Curious About FIRE? Here’s How to Set Up Your Retirement Accounts Now to Avoid Hefty Penalties Later, According to Experts

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You don’t need an astronomical salary to retire early.

What you do need is a clear strategy for deducting from your retirement accounts without putting money on the table. In fact, the way you use your IRA or 401(k) while pursuing Financial Independence, Retire Early (FIRE) status can make or break your personal financial goals.

“I have seen people achieve a FIRE lifestyle when each member of the partnership earns $45,000 to $50,000 per year,” says Cait Howertona certified financial planner (CFP) at Facet Wealth, a company dedicated to unbiased, conflict-free financial planning.

Ultimately, as you get closer to financial independence, you’ll want to withdraw money from your IRA or 401(k). However, if you’re under 59 , this action comes with notoriously hefty fines that can put thousands of dollars on the table and completely lose your “freedom number” (the amount of wealth you need to retire early).

Here are your options and how to proceed if you think about retirement funds early.

When should you get early access to pension funds?

Proponents of FIRE aim to retire years or even decades earlier than planned. But there are other scenarios where you may want to start using your retirement accounts sooner than expected: financial hardship, major career turns, or self-funding the launch of a new business are common reasons to dive into these accounts.

Whatever your situation, it’s good to know what financial planners call diversification of pension funds† Your long-term savings plans usually fall into one of three categories:

Tax Deferred Accounts: Traditional 401(k)s and Traditional IRAs that may or may not have an employer match plan. Your premiums are not taxed, but you pay income tax on withdrawals.Taxable Accounts: These include after-tax investments in brokerage accounts. You pay capital gains tax on net gains when you withdraw money.Tax Free Accounts: Roth IRAs and Roth 401(k)s allow for “tax-free” growth in your investments. Your adjusted adjusted gross income (MAGI) should be less than $144,000 per year if you file your tax return as a single person, and less than $214,000 per year if you file your tax return jointly. Your contributions are after tax and you pay no capital gains or income tax when you withdraw.

To achieve FIRE, Howerton says, people in lower tax brackets focus on cutting costs as much as possible. But they also employ investment strategies that can help anyone get into retirement accounts early without resorting to extremes.

Pro tip

Retirement accounts are important for achieving financial freedom, but many people put off setting a strategy until it’s too late. Maximize your savings in taxable, deferred and tax-exempt accounts to prepare yourself for all the surprises and opportunities that come your way.

One couple “Took advantage of maximizing the 401(k)s of one of the partners,” says Howerton. “Then they took advantage of contributing to Roth IRAs and money in brokerage accounts so they had tax diversification.”

Dawn Dahlby, a CFP and behavioral financial advisor, agrees. “Diversification creates a lot of flexibility for the pre-retired, and it helps balance tax consequences throughout your life.”

So which accounts should you tap and in what order? This is the pecking order that will help you maximize your savings.

For Early Retirement, Prioritize a “Roth Conversion Ladder” First

Roth IRAs have the most restrictive contribution limits. In addition to the income caps listed above, the maximum annual contribution for a Roth is $6,000 per year ($7,000/year if you are 50 years of age or older). But if you plan ahead, you can use these accounts to withdraw completely tax-free money.

The solution here is to be aware of Roth conversions. A Roth conversion allows you to move money from a tax-deferred retirement account, such as a traditional IRA or 401(k), into your Roth account. There are no income or contribution limits on Roth conversions.

You have to pay taxes on the amount you move between accounts, but you don’t pay any early withdrawal penalties (and you should pay taxes on this money anyway, since the contributions were pre-tax). This money can then grow tax-free in your Roth account, and you can withdraw it penalty-free after a five-year waiting period.

Because a Roth conversion is a taxable event — one that not only increases your taxable income, but can put you in a higher tax bracket — you may want to split the move into multiple conversions over several years.

This is known as a Roth conversion ladder, and it’s a great way to maximize savings while pursuing your FIRE aspirations. The Roth conversion ladder is an example of how strategic savings and tax planning can get you to your retirement goals faster.

“Maximize your tax-free income over time,” says Janet Galloway, a GVB with B&B Strategic Management. “Let’s pay what we are legally required to pay, but don’t pay more than we actually have to.”

Roth conversion ladders have several steps and require careful planning with a financial expert. For example, the five-year waiting period applies to each conversion, so you’re limited on when you can withdraw money from your Roth accounts based on when and how you opened them. A financial planner can help you determine how much you will need each year in retirement before 59 1/2 and develop a strategy to ensure you have access to the funds you need at the lowest possible cost.

Incorporating pension funds strategically

A Roth conversion ladder is a multi-year strategy that can save you thousands or even tens of thousands of dollars in the long run. However, as Dahlby points out, there is an opportunity cost to withdrawing money from a Roth IRA early: missing out on tax-free gains.

“In a perfect world, we don’t like people taking money out of their tax-exempt accounts,” she explains. “We put the most aggressive client investments in the Roth as they grow [tax-free]† She recommends tapping taxable accounts first, such as an investment account with a brokerage, as they have no penalties or restrictions. In addition, the capital gains taxes you pay are lower than the income taxes you would pay on traditional retirement accounts.

After that, it’s a matter of weighing the cost of an early withdrawal penalty from your tax-deferred accounts against the opportunity cost of getting a Roth account.

“It may not always be the best idea to pull your Roth right away,” says Dahlby.

Withdrawing pension funds directly from your 401(k) as a last resort

A traditional 401(k)—the most common retirement plan available through an employer—offers plenty of options for raising your money early in case you need it. These options have major drawbacks.

Withdrawing money from a 401(k) before you are 59 1/2 years old comes with a 10% penalty in most cases. The fine will be pasted on your tax bill of the year on top of the income tax you owe on your withdrawal. The IRS makes exceptions to this penalty: You can withdraw due to financial problems, take out a 401(k) loan if the plan allows, or take benefits if you leave your job at age 55 or older.

“You’re robbing Peter to pay Paul,” Galloway says. “You move away from your retirement lifestyle to fund your current lifestyle.”

However, as Dahlby says, you have to weigh this penalty against the potential gains you would miss from withdrawing early from a tax-exempt account.

“Paying a 10% fine may not be the end of the world,” she says. “Sometimes paying the 10% fine isn’t as bad as you think it is to access those funds.”

Set up your early retirement account now Access the game plan

The most important thing you can do — especially if you have the advantage of starting early — is give yourself options. Don’t rely on one type of long-term savings account; it may not meet your needs in the long run.

“Life changes every three to five years,” Dahlby suggests. “So it’s never too early to plan.”

If you find yourself having to retire early — or suddenly become able to because of a windfall — having both taxable and tax-free accounts to tap into penalty-free can help you maintain your early retirement lifestyle. Work with a financial planner to understand your options and use your available resources strategically.

“We live in an uncertain world,” Dahlby says. “Our goals and plans are constantly changing. You want to be able to pull different levers and pull different money from different buckets based on what’s going on.”

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