The Middle Class Trap

I have said the tax laws want you to retire early. 

Counter to that point, the BiggerPockets Money podcast has warned that the tax laws are an effective bar to many retiring prior to age 59 ½.

So who is right? The FI Tax Guy or Scott Trench and Mindy Jensen of the BiggerPockets Money podcast?

This isn’t just a discussion in my mind or a late night debate at the Waffle House. It’s become a debate in the financial independence space. Just last week, the Middle Class Trap was the topic of the ChooseFI podcast. 

We will return to that episode of ChooseFI later. For now, I want to start by defining the Middle Class Trap and providing the two reasons I don’t believe the Middle Class Trap is a trap. Then I will move onto several numerical examples, including four Mindy Jensen provided on ChooseFI. 

The Middle Class Trap Defined

Scott Trench and Mindy Jensen walk through their definition of the Middle Class Trap from in this YouTube video. I encourage you to watch it.

Boiled down, the argument is that primary residence wealth is trapped and traditional retirement accounts are trapped until age 59 ½. Thus, many in the middle class have trapped wealth and cannot retire prior to age 59 ½ despite good numbers on paper.

There are two problems with their argument. First, primary residence wealth isn’t the owner’s wealth as we ordinarily conceive and define it. Second, traditional retirement accounts are not trapped prior to age 59 ½. 

The Primary Residence Question

Too often we think of primary residences as investments. They are not, as Douglas Boneparth observes. They are a form of consumption.

People say “I have a million dollars in home equity so I am a millionaire.” 

No, you are not.

I can prove it.

Peter has a $500 checking account, a car, clothes, and a $1 million home with no mortgage. He sells the home for $1 million. He immediately must get a hotel room to sleep in tonight.

John has a $500 checking account, a car, clothes, rents an apartment, and has $1 million in VTSAX in a taxable account. He sells $10,000 of VTSAX for cash. He now has a pile of cash and need not make any adjustments to have a bed for the night. 

Is Peter’s home equity really his wealth when accessing causes significant life adjustments? John’s VTSAX is his wealth. His accessing it requires no life adjustments. 

So what then is market driven appreciation in home equity? It’s growth in asset value that primarily benefits three classes of people:

1. The next generation
2. Owners willing to change geographies or willing to significantly downsize
3. Owners needing long-term care at the end of life

Market driven increases in home equity are not a trap. Rather, they are wealth that, in many cases, someone else gets to enjoy.

Imagine I’m writing a blog post and the doorbell rings. I answer and the delivery man says, “Mr. Mullaney, congratulations! You won a contest. The prize is $1,000 of Blippi toys!”

Those Blippi toys are my wealth that my toddler Goddaughter gets to enjoy. 

It’s no different with market driven increases in home equity. It’s wealth that shows up on your doorstep that most likely will be enjoyed by the next generation. 

In no way do those Blippi toys trap me. Same with market driven increases in home equity. 

The 10% Early Withdrawal Penalty is No Bar to Early Retirement

I’ve written about the myriad ways to fund retirement prior to 59 ½ without incurring the 10 percent early withdrawal penalty. I’ve spoken about it on two episodes of the ChooseFI podcast (475 and 491).

But until now, I have never explicitly said the following:

Those 50 and older with sufficient assets are in no way barred from early retirement due to the 10 percent early withdrawal penalty even if all of their financial asset wealth is in traditional retirement accounts. 

While 72(t) payment plans are not the ideal retirement plan, they are more than adequate enough to use to retire in the year one turns age 50 or later. Those 50 or older, with a simple spreadsheet and some diligence, are in no way barred from early retirement due to the 10 percent early withdrawal penalty. 

What about those under age 50? 

Few under age 50 will be able to retire on traditional retirement accounts alone because of sufficiency concerns. Tax concerns are not the problem when thinking about retiring prior to age 50 – it’s all about sufficiency!

Fortunately, the profile tends to resolve itself. To have enough financial wealth to retire in one’s 40s, the prospective early retiree most likely contributed to some combination of Roth accounts or taxable accounts prior to retirement. While not insignificant, traditional retirement account contribution limits are such that for many, it will be difficult to rely on them exclusively to build up sufficient assets for retirement prior to January 1st of the year of one’s 50th birthday. The 40-something early retiree can start their early retirement distributions from Roth accounts, taxable accounts, or a combination of both, obviously without penalty. 

Summed up, when assessing the Middle Class Trap, for those under 50, their profile itself usually resolves the issue. For those 50 and older, the 72(t) payment plan rules are so advantageous (due to a major change in 2022) that a spreadsheet requiring one amortization calculation, some coordination with a financial institution, and a bit of ongoing additional diligence resolves the issue. 

For both age cohorts, there is no tax trap. 

Does this mean the 10 percent early withdrawal penalty has been, in effect, repealed? Hardly! If someone like me, in their late 40s, wants to take $20,000 from a traditional 401(k) to fly round-trip in a suite, I will pay a hefty 10 percent early withdrawal penalty. The penalty is still effective to discourage impulsive onetime withdrawals before retirement. But the penalty is not effective to prevent early retirements with a systematic, sustainable withdrawal plan. That’s the obvious intention behind the series of substantially equal periodic payments exception.  

Examples from Mindy Jensen on ChooseFI Episode 543

Last week’s episode of the ChooseFI podcast, featuring host Brad Barrett, Mindy Jensen, and Can I Retire Yet blog author Chris Mamula was a great contribution to the FI space. 

During the ChooseFI episode, Mindy offered some numerical examples to argue for her case. That is a very legitimate tactic, and I personally love examples. Unfortunately, using numerical examples ran up against a limitation of the audio podcast format, since it can be difficult for participants and listeners to fully process multiple numbers while listening to an episode.

Mindy started sharing numerical examples around 25:00 in the podcast. I went back to the YouTube video and put Mindy’s numbers in the below table. I then added a row totaling financial assets and two rows laying out theoretically possible annual withdrawal rates. 

Amount	Person A	Person B	Person C	Person D
Primary Residence Value or Equity	Not given	Not given	$3,000,000	$800,000
Traditional Retirement Accounts	$268,000	$36,000	$1,200,000	$234,000
Roth Retirement Accounts	$18,000	$143,000	$0	$0
Taxable Brokerage Accounts	$187,000	$306,000	$0	$60,000
Cash	$106,000	$119,000	$225,000	$69,000
HSA	$0	$0	$35,000	$0
Total Financial Assets	$579,000	$604,000	$1,460,000	$363,000
Morningstar Annual SWR (3.7%)	$21,423	$22,348	$54,020	$13,431
Six Percent Annual Withdrawal Rate	$34,740	$36,240	$87,600	$21,780

Let’s use a range of withdrawal rates just for illustrative purposes. On the low end, we’ll use Morningstar at 3.7 percent, which can be fairly considered to be conservative. On the high end, let’s roll the dice a bit and use 6 percent.

Notice that the problem in the examples is not that the person has everything locked up in traditional accounts. The problem is sufficiency! Aside from Person C, it does not matter if all of the financial wealth is in Roth accounts, taxable accounts, or split between the two of them. 

Persons A, B, and D are not in the Middle Class Trap. Rather, they are in a situation where they need to work longer unless their annual spending is incredibly modest, even by financial independence standards. 

I believe that Person C could consider living on cash and later starting a 72(t) payment plan, but we really can’t tell without knowing much more information, including their age and their annual spending level in retirement. 

Middle Class Trap 72(t) Payment Plan Examples

In one podcast episode, Mindy and Scott put the parameters of the Middle Class Trap at $1M to $1.5M of trapped wealth (see 3:19 of this video). How bad is the federal income tax result if we assume practically all of that wealth is in traditional deferred retirement accounts?

Using the old Four Percent Rule of Thumb for our 72(t) annual payment at both ends of the spectrum, and assuming a $40,000 taxable savings account and 5 percent interest on it and on the annual 72(t) payment taken at the beginning of the year and spent evenly during the year, here’s the 2025 federal income tax result by my estimation.

	Single $1M	Single $1.5M	Married $1M	Married $1.5M
Interest Income	$3,000	$3,500	$3,000	$3,500
72(t) Payment	$40,000	$60,000	$40,000	$60,000
AGI	$43,000	$63,500	$43,000	$63,500
Standard Deduction	$15,000	$15,000	$30,000	$30,000
Taxable Income	$28,000	$48,500	$13,000	$33,500
Federal Income Tax	$3,122	$5,584	$1,300	$3,543
72(t) Payment Funding for Expenses Other Than Federal Income Tax	$36,878	$54,416	$38,700	$56,457
Effective Federal Income Tax Rate	7.26%	8.79%	3.02%	5.58%
AGI as a Percent of 2025 Federal Poverty Level	274.76%	405.75%	203.31%	300.24%

I believe this table strongly supports my contention that the tax laws want you to retire early. Look how light the taxation is on 72(t) payments! 

You may ask “I thought federal tax rates started at 10 percent – how do these people pay effective rates less than that?” The answer is the standard deduction, which loves early retirees. Because of the standard deduction, all four taxpayers enjoy what I refer to as the Hidden Roth IRA. They take some amounts from their traditional IRAs and pay 0 percent federal income tax on them.

Is the 72(t) payment plan outcome perfect? No. Those on a 72(t) payment plan have to abide by the restrictions of the 72(t) payment plan rules. But those rules are not that bad, and allow for techniques to potentially increase or decrease the annual payment.

I will note two things. First, I am not arguing anyone should simply plan on getting to an early retirement age and have every last penny in traditional retirement accounts. I am arguing that it is hardly a trap if someone gets to age 50, has every penny in traditional retirement accounts, and wants to retire using a reasonable withdrawal rate.  

Second, managing for Premium Tax Credit can be a concern. At the high end of Mindy and Scott’s Middle Class Trap range, a single taxpayer would be shut out of a Premium Tax Credit (having gone a bit over the 400 percent of FPL cliff) if they were on an ACA medical insurance plan in 2026, unless later tax law changes in 2025 amend Section 36B. This person could turn on Premium Tax Credits by electing a slightly lower initial 72(t) annual payment. 

Sufficiency Is The Real Problem

We should spend more time on the real problem: retirement sufficiency. According to UBS, median adult wealth in the United States in 2023 was just $112,157. Even considering that older Americans are likely to have greater wealth than younger adults, the median wealth statistic means many Americans of all ages are significantly behind in retirement savings. The best way to catch up is by making traditional retirement account contributions. 

Stay Tuned

This won’t be the last time you hear from me on this topic. Cody Garrett and I are currently writing Tax Planning To and Through Early Retirement, a book we hope to publish later this year. We will address all sorts of issues when it comes to accessing wealth and tax planning for those retiring prior to turning 59 ½.

What questions do you have about retiring prior to 59 ½? Let us know in the comments below and we might just answer your questions in Tax Planning To and Through Early Retirement!

Sign up for updates about Tax Planning To and Through Early Retirement here: https://www.measuretwicemoney.com/book 

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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.