The core tenant of the FIRE movement is to create as big of a gap as possible between your earnings and your spending. What you do with the difference — your savings — can make a world of difference in how quickly you can reach financial independence.
Of course you want to invest those savings, but choosing the best accounts to invest in can dramatically reduce your tax liability throughout your lifetime. While Roth retirement accounts might be part of those plans, they shouldn’t be a priority for the vast majority of people pursuing early retirement.
Save on taxes while you’re working
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If you have access to tax-deferred retirement accounts through work or through a traditional IRA, you absolutely should be making the most of them. The potential tax savings from those contributions are extremely high for people planning on retiring early. That’s because you save on taxes at your marginal tax rate. If your spending in retirement remains significantly lower than your current earnings, your withdrawals will be at a significantly lower tax rate.
For example, if you, as an individual, make $90,000 per year and only spend $40,000 per year, your traditional retirement account contributions are in the 22% tax bracket. But in retirement, when you make withdrawals of $40,000 from your retirement account, the effective tax rate is about 7.6%, including the impact of the standard deduction. That’s a tax savings of about $5,750, which is a huge chunk of your spending.
Of course, that’s based on current tax rates, which could change. But in general, the more money you can funnel into tax-deferred retirement accounts, the more you’re likely to save on taxes.
You should have some money in taxable accounts
If you’ve maxed out your employer’s retirement plan, aren’t eligible for a traditional IRA deduction, and you’re trying to decide between a Roth IRA and a taxable brokerage account, it’s a tough decision. But there are three advantages for early retirees to invest in a taxable account.
First of all, you can access funds in a taxable account at any point. For a Roth IRA, you’ll be able to access contributions, but any growth on your investments is locked up until age 59 1/2.
Second, you might be able to access funds in a taxable account in retirement with minimal or possibly no taxes. If you keep your spending low, and your withdrawals from your traditional retirement account are minimal, you may fall into the 0% capital gains tax bracket. Even if you miss the mark by a bit, the taxes on your capital gains above the threshold will only be 15%.
Finally, having investments in a taxable account will open up opportunities for tax-loss harvesting while you’re in your working career. By purposely producing losses to offset your income while you’re working, you’re effectively making a deal to save at your marginal tax rate today in exchange for the capital gains tax rate (0% or 15%) in the future. Just be aware of the wash-sale rule, which will prevent you from buying back the same stock within 30 days of the sale.
If you can fund a Roth IRA and still have plenty of money to invest in a taxable account, it may be worthwhile for the sake of diversifying the tax treatment of your accounts, but it’s still not a clear winner over a taxable account for someone planning to retire early.
The Roth IRA has its place
Even though a Roth IRA shouldn’t be a priority for someone seeking early retirement, it can still have its place in a retirement plan. Early in your career, you’re in such a low marginal tax bracket that a traditional IRA doesn’t provide much tax savings, and a Roth IRA can be a smart move. Also, big savers may be able to fund a backdoor Roth IRA or mega backdoor Roth IRA while still fully funding traditional retirement accounts and saving in a taxable account as well.
An early retirement may strategically convert funds from a pre-tax retirement account to a Roth IRA once they stop working, utilizing the Roth conversion ladder strategy. That can allow early retirees to access pre-tax retirement funds before age 59 1/2.
The Roth IRA can be a very useful tool for minimizing taxes, but when it comes to planning for early retirement it’s low on the priority list.
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