Consumers are widely recommended to contribute around 15% of their paycheck to a retirement plan. The question whether to pick a ROTH IRA or a traditional IRA does not have a definite answer. For instance, it depends on whether one’s future [retirement] income is expected to in a higher tax bracket (ROTH) or a lower tax bracket (traditional), or whether one intends to live in a state with no income tax but high sales tax (traditional) or vice-a-versa (ROTH). Finally it depends on any future changes to the tax laws (25% sales tax, anyone?), so it is a difficult question which many experts have weighed in on.
For extremely early retirement, it is a lot simpler. Undoubtedly extreme early retirees will have learned to minimize their expenses to a level comparable to poverty. This means we get all the tax benefits of the poor while having lots of money.
Extremely early retirement planning thus falls in three stages.
- While having a W-2 income, save 50-70% of the income and maximize traditional IRA or 401(k) contributions and put the rest in taxable accounts. Personally, I have
a 401(k) anda traditional IRA. I will likely open a high-deductible HSA plan soon.I also have a HSA. I am not getting a ROTH IRA, yet. The taxable accounts should carry one from early retirement age (30ish) to 59.5 which frees the tax-sponsored plans from early withdrawal penalties.
- Once retired one will likely drop several tax brackets down to paying no taxes at all. Given a small income (*), I currently estimate from eyeballing the standard deductions on a 1040 that a single should be able to make $12,250 (twice for couples) before paying anything in taxes (standard deduction + IRA + HSA). Since any extreme early retiree worth his or her salt can live on less than that, the excess can be spent to convert a traditional IRA into a ROTH IRA tax free.
- Once reaching 59.5, this money can be taken out of the ROTH tax free. Upon reaching 65, money can also be taken out of the HSA and spent on non-health without penalty.
(*) A small income allowing one to take the deductions should not be too hard to come by presuming that one stays active. For instance, I saw an advertisement to lead a group of rookie cyclists on a Saturday tour, there’s dog walking, news paper routes, sign spinning (ha!), etc. The more ambitious might opt for freelancing and consulting.
Using FIRECalc, I note that I now have enough money in my taxable accounts to sustain myself
for 60 years after which I intend to be dead forever . However, I fully intend to take advantage of the above scheme to escape some capital gains tax.