Early retirees are an interesting bunch… on the one hand, it takes a lot of audacity to leave the workforce decades early. I mean, who does that?!
On the other hand, most of us are extremely fiscally conservative. People are even competitive over who is the most risk-averse… “You go ahead and target a 3% withdrawal rate, buddy, I’m going to keep working until I can spend less than 1.76852%!”
For most people though, the debate is primarily internal and manifests itself as One More Year Syndrome. “I’ll just work one more year to cushion the portfolio a bit more, THEN I’ll quit…”
It’s a very reasonable discussion to have with yourself. But working one more year also has some costs.
The Cost of Working One More Year
There are some negative connotations to the phrase One More Year Syndrome (the acronym even sounds like, “Oh My!”) Implied is that you have already reached your original financial goals (whatever those may be), but continue to move the goalposts… and thus you have a second and third and fourth “one more year.” (Myself, I worked 3 extra years.)
The allure is strong. More working years means more money, and who doesn’t like to have more money? (Want it, yes. Will it make us happier? Probably not.)
From an already strong financial base, continued work means another year of 401k and HSA contributions and another year for the portfolio to grow without the hinderance of withdrawals. You will also (probably) increase the value of future Social Security benefits. These are all nice things we can do.
But what we can’t do is take full advantage of the tax-free Roth IRA conversion and capital gain harvesting opportunities.
What is that worth?
The Value of Tax-Free Opportunities
Every year a married couple has the potential to do a tax-free Roth conversion worth up to $24,400 (standard deduction.) Additionally, it is possible to realize long-term capital gains of up to $78,750, also tax-free. (2019 numbers. Single filers divide by 2.)
(Related: our overall tax minimization strategy.)
If these 2 actions are taken while working, common tax rates of 22% might apply to the Roth conversion and 15% to the capital gain, for a total tax burden of $17,181, or about as much as a max 401k contribution. More for higher-income earners, less for others.
Paying an extra $17k in tax isn’t something most people will do voluntarily, so one more year of work means one more year with neither Roth conversion nor capital gain harvesting.
As with most things investing, compounding is a significant factor. Even small amounts of money can grow to incredible heights given enough time.
$24k in a Roth or Traditional IRA with a real CAGR of 7% will double every 10 years or so, quadruple in 20 years, octuple in 30 years, and sexdecuple (16x) in 40 years to about $400,000 (inflation-adjusted.)
A 401k with a value of only $24k at age 40 will already become a 401k that is too big to pay zero tax by age 70.5 when RMDs and full Social Security begin.
Or phrased differently, a single tax-free $24k Roth conversion at age 40 will result in zero tax paid on about $200,000 worth of assets (2019 numbers) by the time most people are eligible for full Social Security.
By contrast, the one-more-year worker will most likely have that $200,000+, along with most/all of the other 401k contributions, in a Traditional IRA. Withdrawals from this one missed Roth conversion from the past will be taxed at their highest marginal rate.
With Social Security income, investment income, RMDs, and perhaps even the real death tax, marginal tax rates will potentially be in the neighborhood of 22%+. Or the same rate that we didn’t want to pay 40 years ago.
Capital Gain Harvesting
Raising basis through capital gain harvesting does not have a profound compounding benefit, but there is still significant value. (How to prioritize: Roth conversions vs Capital Gain harvesting.)
By raising basis in our portfolio, instead of a future $10,000 stock sale resulting in a taxable gain of $7,500, maybe it is only $1,000, for example. (Full chart here.)
The tax advantage of a single harvest will be limited to just 15% of the harvested gain in most cases, or $78,750 * 15% = $11,812.
That is certainly nothing to sneeze at. But where this really shines is when we have future edge cases where just a little more taxable income can result in significantly higher taxes or expenses.
- a high-income year, where capital gains might be taxed at 20%+
- years when income is close to 400% FPL (the ACA subsidy cliff)
- years before events that are heavily impacted by MAGI, e.g. applying for financial aid for Jr’s college
(related: why Jr doesn’t have a 529)
- before moving into a higher tax environment (e.g. moving to France, moving to California, etc…)
- Social Security tax torpedo
We can minimize the potential of having one of these negative tax experiences in the future by harvesting gains early and often. (I”ve already harvested $173,000 over 6 years.) If we need to avoid realizing a capital gain, even with higher basis, then we can tap the seasoned Roth conversion money instead.
Nobody is getting any younger. A year may be only 365 days, but each day passes never to come again.
We can work another year (or so) to improve the historical failure rate of our portfolio from 2% to 1.8%, but the human body has a failure rate of 100%.
Check out the longevity failure chart in the post, You Will Die Before You Run Out of Money for a sobering visual.
For an aspiring early retiree, working an extra year or five will almost always result in a greater net worth. I worked 3 years longer than originally planned and indeed our portfolio is larger for it.
A larger portfolio means the historical failure rate of said portfolio will be lower, because of a lower withdrawal rate.
This does have a cost, however.
Working longer also eliminates or reduces the opportunity to do tax-free Roth conversions and to harvest long-term capital gains (also tax-free) during the extended working years.
It also costs time, our most limited commodity. Part of the reason the portfolio has a greater success rate is that it doesn’t need to last as long.
For the few who actually achieve a zero-tax retirement, no harm no foul. But for most of us, this won’t be the case.
Whether these costs are significant is subject to interpretation, but it is at least worth recognizing that they exist.