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.

  1. 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) and a 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.
  2. 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.
  3. 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.

Originally posted 2008-03-19 07:26:27.