14 years
$50k: 13 years
$60k: 11 years
$70k: 10 years
Of course, extremely high earners can find ways to net even more in savings each year, but we’ll save these loopholes for another time.
The most common counter-argument I’ve heard at this point is “well, spending your money is more valuable when you’re younger”. I’ll point them to the book that many consider the genesis of FIRE – Your Money or Your Life.