I realized something recently. I’m not sure why it took so long. It seems simple and obvious now. You’ve probably already realized this, but if not, here’s a nugget of truth:

You Can’t Spend More Than Half Your Income

I’m not talking about net income. Physician on FIRE challenges those seeking FIRE to “live on half.” That’s not what we’re talking about here. I’m talking about the answer to this question:

How much of my gross income can I spend each year and expect to be able to sustain my standard of living throughout my life?

It turns out the answer to that, at least as a general rule of thumb for a high income professional, is “about half.” Why is that you ask? Because the other half has to go to taxes and savings. It has to. The taxes aren’t optional and they’re going to be fairly high for most of us during our peak earnings years. The retirement savings is optional, I suppose, but not if you wish to actually avoid eating Alpo.

Take a look at the math.

Taxes Eat Up Lots of Your Gross Income

First, let’s think about taxes for a bit. When I was making the average physician income, my effective tax rate was in the teens. But it turns out I was a fairly unusual case. Most docs pay an effective rate in the 20-30% range, some a little more, some a little less. So if you subtract out 30% of your gross income for taxes, that leaves you 70%.

Safe Savings Rate

Next let’s look at what kind of a savings rate is needed to provide a reasonable retirement. Long term readers know I generally recommend docs use a 20% saving rate. Will they be okay with 15%? Probably. But 5-10% just isn’t going to cut it. Let’s demonstrate why it needs to be higher than that with a simple future value calculation.

Let’s take a doc making \$200K who starts saving for retirement at 35 and hopes to retire at 60. She earns 5% real on his investments and saves 20% a year? How much will she have at age 60 and how much of her pre-retirement income will that replace? Plug this into your friendly spreadsheet:

=FV(5%,25,-40000) = \$1,909,084

Multiply that by about 4% and it gives you an income from your portfolio of about \$76K real per year. That’s about 38% of your pre-retirement income, which is smack dab in the middle of that 25-50% range that a typical doctor needs in addition to Social Security to maintain her standard of living in retirement, assuming the kids are launched and the house is paid off.

So subtract out another 20% from that 70% you had after taxes and that gets you to 50%. That’s what you can spend if you hope to avoid ever having to decrease your standard of living. Said another way, if you spend more than that regularly, you’re going to have a lower standard of living in retirement.

Higher Earners Have It Worse

Spending more than half your income is riskier than rappelling

The percentage gets even worse if you make and spend more than the typical doctor. That’s because the tax code is progressive. It is progressive during your earnings year and it is still progressive in your retirement years. In addition, the more you make and spend the lower your relative contribution from Social Security will be.

Consider another example:

How much peak earnings income does it take to create a sustainable \$400K a year after-tax spending level? A lot more than you might imagine. Let’s start at the end and work back to the beginning.

In order to spend \$400K a year in retirement, you need about 25 times that as a nest egg, or \$10 Million. At that sort of spending level, Social Security can almost be ignored. But wait, you need \$400K in after tax money. At that sort of tax bracket, you’re probably looking at an effective tax rate of at least 25%, perhaps 30% even in retirement. So we’re really talking about perhaps a \$13 Million nest egg.

How much do you need to put away each year at 5% real to have \$13 Million after a 25 year career?

=PMT(5%,25,0,13000000) = \$272,381.