What if I told you that retiring early could lower your tax bill instead of raising it? Most people think that leaving their job means losing tax advantages, but today, we’re revealing why early retirement might be the best tax strategy you’ve never considered.
Hello, hello, hello and welcome to the BiggerPockets Money podcast. My name is Mindy Jensen and with me as always is my never taxing co-host, Scott Trench.
Thanks Mindy, great to be here. We won’t defer the tax puns until you’ve started immediately on today’s show.
We are so excited to be joined today by Sean Mullaney and Cody Garrett here at BiggerPockets Money. We’ve had them separately on the podcast before, but we are so excited to be joined by them together to talk about their new tax book, Tax Planning To and Through Early Retirement. Sean and Cody, welcome back to BiggerPockets Money.
Thanks so much for having us.
Yeah, we’re glad to be here. Thanks so much.
Do you guys both agree that people believe that taxes in early retirement are going to be worse than they ultimately end up being.
I generally think that’s true. There’s this, I call it an inchoate fear, right? Because people talk about widow’s tax trap, ERMA, required minimum distributions. These things have scary names, and so they become these sort of boogeymen. But a lot of times, you know, I think the next time you think about a commentator or some sort of commentary talking about taxes are going up in retirement or taxes are going to be daunting at retirement, ask where the math is. And it tends to be, look, we cannot give 100% blanket statements on the BiggerPockets Money podcast. But it tends to be that most people are going to pay less tax in retirement during their working years, mostly for the simple reason that they don’t get up every morning trying to go to work to earn an income. It turns out when you don’t try to earn income, you tend to pay less tax.
So Scott, I do think there is this sort of inchoate fear out there that, oh no, you know, taxes are going up and I’m going to pay a lot of tax in retirement. And, you know, in our book, we go through several reasons why we don’t think that’s true, but the one I’ll touch on right here is it’s going to be very helpful to not go to work every day, because when you don’t go to work every day, you’re not generating, you know, ordinary active income every day, you tend not to have as much taxable income.
One thing that Sean mentions in the book is this idea of like spending being a break on your income. So when you’re working, right, regardless of what you spend, right, your income is based on how much you’re getting paid at work. You know, that W2 income is coming in at ordinary income tax rates. So the worst, quote unquote, the worst tax rates if we wanted to add a little spin of fear there. But when you’re in retirement, you know, you don’t just take income, you know, based on, you know, some some magic number. It’s really your spending is a break on your income. So however much you spend, you’re typically going to take, you know, equal to your spending or less in retirement versus when you’re working, you know, you just get paid and then you typically spend less than you make.
So, um, another thing about that is the there’s a sphere right now that tax rates are going up. You know, you know, whether they look at the deficit or know, there’s a lot of political divide on this, that tax rates are going up. But in retirement, it’s so much more important to focus on your sources of taxable income rather than the tax rates themselves. So even if tax rates might go up, even Sean has done some awesome calculations that even if tax rates, you know, go up by 50%, we still have many cases that retirees will still pay less in retirement than they did while working.
That is really interesting. Sean, could you give us another layer of depth on that analysis? I think that’s a major thing in the back of my mind here is tax rates got to go up over the next couple of years. And I’ll I’ll throw this in there. I am more than half of the BiggerPockets Money community, which I think is different than the ChooseFI community, for example. But more than half of the BiggerPockets Money community wants to continue building wealth after early retirement. And I think implied in that is an eventual realization of a chubbier fat fire lifestyle, which may end up producing more or higher taxable income. Even in that situation I’m hearing, really you got to believe something really arrogant if you think your taxes are going to be higher for you in retirement. Is that what I’m hearing, Sean?
Scott, I think it’s helpful to divide retirement, particularly for a prospective early retiree, into early retirement and later retirement. Generally speaking, early retirement, even if you’re still building up financial assets, is going to be mostly characterized by long-term capital gain income and some qualified dividend income for most early retirees. We’re we’re talking about very early retirees. Most early retirees are going to live off capital gain sales in their taxable accounts. Most in the audience are probably familiar with the 0% long-term capital gains rate and then the 15% long-term capital gains rate. So a lot of that income is going to go off at 0% federal. Yeah, there’ll be some state tax, but that’s no big deal. The other thing about capital gains is basis recovery. So Scott, say you get to early retirement 50 years old and you say, hey, we’re going to live off $150,000 of mutual fund sales this year. Well, what’s your taxable income going to be? It’s going to be a lot less than $150,000. Now it depends on what the stock or mutual fund you’re selling is, but maybe there’s 100,000 of basis in that holding. So you’re spending 150,000 a year, but your taxable income is 50,000 if it was 100,000 of basis. And oh by the way, that’s long-term capital gain for the most part, which is 0% up to for a married couple year 2025, 96,700 of income goes off at 0% long-term capital gains. So that’s the early part of retirement.
Well what about the later part of retirement? And yes, here there is more risk. But again, we have to run up through the progressive tax brackets and the very large standard deduction. This is one of the favorable changes in the 2025 tax bill. The higher standard deduction was continued permanently and slightly increased, $1,500 for a married couple this year. There’s also a new senior deduction, that’s temporary, we could talk about that. But essentially what’s going to happen in retirement is you’re going to spend, say just out of those traditional retirement accounts. So the first dollars will come out against the standard deduction, that’s 0%. Now, eventually social security will soak up that standard deduction, but at least for some of that, we’re just going to take against the standard deduction. And then we go against the 10% bracket and the 12% bracket. And so even if we increase the 10% bracket to the 15% or, you know, a 50% increase, or 12 to 18%, 50% increase, you’re going to find a lot of that income is still going to enjoy a lower tax rate than the rate it enjoyed on the way in to say a 401k. A lot of the viewers are probably going to be deducting to say a traditional 401k at work at 22%, 24%, 32%. So that’s a current benefit. And to get back to a level where in retirement that benefit’s going to be erased, they’re going to have to increase taxes a whole, whole lot. That tends to be politically unpalatable.
And so, look, is there a risk of future tax increases in the United States? Absolutely. But part of our thesis is, well, if you’re deducting into 401ks at 24% or 32% and then you tax it back into income at 10%, 12%, 22%? Well, they’re going to have to do some significant tax hikes to make that trade-off not worthwhile. It’s not exactly a risk-free proposition. But boy, the tax hikes that would be needed to get us to a place where that’s not a favorable trade-off for most viewers, most listeners, the political environment isn’t there today and I don’t think it’s likely to be there in the next decade.
Yeah, and Sean, um, you know, really visualizing that when you’re working and contributing to those traditional 401ks, traditional qualified plans, you are deducting or excluding that from your income really top down. So if you think about the brackets, like 10, 12, 22, 24, 32, etc., when you’re contributing while you’re working, you’re deducting income from the top down. Right? So you’re cutting off, you’re deducting income at your highest tax rates while working. But in retirement, you have to think differently. You kind of have to flip the switch. In retirement, when you’re filling up your income, you’re actually going bottom up, rather than top down. So you’re deducting top down, but you’re, you know, drawing and distributing bottom up. So that’s really filling up like you mentioned, those significant standard deduction which is effectively a 0% tax rate, 10%, 12%. So when you average out your tax rate in retirement, we call this the effective tax rate, the average tax rate. That’s typically, I mean, most of the analysis that we’ve done, your effective tax rate for most early retirees is going to be like half or less than the tax rate that you deferred those traditional retirement account contributions.
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All right. Well, thanks for sticking with us. We’re coming back.
Cody, a moment ago, you said in retirement, it’s more important to focus on your sources of taxable income. And then Sean, you said that uh long-term capital gains are taxed first at 0% up to 97,500, I believe is what you said. So are there other sources of taxable income that are taxed at different rates?
Yeah, so the two that we focus on, I mean, especially for the like early retirees is going to be ordinary income, right? So I talk about fire as financially independent recreational employment. So some people, you know, even when they reach fire, they continue working. So, you know, if they have self-employment income or maybe a W2 job, that’s ordinary, meaning that’s taxed to those marginal tax rates that we mentioned, the 10, 12, 22, 24, etc. Also in early retirement, if you’re distributing income from an IRA, again, you have to be careful about using tactics that will avoid the 10% early withdrawal penalty. But if you’re taking money, distributing money from an IRA or doing Roth conversions, that’s also considered ordinary income at those marginal tax rates. But then the other side of the coin are these long-term capital gains tax rates. So those are for your qualified dividends and your realized long-term capital gains. So, as Sean mentioned, a lot of people in early retirement, they’re going to have some taxable brokerage money. So, we think about our checking accounts, our savings accounts, and taxable brokerage that when you sell those investments, a lot of them have been held longer than a year. So when you sell them, only the gain is going to be included in taxable income, but taxed at that favorable long-term capital gains tax rate versus the ordinary rates.
Mindy, we also happen to live in a period of history that’s very favorable for this sort of planning. So what I mean by that is low yields. Now look, is it possible that we go back to the 1980s and the S&P is yielding 5% and you know, T bills are yielding, you know, 15% or whatever they were yielding. But in today’s environment, what you can do is generally speaking through a a concept of called asset location, you can put your taxable bonds in traditional 401ks, traditional IRAs. So even if yield spike, that income is going to be deferred still and protected from this year’s tax return. And then think about the early retiree who’s, you know, under age 75, they’re not taking RMDs. They have these capital gains in equity mutual funds. Well, what’s the dividend yield on the equity mutual fund? In today’s environment, if that’s a domestic, well-diversified equity index fund, it’s almost certainly under 2%, assuming it covers most sectors of the US economy. So yields are tiny and we are living on capital gains. So yes, our our income on our tax return in early retirement is capital gains, that’s the preferred rates, the small dividends, right? Very small yields. Those also mostly qualify for these preferred rates. And yeah, maybe we have a small bank account, 4%, 5% interest on a small savings account, no big deal. So yes, history right now is being very favorable to us. Could these things change? Yes, but we have the protection of traditional retirement accounts for our interest bearing our bonds. And then we also have Roth accounts, so we could put some of those equities in Roth accounts and escape taxation that way too. In our book, it’s not all just deducting to 401ks and that’s your path, right? We talk about all sorts of different tactics. We happen to like Roth IRAs at home. And so if you have taxable accounts, Roth IRAs, traditional 401ks, the odds are you’re going to have asset location where even if yield spike, your income in the early part of retirement is going to be relatively low.
Is there a calculator that you’re aware of that you can use to help you really understand your effective tax rate?
Yeah, I would say, um, you can use something like a Dinky Town calculator. There’s some online, effectively these are just you type in your sources of income, right? from W2, you know, self-employment, your dividends, your interest income, things like that, maybe even some Roth conversions if that’s your choice. But once you do that, what you can do is, again, even if it doesn’t tell you your effective tax rate, you can effectively get to the bottom and look at your taxes owed, so your total tax liability, and then divide that into your total income sources. So in retirement, that might mean, you know, I have some income from interest from my bank accounts or my money market funds in my taxable brokerage accounts. I’ve got qualified dividends, non-qualified dividends, including, you know, REITs, we’re going to talk a little bit about real estate today. And then I also might have some, you know, some ordinary income from doing Roth conversions, some other sources, but you can add up all those, make that your big gross number, then you go through the income tax formula. Again, uh, thankfully the book has this fundamental calculation showing step-by-step how to calculate that. But once you get to the bottom number, which is your taxes owed, or your total tax, you can divide that. Um, you know, some people divide it into their taxable income or their AGI. We actually prefer, at least at the first level, to divide your tax liability into your total gross income sources to truly understand, you know, your lived experience of how much you pay in taxes as a percentage. For most early retirees, it’s very rare for that number from my perspective to be over 10%.
Oh, okay. There are people who say that taxation is theft, and I think that I like having streets and roads and interstates and police and fire and schools and all the things that, you know, taxes go towards. So, 10%, I’m okay with a 10% rate.
One more question on this point because I think it’s so easy to sweep away some of the analysis around taxes with this kind of this kind of question here which is out there, but I’ll ask it anyways, like that doesn’t make any sense from a civilizational perspective, right? Like why would the workers pay all of the taxes with their wage income and the capital, like, it seems like, it doesn’t seem like a smart system to have it where there’s so, such a much lower effective tax bracket on capital gains and wealth than there is on wage income. You know, you can feel how you want about that right right or wrong around there, but it feels like that’s a, there’s a risk that’s going to change at some point in the future fundamentally, right? In in some election cycle, 10, 15, 20 years down the road. Is that not something I should be worried about as an investor here?
Great question, and there’s no definitive answer, but I can share some thoughts. The first thought is this, if we look at the electorate in the 2024 election, one source we found claimed that 58% of the electorate was aged 50 or older. So your typical voter is a relatively old person at or near retirement. And that matters, okay? It’s hard to envision an environment where politicians of either or both parties are going to be eager to increase taxes on those at or near retirement. The other thing we talked about in the book is, well, you could disguise a tax hike, you could sort of make a tax hike more on workers than on retirees by upping the the 22, 24, 32%, 35, 37% brackets, but leaving those 10 and 12% brackets alone, what you’re going to wind up doing is taxing workers a lot more than you are retirees. Now, I do agree with you Scott that work is a good thing and productivity is a good thing and we might want to start rethinking some of these policies. Now, I will say though, late taxation of capital gains is not unique to the United States. Your friends Bill and Jackie on their catching up to FI podcast recently had a woman named Ruth from New Zealand and she was talking about capital gains, they’re just exempt in New Zealand. Well, that’s not uncommon. Capital gains are sort of this funny thing because there’s an argument it’s double tax. I go to work, I pay taxes on that money, I take that money, I invest it, then I have a gain on that and you know, now I pay a tax on that. We can quibble and we can fight about that all day. We’re not going to resolve that issue today. There’s a lot of tension in the system, Scott. I very much agree with that, but I don’t see a radical change. And you got to remember too, the government can print money and I’m not for printing money, but the government can run deficits in a way that you and I cannot. And so that’s another thing out there that sort of says, well, maybe they’re not just going to rush to increase taxes to close the deficits. And by the way, they haven’t thus far.
It seems like you shouldn’t be taxed for preserving wealth, right? Like if you have a million bucks, keeping it a million bucks in inflation adjusted dollars over 30 years, that doesn’t make sense to tax, right? And of course our system does tax that. But on the other hand, it seems like they get a gains of real gains inflation, it seems like there’s some, there’s some world where that’s going to change at some point in the future, which is, which has always been bugging me. But either way, if you keep your expenses low and your your tax planning here, you really won’t have to worry about it because there almost certainly be these these buckets of income, right? These these these tax brackets that will work through and your point remains the same. This is not something that is going to derail people’s retirement plans. So with that, let’s talk about the nuts and bolts of some of the key takeaways that you guys have for retirement planning. Like, what, what should people do given these, these, these assumptions that, hey, you’re going to be in your high tax years while you’re working and you’re going to be in an relatively low tax environment when you retire, whether early or at traditional age? How does that impact what you should do?
One of the biggest concepts in this book is called pay tax when you pay less tax. Sean came up with that fun line. And I think the biggest thing here is, as I mentioned before, right, a lot of people are focused on what are my tax rates now? We’re typically saying, what are my marginal tax rates now, my highest tax rate now. And then they think, well, tax rates are going up, so I’m just going to have higher tax rates than I do in the future. But we talk about this idea of paying tax when you pay less tax. We did mention that, you know, you’re usually going to pay less tax in retirement. And there’s kind of this fear though, right? Is when people go into retirement, they’re already scared sometimes often to even take money out of their accounts, right? And then when they say like, why should I pay my tax in retirement where that’s actually where I feel like they need the most money. It’s one of those psychological, you know, quantitative versus qualitative issues to to go through. And I think a lot of this comes down to, I think of really this this tolerance, this behavior and emotion around investing and paying taxes. Again, some of it’s political, some of it’s just based on how you grew up and even what you what you learned from your parents about money, whether a frugal mindset or a money avoidance mindset, that it’s often really easy to go into this confirmation bias of looking for fear-driven, you know, data. There’s a lot of books out there that even the title of the book will will make you think, oh my gosh, like I I must read this book book, otherwise I’m going to be crushed by taxes if I don’t. We specifically wanted to lean into like, you know, no fear in the book. So, you know, that concept quantitatively of paying tax when you pay less tax. And then qualitatively, really understanding this analysis fundamentally, and if you want to go into the more advanced tactics, but from a place of absolutely no fear. And Sean, I’d love for you to kind of mention that. I love this idea even in the introduction, you say, before we talk about the numbers, we first have to understand our emotions coming into this. And we’ve, I know, we’ve talked about the middle- class trap in here and other podcasts. We have to understand both the quantitative and the qualitative, you know, concepts at the same time to really have a successful retirement with clarity and confidence.
Yeah, Scot, I’ll just mention a couple of the tactics, right? So if we think we pay less tax uh in retirement than we do when we’re working, we probably should prioritize tax deductions. For most listeners, that starts with a traditional 401k. You know, you say, well, the Roth 401k is not objectively a bad thing, it’s not, but it sacrifices what might be your most valuable tax deduction. So for most out there, we tend to favor traditional 401ks at work. What about at home? You have an IRA? Well, there we tend to like the Roth IRA. Well, wait a minute, I thought you said traditional at work. Well, yeah, I did, but the Roth IRA at home has several benefits. One is many listeners cannot deduct a contribution to a traditional IRA. So there’s really little value there outside of something like a backdoor Roth IRA. We could talk about that if you’re interested, but there’s been lots of ink spilled on that. But you know, so many the combination in terms of retirement accounts is traditional 401K at work, Roth IRA at home. And then a lot of viewers are going to say, well, that’s not enough to get to early retirement and often that’s true. So then what else? Taxable accounts. And we have got a couple of examples later on where I think we’re going to find those taxable accounts aren’t all that taxable in early retirement. So we call those in the book the compelling three. Traditional 401k or other, you know, it could be a 403b, 457, TSP. So traditional at work, Roth IRA at home, taxable accounts. You’re setting yourself up for success in an early retirement and then even in a later retirement.
Let’s check our order of operations here. What we spent the first 15 minutes talking about are a philosophical overview of the fundamental assumptions that we’re working with here. The assumption is we’re taking somebody who is looking for that kind of classic one to two and a half million dollar fire number. They are a middle to upper middle class income earner, typical of the fire community, probably maybe starting out somewhere in that $75,000 range and ending their career in that $150,000 range over a 15, 20 year career. They’re in a relatively higher tax income bracket during their working years than they will be in retirement. This person will have a very low effective marginal tax bracket at retirement age. So with those assumptions that we worked out, here’s the order of operations that we suggest here. Can you guys beat us up here and tell us where where you might modify based on your extensive research and being true professionals in this space with with the tax certifications to back them up? So we have $1,000 emergency reserve, paying off any high interest rate debt. The tax tail does not wag the investment dog here. We got to you got to have a buffer against the world and pay off your high interest rate debt. Take your employer match. If you have an employee stock purchase plan, take advantage of it and sell immediately, have more taxes to pay, but take your gain, your 15% discount and get the free money there. Fully fund the emergency reserve. And then we get into our tax world, right? We suggest the HSA first, the 401k second, the Roth IRA third at home as you’ve put it. I love that. Then any 529s if college planning is part of that, part of the deal there. Then after tax brokerage, then low interest rate debt. And of course, we could swap out the 401k for teachers, military, all that kind of stuff. What do you guys think? Is this is this the right kind of classic order of operations for financial independence to typical pathway?
Yeah, I think that’s a great uh, you know, general order. I would say this, this order, you know, there’s this idea of flexibility versus tax optimization. There are a few things on that list that are really focused on, you know, risk management, right, and flexibility and like access to funds quickly. So that emergency fund, the time horizon for emergency could be as little as uh moment’s notice. So, typically, yeah, like building an emergency fund that’s certainly a risk management tactic that’s focused on flexibility. Really like I want you know liquidity and stability. I don’t want this money, you know, volatile, but I also want access to it quickly if my car breaks down, et cetera. I definitely believe in that, you know, the high interest debt being not necessarily like your hair’s on fire, but making a a very thoughtful approach to having flexibility around paying that off. From the tax optimization standpoint, we can kind of see the compelling three in here, right? We see the fully fund the 401k, the Roth IRA, the after tax brokerage, even though it’s lower on the list, you’ll notice that some of the things on this list, they’re like do these if you have access to them. So you’ll notice the employee stock purchase plan, the ESPP, you know that qualified ESPP, like, you know, that’s not going to be offered you at most companies again, certainly in the tech world, you see this a lot. But then when you see HSA, in 2025, you have to be covered by high deductible health plan, whether through work or even in retirement by the way, you can still contribute to an HSA even without earned income, assuming you have that coverage. And then the 529, right? That’s one of those kind of optionality kind of in the same realm as optionality for those future savings and investing.
So, I got a couple of thoughts to share. The first one is Scott is, you are a very brave man. You put fully fund 401k ahead of a Roth IRA. And in other personal finance fora, you’re going to get torn apart for that assertion. So I commend you for that because I agree with it. Well done, Scott. I don’t know if Mindy, this is your list as well. Well done to the both of you. So just be aware of that. There’s a lot of Roth IRA rabbit fans out there. So you might get some feedback on that from them, not from me.
Can we dive into that point? I know you have more more on this, but like, let’s let’s cover that because there’s going to be seven or eight versions of this order of operations. And when we talked about this, we said if you’re a real estate investor, you’re looking to house hack, you stop here and you start building cash for that house hacker or real estate investment, right? Um in there, and you’re forgoing these. And and that’s the this is the challenge here is the order of operations is great, but a lot of it just assumes, oh, you make so much money, you can just neatly go down the entire list here, no problem, right? But nobody can do that. Very few people can do that. You have to stop somewhere. There’s a prioritization component here. And that’s where this gets really heated because it’s usually somewhere in the process of seven and eight here of of of fully funding the 401k or the Roth versus the Roth IRA. My belief is that the the goal of personal finance and tax play, the Holy Grail is to get the money into the Roth IRA. It’s just that the best way to get the most money into the Roth IRA for many people, especially those looking for early retirement, is going to be to fully fund the 401k and then to at some point in their life, there’s likely going to have an opportunity to a low-income tax year, maybe when they have a lost loss or whatever, be able to roll that money into the Roth IRA at a future point. So I have a more nuanced take of like, I agree with the people in the forums going with the Roth IRA component. It’s just that this is the more tax efficient way likely for many people unless you’re truly going to work for, you know, through to traditional retirement age, earning a high income the entire way through and never have that opportunity to do that conversion. But what’s your what’s your response to that?
So, Scott, I like the Roth IRA and I do advocate for some Roth conversions. I don’t think the Holy Grail is to get everything into the Roth IRA, and I’ll give you just two quick reasons for that. One, we live in an era of high standard deductions. So for a lot of retirees having some money in that traditional just to take that out against the standard deduction. I refer to that phenomenon as the so-called hidden Roth IRA. Like, why do we need to convert into a Roth IRA if we can withdraw from a traditional IRA tax free against the standard deduction, particularly for those in their mid to late 60s, that could be very valuable distribution planning. And then the second thing is qualified charitable distributions. The tax laws do love retirees. One of the ways is this at age 70 and a half and older, you know, if you’re giving to your church or any other charity, 501c3, do it directly from the traditional IRA. It goes around everything else. It’s just excluded from income. You don’t get a tax deduction, but you don’t need a tax deduction because you’re going to take the standard deduction anyway. Your charitable distribution is excluded from income. It’s a way of tax-free bailing out the traditional IRA. So for those two reasons alone, I’m not a big fan of having every last dollar in the Roth, not that that’s a horrible, horrible outcome, but you’re wasting standard deductions and you’re wasting charitable or qualified charitable distribution rule. So why pay a conversion tax even if it’s a small tax to get every last bit into the Roth IRA.
And I and I think that thinking about Roth, there’s this binary decision of do I contribute to Roth now or do I never get Roth at all? Right? I think, you know, kind of maybe leading up to the holiday season with Halloween, we can kind of talk about now and later, right, as a candy, but it’s really, you know, do I want Roth now or do I want Roth later? And I think for most, you know, on the path to early retirement, you know, they they might, you know, might contribute to the Roth IRA at home, like Sean mentioned, but in terms of the the traditional 401k versus the Roth 401k, I think a lot of people on the path to early retirement are saying, well, I’ve heard Roth is amazing and I love Roth. I’ve even learned a lot about it. I’m going to contribute to my Roth 401k. And we’re like, wait, hold on, hold on. Just at least pause for a moment and think, it’s not Roth now or never, it’s Roth now or later. And for most early retirees, it’s actually like better to contribute to the traditional 401k at work to get those tax deferrals and then in early retirement possibly, you know, later convert that money to Roth at a much lower tax rate.
That’s my rationale, pretty much in a nutshell here. It seems like we certainly agree on the order, if not fully agreeing on the motivations behind it at certain of those levels. But it seems like this is like the classic kind of approach for that that sweet spot, like that very traditional path, the middle to upper middle class earner looking for fire in a 15, 20 year period in their maybe in their 40s for example. What would it take to get this to flip for you guys? Under what conditions would you have someone max out the Roth before the 401k?
All right, Scott. So you’re asking a really good question, and there are times where Roth beats traditional. So I’ll give you a couple of examples. One is in the book we use the term income disruption. So this could be mini retirement, this could be sabbatical, this could be layoff, this could be grad school, right? So we could have these times where, hey, you know, I’ve been accumulating and now I’m only doing a little bit of accumulating or not any accumulating. So at these times, what I might do is prioritize a Roth IRA contribution or do a taxable Roth conversion in my accumulation years because my income has been either fully disrupted or largely disrupted. And the other thing to think about is early career. So think about that person who’s 22, 23, they just graduated college and they start their first full-time job in October, and there three months of salary just aren’t that high. Maybe then do the Roth 401k, capture the match, and then maybe when we get to a 12-month income year, we flip to a traditional, that sort of thing. There are absolutely times. The other time is end of career. So there are going to be plenty of people who don’t just retire, they phase out. So they go from 40 hours to 30 hours to 10 hours. And at that 10 hour point, maybe, all right, those last few contributions, maybe we do the Roth.
I think there’s a lot of people who again, in the BiggerPockets Money community who who again, a third of the members of the BiggerPockets Money community certainly plan to build a business following their early retirement. Another third are unsure and another third are definitely not going to do that. They’re going to traditionally retire and not not do much. And there’s a big third and a small third and a medium-sized third in all of in that analysis by the way. But that’s roughly breaking it out. Let’s say that you’re, you know, one of those people who intends to pursue chubby or even fat fire and know you’re going to build a business after you leave your wage income. You know, and so you’re going to have a very prolonged period of high income years. You know, and your choice is 401k or Roth 401k. What would you advise that person?
One of the fascinating parts about this is, you know, you’re going into early retirement, let’s say you do build like a really awesome, successful business with a lots of income. What’s really nice is, you know, one part is you’re switching from a W2 earner to a schedule C, you know, self-employment. You have a lot more opportunities for deducting your expenses. So ironically there, moving into early retirement started a business, those first few years of starting your business, you might actually have fantastic opportunities to deduct. As you know, startup costs, starting a business is often more expensive than, you know, you know, running it ongoing. So one example here, you know, I left a W2 job to launch my financial planning firm back in 2021 and my first year of income, I left there kind of half year, I actually had income from self-employment when I was, you know, building my business, but I had a lot of deductions, right? I had to register my business, I had to, you know, file all the things, I had to pay for all the, you know, the home office kind of stuff. With the startup cost of launching a business in early retirement, you might have one to two years of fantastic opportunities to actually be doing those Roth conversions and things to get ahead of your ultra successful years of the of growing that business and retirement.
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Let’s jump back in.
There’s this this concept that uh uh we are getting credit for inventing, which we did not invent, but we’ve talked about here on BiggerPockets Money called the Middle Class Trap. I think that as we’ve explored this topic, it’s clear that there are many ways mechanically to access funds in retirement accounts well in advance of traditional retirement age if you leave work and access those funds, right? It’s just not a mechanical issue and there are many workarounds. However, I do want to call out that I think that there’s a challenge to accessing those funds while one is still working and that creates, I think a bridge problem to that future state, right? Folks who are been accumulating for many years are not well versed in the decumulation portfolio strategies and then the mechanics of actually setting these things up. And it’s very difficult to stop work on Monday and set up these things on Tuesday. Are there tax advantage ways to begin practicing or accessing these things in advance of leaving one’s job, maybe a year or two in advance, so I can bridge and get comfortable with the dynamic of my early retirement withdrawal strategy before I actually stop earning that high income.
I think this idea of the bridge is somewhat like a misconception or misnomer. I think it actually came from the idea of what we call the Roth IRA conversion ladder where they say you need to have at least five years of income like as you’re doing these, you’re laddering out these Roth conversions so you have, you know, you have penalty free access to that money in five years. I think that concept has also kind of told people, I need at least five years of income in my checking, savings, taxable brokerage before I can retire. And I think that bridge is actually a misnomer. I do believe that somebody retiring without money in a checking, again, most people are going to have at least, you know, a small, we talked about emergency fund was up in your up in your list of order of operations. Typically when somebody retires, they’re at least going to have some money in checking and savings, even if they have a lot in their 401k, they’ll probably have enough time. Again, that bridge doesn’t need to be five years, right? I guess that’s a way of saying it, the bridge is really just, you know, enough time to set up those distribution strategies, which thankfully don’t take too much time to set up. I would say though, you know, your 401k, you know, doing that trustee to trusty transfer from a 401k, to your IRA, you might be doing the the rule of 55 from your 401k, right? Some of those things administratively might take a few weeks, maybe a month or two to set up. But I don’t think you need like years of bridge to become an early retiry.
I guess at the higher level, I don’t know if that’s the problem. I think the problem is people feel like the money is inaccessible in those accounts. And to begin accessing it, you would then have to distribute it using perhaps like an SEPP or 72T type distribution, and you will pay taxes at your marginal bracket in that situation during any period that overlaps with your work. Like I think that’s more more of the issue is, you know, you think these people that have, you know, a million to $2 million of net worth and it’s all in their house and their 401k and a little bit in their roth and it feels inaccessible, especially in those years that are grinding out the death march to FI, right? It’s hard to coast in that particular situation or begin withdrawing, it seems like, given how the tax code is set up. Is that the right assessment in your guys’s view?
Scott, I think a few things are true. One, I do think it is helpful to have taxable accounts and cash going into early retirement, 100%, it’s very helpful. But just because something is very helpful does not mean it’s required. So I think you can think about, well, okay, I’m two years out from retirement. All right, what’s it going to look like and what am I going to live off of? And it may just be that the lion’s share is in the old 401k. That exists in the world where people have 401ks that just crushed it and they just don’t have a lot else. Well, okay, in the last few years of work, set up a bit of a bridge, you know, in terms of, maybe it’s a three-month cash fund or a six-month cash fund. I’m not big on mitigating sequence of return risk with three years worth of cash, right? But that’s me, you do you. I think the exceptions that exist today are voluminous enough and reliable enough, including a 72T, which is not that difficult to set up, relatively quickly. Now, you’re absolutely right that if you retire on June 30th and you have the 401k at the employer, you’re not going to get that 72T set up for a couple of months probably, right? That just is what it is, but it’s probably a two, three month transition issue, it’s not a year’s transition issue. So as Cody alluded to, what you’d probably want to do is work with one of the financial institutions to do a direct trustee to trustee transfer of that old 401k to the IRA. Now, there are going to be some people in this audience who are maybe they’re 57 years old. Well, maybe they got the rule of 55, right? Where they don’t even have to do this 72T and this roll over to an IRA, at least not initially. They can just take from their old plan as long as the plan has partial distributions. So that’s going to be a potential option. Government 457, there’s going to be some folks who have a governmental 457B where same thing and doesn’t even matter their age, no penalty on that, just take as you take. So Scott, I think there are transition issues, but they tend to be months long if that, they certainly don’t tend to be years long.
And I’ll add that there that one of the concepts is like, how can you speed up that transfer? Again, you got to be careful with transfers, but how can we possibly speed up a transfer? So let’s say that I have all my investment accounts are at Vanguard and my 401k is at fidelity net benefits. What I might want to do is rather than trying to send a 401k from fidelity to an IRA at Vanguard, maybe I I set up an IRA at fidelity so that, you know, sometimes depending on the employer and how it’s set up, sometimes that 401k to IRA transfer at the same custodian could be, you know, within the week, right? So if we if we want to get to our IRA quickly, and another thing to keep in mind is that, you know, moving IRA to IRA somewhere else is a lot easier than moving a 401k or another qualified plan to an IRA at a different custodian. So we might want to just consider a tactic of, you know, kind of speeding up, again, doing it smartly, but you know, speeding up that transfer so that we’re not waiting, you know, for a for a traditional check in the mail for two months, kind of figuring out, okay, I can’t retire until this, you know, check comes in the mail. It might be just a week or two that you can get that 401k to the IRA. Maybe even work with a professional to set up the 72T if certainly that’s not something to guess. Really, you want to really truly want to understand that tactic. But thankfully, again, if you have two years out to retirement, now you have the time to understand how it works, the fundamentals and the advanced tactics.
Let’s take a different example here, someone who’s just starting out on their journey. There’s two people that we come to mind. We have Average Joe’s a median income earner starting out at, you know, in their very early years, no wealth whatsoever. And their equivalent, um, who we’re calling Barb lately. There’s been a lot of interest in Barb. This is a 50-year- old divorced woman who has been a stay- at- home mom for 25 years and is terrified about traditional retirement. And in these situations, my belief is that they should not invest in their retirement accounts for a year or two because they need to jump start the income and wealth building journey. and that first 25, $30,000 of accumulation of cash can be used to either house hack or begin a business opportunity. And so I’m I’m not anti-retirement accounts. People think that I’m anti-retirement. I’m just in this situation, I like to defer those because retirement accounts almost always come with these restrictions on buying real estate that you’re personally using or business assets that you’re actively managing. What’s your reaction as tax professional on the CFP to that statement there? How how heretical is that in your view? Just for the first two years.
I do want to mention, so what one thing you mentioned is a divorced mom, right? You know, like maybe they were married for a long time. I would say that one of the possibilities for taking money out of a traditional retirement account early is with that qualified domestic relations order that quadro. So in divorce, that can actually be a way to avoid the 10% penalty. Again, it has to be set up correctly. Like don’t just assume it’s that way if you’re divorced, you can don’t just start taking money out of your retirement accounts. But um, you know, there might be a possibility to avoid the 10% penalty if you do need access to, you know, liquidity quickly or even like Scott, like you mentioned, after divorce, if you if you are splitting up some retirement accounts, like don’t feel like they’re off limits, you know, now that, you know, you’re, you know, you’re kind of, you know, kind of starting from the bottom up and, you know, catching up to FI as an an individual now.
I will say, you know, most Americans are not as entrepreneurial as Scott Trench is, right? So, you know, look, if you’re setting up a business, I agree with you that absolutely the flexibility of having cash, checking accounts, savings accounts, and all Americans should have at least some emergency savings to a degree at least, particularly accumulators. But I also look at people who are essentially just, you know, 30-year-old just starting out or the 50-year- old starting over, I really like managing today’s tax liability. That person, whether they’re the 30-year- old starting out or the 50-year- old starting over, they don’t have a tax problem in retirement. So that’s sort of tells us that Roth is probably not the path for them, at least initially. It could become part of the path, they might crush it over the next five or 10 years. But when you’re just starting over or starting out, at that point in your life, you don’t have a tax problem at all in retirement and that strongly points to, hey, I got to get my finances in gear today. I could really use that tax deduction if I am saving for my future. So just sort of my take on it. I do think it’s commendable to build up some emergency savings and if you are going to be more entrepreneurial, yes, you’re going to need more in those taxable accounts. But most Americans tend not to be that entrepreneurial. I mean, yes, we are an entrepreneurial country, but a lot of Americans have jobs. And so, okay, let’s manage first for today’s taxes, and then maybe in the future, we’re going to have a tax issue in retirement and we can then start thinking about more Roth type stuff.
And I’ll add Scott and Mindy, we talked earlier about kind of my path, you know, going from employee to employer, self-employed. And one thing for me is I mentioned, I haven’t contributed to a 401k in the last five years. And every like, oh my gosh, like what? How can somebody who’s such a big fan of these these concepts not contribute to a 401k? But like Sean said, like that flexibility and that liquidity, especially when you’re starting a business, is really important, not just for your runway for your personal and professional expenses, but also just the, you know, the future opportunity. You’re like, I’m willing to say no. I think that this is where it comes down to intention. It’s intentionally saying no to tax optimization versus not understanding it exist. So, you know, me not contributing to a 401k was really focused on increasing my flexibility, but I made that decision intentionally, not just, you know, without knowledge going in.
I love the intentionalness of your decision. And that’s probably the best decision for you in this specific situation. But I don’t want somebody to hear, oh, well, Cody’s not contributing to his 401k, so I don’t have to either. Well, no, that’s the exact wrong time to make that decision. Why would you be making this decision just because Cody did it? I mean, Cody’s done a lot of things that are great for Cody and are terrible for you. Just like Sean has done a lot of things that are great for Sean because he thought about it. So I love that you caviated that with, I did think about it. It was intentional.
And guess what I’m doing this year? I’m contributing to a 401k. So now people are like, what? He’s flipping back and forth? What’s going on? Oh, that’s another good point.
I think Sean’s right. Most people are not that entrepreneurial. But if you are, then those investments like a house hack or maybe a business could completely overwhelm the opportunities that come into your life relative to the tax advantages of these accounts. And when the income stream is on, max out the accounts basically for the rest of your your career on that. And that’s what you’re going to do, Cody.
Well, Cody and Sean, this was a super fun conversation. I learned a lot. I learned that I uh need to start planning my uh income and review that way earlier than I actually do. So, um I have already learned so much from you, but we didn’t even get to the retirement withdrawal order of operations. So we’re going to have you back next episode, which comes out on Friday, to talk about the order in which we should be withdrawing from our accounts. So I am super excited to talk to you guys again in just a couple of days. Uh tell us more about this book. What is the name of it? Where can people get it? Cody, I’m putting that on you.
Yeah, so the book is Tax Planning To and Through Early Retirement. It’s actually available today when this is coming out as a paperback or Kindle ebook. Um you can go to Amazon for that, but if you want to just easily go to measuretwicemoney.com/book and that will that will have all the links ready for you.
Awesome. And Sean, where can people find you online?
Thanks so much for having me today, Mindy and Scott. Uh you can find me at my blog, fitaxguy.com.
All right, Cody and Sean, thank you so much again for your time today, and we will talk to you in just a few days. All right, Scott, that was Cody and Sean, and that was so awesome. I love talking to those guys. They’re always such a wealth of information. What did you think of the show?
My gosh, these guys are a great source of knowledge and we only covered the accumulation phase on the tax side. We didn’t even get to how we’re going to distribute funds in retirement and how there’s even more advantages um that come into play, not with relative to just a lower income tax brackets that most retirees find themselves in versus their working years. So I think it was a great concept and I think that it’s illuminating to see just how much tax brackets would have to rise for a typical person pursuing financial independence for them to be paying in a higher marginal tax bracket in retirement in almost any circumstance than what they’re paying during their working years.
Sometimes it’s just really helpful to see actual math. Oh, that really opens my eyes. So I’m so glad you asked that question and I’m so glad they had such a great answer for it. All right, Scott, should we get out of here?
Let’s do it.
That wraps up this episode of the BiggerPockets Money podcast. My name is Mindy Jenson. He is Scott Trench. We’ll be back next episode with more Cody and Sean, and I am saying for now… When you’re ready to start your business, Northwest registered agent helps you do more than just file paperwork. You get all the tools to build a real business identity from day one, a business address, website, phone number, operating agreement, free guides and more at no extra cost. Northwest registered agent has been helping small business owners and entrepreneurs launch and grow businesses for nearly 30 years. They are the largest registered agent and LLC service in the US with over 1500 corporate guides. These are real people who know your local laws and can help you and your business every step of the way. With Northwest, your business is set up to stand on its own from day one. That means your home address, personal email, and phone number stay private. Don’t pay hundreds or thousands of dollars for what you can get from Northwest for free. Visit northwestregisteredagent.com/moneyfree and start using free resources to build something amazing. Get more with Northwest registered agent at northwestregisteredagent.com/moneyfree. Take a bow Highland cow.
