I have a plan.
A financial road map, leading me from where I am now to where I want to be. It ignores get rich quick schemes and the latest crypto craze and takes the shortest route I know that will get me there in one piece.
I have been quite proud of this plan. Being a spreadsheet geek, I have spent many a happy hour setting it up, tweaking it and generally just playing with the numbers. It has different sections for different scenarios and is artfully colour coded. I consider it a work of great beauty and I often look at it just to relax. (Some of you will understand…..!).
My Financial Background
Since you don’t know me from Adam, let me explain a little bit about myself. I qualified as a Management Accountant back in the day and have spent the twenty five or so working years of my life in a variety of finance or accounting roles – based in the finance department of a company of one sort or another. I am not a financial advisor or financial planner, but I am comfortable with most things money related.
I have always been reasonably careful with my own money but in recent years I have woken up to the idea of having money work for me. I now treat personal finance as a hobby – I read books and blogs and listen to podcasts and invest many hours a week in this continuing education, soaking up the wisdom of all those willing to share their experience.
So imagine my horror when I discovered a flaw in my beautiful plan. A big, black, ugly tax-shaped flaw.
The 4% Rule
My error revolves around the 4% rule.*
For those not familiar, in simple terms the 4% rule is a guide to help you recognise when you have reached financial independence.
When is your savings pot big enough that it can support you without the need for any further earned income? The 4% rule suggests that you have enough when you have 25 x your annual expenses invested. You can then “safely withdraw” 4% of this in the first year (increasing the amount annually by inflation) and have enough to live on for the rest of your life.*
It is assumed that average investment returns over the long term will be comfortably higher than the 4% you are withdrawing, such that you don’t eat into all of your capital.
What About Tax?
So – save and invest a portfolio worth 25 x your annual living expenses and you are financially independent. That is the common wisdom and what I had been diligently working towards.
As an example, let’s say living expenses are 2k a month for a comfortable lifestyle. The investment pot needed for financial independence would be 600k (2k a month x 12 months x 25). Right?
Sadly it’s not that straightforward 😦
Be honest, if somebody asked you how much you spend each month would you include tax in that list? I wouldn’t – and at the beginning of this journey, I didn’t. Perhaps the self-employed are at an advantage here, but for those of us who are employed, our employer takes care of our taxes.
When we think about our monthly spending, tax is not even on the radar. Our tax has already been deducted before that money hits our bank account. And unless we have any income streams outside of our employment, we really don’t have to think about tax at all.
Perhaps I am slower than most but I was a few months into my financial independence quest before the penny dropped. Even completing my annual tax return and having an additional payment to make didn’t lead me to think of tax as a “living expense”.
Definitions Affect the 4% Rule
Although you can employ strategies to be as tax efficient as possible, you can’t avoid it. When it comes to retirement savings it is a case of choosing whether to pay tax now or pay it later.
Pay Tax Later
It is possible to save and invest out of pre-taxed income. Pension contributions made from your salary before tax is deducted is a way of achieving this. Traditional advice for those intending to retire at standard retirement age would be to maximise contributions to these investments, with the assumption that the tax you pay while working may be at a higher rate than the tax you will pay in retirement. You can also enjoy the benefits of compounding on a larger base amount.
When you eventually start to withdraw from these investments, (subject to any tax-free lump sums and personal allowances that may exist) you will then pay tax at your standard rate.
To receive the 2k a month for living expenses in our example, we will need to withdraw more, pay the tax and receive the net 2k.
This will drain our investment fund quicker than expected. Which means that if we are following the 4% rule, the savings target we need to reach is higher than it may at first seem. (Using UK tax rates and personal allowances, it would be over 75k higher than we originally thought).
Pay Tax Now
An alternative is to save and invest using money that has already been taxed. In the UK at time of writing, we can save up to £20k a year into an ISA. All interest, gains and withdrawals are tax free. The advantage here is that there is no minimum age before you can access these funds and so they are particularly useful for those seeking early retirement.
In an extreme case, if all of the income needed in our example was to be taken from this pot, we wouldn’t have to think about tax at all and our original assumption of 600k would be just fine.
The 4% Rule is a Guide Not a Bible
When I first discovered the 4% rule it changed my whole outlook on life. It allowed me to apply logic and reasoning to saving and investing, and gave me faith that once I hit a magic number in investments, I could be free.
But it is nowhere near an exact science and we need to be careful with definitions. The reality for most people will be a mixture of pre-tax and post-tax savings – income from various sources, perhaps rental income or part-time income too. And how we account for these in our calculations can cause big swings in the target number.
We all need a goal. We all need something to work towards to measure our progress and stay motivated and we can use the 4% rule as this goal or as a guardrail. Just don’t take it as gospel.
Join the Discussion
Was it just me that found a “rule” and clung to it? There are many retirement calculators freely available – do you think about the assumptions behind them? Do you have a fixed FI number in mind or is it more about a fixed date for you? Are you comfortable with broad based assumptions or do you model your numbers more accurately? Please let me know in the comments.
* There are several studies supporting safe withdrawal rates; one of the best known being The Trinity Study http://afcpe.org/assets/pdf/vol1014.pdf . This analyses different allocations between stocks and bonds and many time horizons.