How to Avoid the “Middle-Class Trap”

You do everything you are “supposed” to do financially. You buy a home and max out your retirement accounts. You’re building wealth, but your net worth is trapped in home equity and investments that can’t be harvested without penalty. So, despite having a reasonably high net worth, you lack the freedom to change your lifestyle. You are “trapped.” 

They then proposed solutions to avoid or escape this “middle-class trap.”

Listening made me ask two questions:

1. Is “the middle-class trap” a real problem?
2. If so, what are the solutions?

Quick Background

The fact that I’m writing this post probably tells you that I disagree with at least some of their conclusions. If I agreed this was an important problem and felt they nailed the solutions, I would share the episode in my monthly “Best-of” post and move forward.

I rarely write these posts rebutting other people’s opinions and advice. There is a ton of garbage personal finance content published every day. Most of it deserves to be ignored.

When I write these posts, it is because I respect the source of the content and think the topic is important. Thus, it deserves a rebuttal. 

That was true when I published my disagreement with Vanguard’s take on the FIRE movement. That is the case here as well.

Mindy and Scott created the episode based on popular demand from podcast listeners. So this is a concern for many people and it is important to address that feeling.

Retirement Account Trap

Let’s start with the idea that retirement accounts are “a trap.” Neither Mindy nor Scott pushed back against this idea. Instead, they focused on alternative uses for these dollars, which included:

• Paying off a mortgage to lower future ongoing expenses,
• Investing instead in a taxable brokerage account,
• If using retirement accounts, at least use a Roth option so you can access the principal (contribution amounts) penalty-free.

Are Tax-Deferred Retirement Accounts a Trap?

I would argue that these accounts are not a “trap” and that there is nothing wrong with the standard advice to prioritize them when saving towards FIRE. There are several reasons for this.

You’re Not Actually Trapped

Part of the definition of the “middle-class trap” is a feeling of being trapped, unable to access money saved and invested in retirement accounts until you reach age 59 1/2. 

Just because you feel something doesn’t mean it is true. You have several options to get money from a retirement account penalty-free.

Let’s start with a provision applicable to tax-deferred Qualified and IRA-based plans. You can take money penalty-free by establishing a series of substantially equal periodic payments (SEPP) from either of these account types.

Qualified, but not IRA, plans allow you to start taking penalty-free distributions at age 55 if you separate from service during or after the year you reach age 55.

IRA, but not qualified, plans allow you to take penalty-free distributions to pay for qualified higher education expenses, health insurance premiums while unemployed, and up to $10,000 for qualified first-time home buyers.

If you use a Roth IRA, as noted in the episode, you can withdraw contributions from the account at any time with no penalty.

The Worst Case Isn’t That Bad

Assume a worst-case scenario. You have all of your dollars tied up in tax-deferred retirement accounts. It doesn’t make sense for you to set up SEPP distributions. None of the other provisions outlined above apply to you. You still are not trapped. 

You pay a 10% “penalty” or additional tax on early withdrawals. This still may not be a bad deal.

Imagine you deferred taxes that would have been paid at a 22% marginal tax rate. If you later need money because you don’t have other income to cover your expenses, you may now be in a lower, say 12% marginal rate. 

So even if every dollar you withdraw is taxed at that 12% marginal rate + the 10% early withdrawal penalty, you are paying the same 22% you would have had you not used the retirement account.

Remember, if this is your only income, it won’t all be taxed at your marginal rate. Some of those dollars that would have been taxed at 22% in the year earned will be taxed at the 10% marginal rate + the 10% penalty = 20%. Your first dollars in a given year would fall under the standard deduction, and the 10% penalty would be the only tax they would be subject to.

So even after paying a 10% penalty for an early withdrawal, you may come out ahead using retirement accounts. The higher your marginal tax rate when saving and the lower your living expenses when taking withdrawals, the more likely you will end up even or ahead, despite paying the 10% penalty for an early withdrawal.

Related: Early Retirement Tax Planning 101

In general, people overestimate taxes in retirement. If you spend a lot of time worrying about high taxes in retirement, check out these posts about the favorable taxation of income in semi-retirement and traditional retirement. 

Use It Or Lose It

Tax-advantaged accounts have contribution limits and deadlines for making those contributions. Once you miss taking advantage of them there is no going back.

If you decide not to utilize your retirement accounts in 2025 and then in 2027 come to regret it, there is no undoing the earlier decision. That is an opportunity missed.

If you decide to utilize your retirement account in 2025, and then in 2027 you regret it because you need those funds before age 59 1/2, you can still get them. As noted above, you may actually come out ahead even after paying the penalty.

Thus the impact of a sub-optimal decision is asymmetrical and favors using the tax-advantaged account if in doubt.

Tax Drag and Increased Health Care Premiums

People on the path to FIRE often fall into one of two camps.

1. They don’t actually want to retire. They want to work less and find more life balance, leave more stressful but higher-paid jobs for lower-paying but also lower-stress and more meaningful work, or try their hand at entrepreneurship without the risks typically associated with it.
2. Others do want to be done working, but they aren’t financially able to do so yet.

In both scenarios, these individuals or households may be able to make lifestyle changes, but they will still earn income out of want or need. After leaving the full-time workforce, they also may have to buy their health insurance on an exchange.

Taxable accounts produce income in the form of interest and dividends that you may not need if you’re still earning income. Whether you need this income or will reinvest it makes no difference to the IRS. It will be taxed. This is not true of tax-advantaged accounts which provide a tax shelter.

This creates tax drag that lowers your returns on taxable accounts over time. If buying health insurance through an exchange, this excess taxable income will also decrease your Premium Tax Credits, causing you to pay higher health insurance premiums.

Related: Maximize ACA Subsidies and Minimize Health Insurance Costs

I have nearly half of my savings in taxable investments and personally deal with this issue. I have several financial planning clients who have achieved financial independence and I help manage this scenario. 

In contrast, I’ve never encountered someone who couldn’t do anything they wanted because their money was trapped in retirement accounts once they understood their options to access those funds.

Trap or Advantage?

The feeling of being unable to access money from retirement accounts was described as part of the “middle-class trap.” I would reframe this inaccessibility as an advantage.

Even if you were a good saver early in life and are on the path to early retirement, you still have to plan and save for traditional retirement. Having these dollars grow tax-free for decades is a good thing. The penalty for taking them early is a reminder to consider your options before giving up this advantage.

Tax-advantaged accounts also provide protection against liability that taxable accounts do not. ERISA provides qualified plans with legal protections. IRA accounts also have some protection that varies based on state law.

Work-sponsored retirement plans also tend to have limited investment options. While some may think this is another disadvantage, it is more likely an advantage for most investors. This is especially true for someone who bought into the “middle-class trap” and may be impatient and frustrated with their trajectory.

Investors are susceptible to taking risks they don’t fully understand or can’t afford to take. The “trap” of a retirement account that limits them to more vanilla investment options may be the medicine they need to stay the course.

Is Home Equity a “Trap”?

The other piece of the “middle-class trap” is the “home equity trap.” I agree with the premise housing is a major obstacle for many who want to achieve financial independence quickly.

Housing is the largest expense for most households. If you want to develop a high savings rate, as required to achieve financial independence quickly, optimizing housing costs is vital.

This has always been true. However, this has become much harder in the past few years, due to a combination of factors.

1. Inflation in home prices and secondary costs of home ownership (insurance, property taxes, maintenance and renovation costs, etc.)
2. Rising interest rates.

Home equity increases your net worth. However, owning a home can trap you into a particular lifestyle because you must support the ongoing expenses associated with home ownership. 

I appreciated both hosts acknowledging this is a real challenge. However, I was surprised by the proposed solutions to the home equity trap they offered on the podcast.

Proposed Home Equity Solutions

Scott’s first suggestion was to pay off the mortgage quickly, eliminating the need to make future mortgage payments. Thus, you drastically lower your future spending needs. He argues, “You’re going to be freer if you pay off the mortgage” due to lower ongoing monthly liabilities.

Mindy’s counter suggestion was to keep the mortgage, but bypass tax-advantaged retirement accounts and instead invest in a taxable brokerage account. She argues that you will likely come out ahead by investing those dollars and later using the proceeds to pay your expenses, including the ongoing mortgage. Saving in a taxable account provides access to your money without restriction or penalty.

Both of these ideas have some validity. However, neither solves the problem. Instead, they’re kind of like moving chairs around on the deck of the Titanic. You’ve done something, but the ship is still going down.

What Have We Solved?

Paying off the mortgage requires applying substantial resources towards that goal. By definition, those resources then can’t be directed towards other investments.

Once you pay your mortgage, you will have lower ongoing expenses. However, you will also have no assets from which to pay the expenses you do have, including ongoing costs of home ownership like property taxes, insurance, repairs, and maintenance. Are you significantly more free?

Keeping the mortgage and investing in a taxable account may work out to your advantage. You would anticipate over long enough periods that you could earn a higher rate of return investing than the rate you are paying on a mortgage, particularly with many people who took out or refinanced mortgages at low rates coming out of the pandemic.

However, there is a trade-off. Investing adds an element of risk compared to the guarantee of a mortgage payoff. 

Even if that risk pays off, eventually you will need to use your portfolio to cover living expenses. You would then have to invest more conservatively and thus lose the potential delta between investment returns and mortgage rates. The only alternative would be to take considerable risk by continuing to hold volatile investments when you need them to be there to meet spending needs.

In addition to risk, having a mortgage means you must generate the income to pay it each month after making lifestyle changes. As noted above, the income required to meet this obligation can decrease your Premium Tax Credits. This results in paying higher health insurance premiums.

The Only Home Equity Solution

Most people buy the biggest, nicest, most expensive house they can afford. They allow what they can afford to be defined by what someone will lend them. Avoiding the home equity part of “the middle-class trap” requires doing something different. The more flexibility you desire in lifestyle, the more creative you may need to get.

To be fair, Mindy and Scott know far more about real estate than I do. They each understand the solution to the home equity trap. Scott did come back to this at the very end of the podcast and I got a sense they were trying not to come off heavy handed in the episode.

I know Scott knows a solution. He utilized “house hacking” to create lifestyle flexibility early in his adult life. This was a foundational idea in his outstanding book Set for Life.

I know Mindy knows this. Her husband Carl has written about their strategy of taking advantage of “live-in flips” to help them achieve financial independence.

I know this. Kim and I used geoarbitrage when we moved to a small town where my healthcare salary was both higher and went further than living in a higher-cost city early in our adult lives. 

We downsized when we relocated to a higher-cost mountain town after achieving financial independence. There were trade-offs associated with downsizing. We made these decisions because they enabled the lifestyle change we desired.

I appreciate Mindy and Scott not following the tired script that many personal finance educators use of saying, “Just do what I did.” There is no single way to avoid being trapped by housing costs. What works for one person may not work for another due to different skill sets, family situations, geographical areas, etc.

However, you have to do something differently than everyone else to create a lifestyle that looks different from everyone else’s. 

Those on the path to financial independence need to understand this. It is important for those of us helping them to be clear and honest in communicating that.

Reframing the “Middle-Class Trap”

The “middle-class trap” is an understandable feeling. Applying the principles of FIRE enables achieving financial independence reliably in 10-20 years.

This sounds fast compared to a standard 40-50 years career many people work between finishing school or training and traditional retirement age. Still, it is a long time in the grand scheme of things!

Don’t get caught up in the idea of the “middle-class trap.” Don’t get impatient and look for shortcuts. Instead, focus on applying proven principles while creating a path to financial independence that you can enjoy. 

Finally, don’t get caught up in the idea that financial independence is an all-or-nothing proposition that can lead to “feeling trapped.” Appreciate and enjoy the growing freedom you are accumulating along the path to financial independence.

Use that growing freedom to make incremental improvements in your lifestyle. You’re not trapped!

Related: The Stages of Financial Independence

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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. After achieving financial independence, Chris began writing about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. Chris also does financial planning with individuals and couples at Abundo Wealth, a low-cost, advice-only financial planning firm with the mission of making quality financial advice available to populations for whom it was previously inaccessible. Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He has spoken at events including the Bogleheads and the American Institute of Certified Public Accountants annual conferences. Blog inquiries can be sent to chris@caniretireyet.com. Financial planning inquiries can be sent to chris@abundowealth.com]

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