How a Roth IRA Fits Into Your FIRE Plan

Using a Roth IRA to retire early

If you are following a Financial Independence, Retire Early (FIRE) plan, you are likely already aware of the importance of minimizing your spending and maximizing your savings. However, it’s also important to consider the tax that you will pay when you withdraw these savings in retirement—and that’s where a Roth individual retirement account (Roth IRA) comes in.

Roth IRAs are similar to traditional IRAs, with the biggest difference between the two being how they are taxed. Roth IRAs are funded with after-tax dollars; this means that the contributions are not tax deductible. Once you start withdrawing funds, the money is tax free. Traditional IRA deposits are made with pretax dollars; you generally get a tax deduction on your contribution and pay income tax when you withdraw the money from the account during your retirement years.

In this article, we’ll look at how Roth IRAs can fit into your FIRE plan.

Key Takeaways

  • Money invested in traditional pretax retirement accounts like a 401(k) can be converted into an investment in a Roth IRA.
  • This allows FIRE investors to access their retirement savings in early retirement tax free as long they stay within the rules.
  • Roth IRAs also can be used as a source of emergency income in early retirement or as a way of passing on wealth to your heirs.

Roth Conversions

There’s nothing wrong with using a Roth IRA in the standard way, even if you have a FIRE plan. Roth IRAs can be a good vehicle for long-term investments that you can then withdraw, tax free, in retirement. If you plan to retire early, you can withdraw your contributions to a Roth IRA before you are 59½ years old, but you must wait until after that age to withdraw your investment earnings. Otherwise, you will pay an early withdrawal penalty.

There are some general advantages to Roth IRAs for FIRE investors. These are a consequence of the main differences between Roth IRAs and standard IRAs. With a Roth IRA:

  • Contributions are not tax deductible.
  • Contributions can be withdrawn anytime tax- and penalty-free.
  • Both investment earnings and contributions can be withdrawn tax- and penalty-free as long as you are at least age 59½ and your Roth IRA is at least five years old.  

There are other exceptions for taking money out of a Roth IRA, such as using them to pay for a first-time home purchase or qualifying educational expenses. However, for the purpose of early retirement, the three points above are the most important.

The other factor to consider for FIRE investors is that money originally invested in regular retirement accounts—traditional IRAs, and 401(k) or 403(b) plans—can be moved into a Roth IRA. This is called a Roth IRA conversion. Contributions to these accounts are generally tax free, and since Roth IRAs allow you to withdraw tax free, you get the best of both worlds. You can contribute to your regular IRA tax free while you are working, and withdraw this money from your Roth IRA tax free, even in early retirement.

That’s not to say that Roth conversions are free. You will have to pay ordinary income tax on any retirement savings transferred into a Roth IRA in the year of conversion. For example, if you move $40,000 from an old 401(k) plan into a Roth IRA, and you’re in the 12% tax bracket, then you’ll have to pay $4,800 in federal income tax on the amount converted.

However, those on a FIRE plan generally will have a number of years in early retirement (before they reach age 60), during which they will have a low income and consequently be in a low tax bracket. During these years, you can convert money into your Roth IRA and build a stream of tax-free income for your later retirement years.

Since Roth IRA contributions are not tax deductible, they can be withdrawn tax free at any time as long as you’ve had your Roth IRA for five years. That means even before you turn age 59½.

Roth IRAs in Early Retirement

When FIRE investors talk about Roth IRAs, it’s generally with regard to the type of Roth conversions that we’ve described above. However, Roth IRAs have some other advantages for FIRE investors, even without a conversion strategy.

For example, a Roth IRA can act as an effective (and tax-efficient) contingency or emergency fund. Because Roth contributions can be withdrawn without penalty (again, not the gains, only your original contributions), they can be used to cover a year when your other investments haven’t grown as they should, or if you come up against an unexpected expense.

Similarly, Roth IRA withdrawals can be used as a source of additional cash flow that doesn’t impact taxes or healthcare premiums. FIRE investors will generally optimize their income to stay either under a particular tax bracket or within a particular range for healthcare premium purposes. Accessing some other types of retirement funds—selling shares of taxable accounts, or taking a 401(k) distribution if you’re over age 59½ but under age 65 and not yet on Medicare—triggers taxable events. Taking your contributions out of a Roth account doesn’t trigger anything.

Finally, Roth IRAs are a good way to build your legacy. If part of your FIRE plan involves passing on wealth to your children (or grandchildren or great-grandchildren), Roth IRAs are a good vehicle for this. That’s because, unlike some other retirement accounts, Roth IRAs don’t have any required minimum distributions during the life of the owner—so the money in them can keep growing tax free.

What are the best Roth individual retirement account (Roth IRA) investments?

The best investments for Roth individual retirement accounts (Roth IRAs) are similar whether you are following a Financial Independence, Retire Early (FIRE) plan or a regular retirement plan. Good options include income-oriented stocks, growth stocks, and indirect and/or direct real estate investments.

Is a Roth IRA good for FIRE?

Yes. Roth IRAs can form a valuable part of a FIRE strategy—as a long-term investment vehicle, a source of emergency funds, or part of a Roth IRA conversion ladder.

Is it better to invest in a Roth IRA or a 401(k)?

In many cases, a Roth IRA can be a better choice than a 401(k) retirement plan, as it offers a flexible investment vehicle with greater tax benefits—especially if you think that you’ll be in a higher tax bracket later in life.

The Bottom Line

Most FIRE investors think of Roth IRAs in the context of a Roth ladder: a chain of Roth conversions that can allow you to access your traditional retirement dollars tax free in early retirement. However, Roth IRAs also have some other advantages for those on a FIRE plan, acting as a source of emergency income in retirement or as a way of passing on wealth to your heirs.

Just make sure that you understand the complexities of Roth IRAs—especially the distribution rules—before you build them into your FIRE plan.

Article Sources

  1. Internal Revenue Service. “Traditional and Roth IRAs.”

  2. Internal Revenue Service. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs): What Are Qualified Distributions?

  3. Internal Revenue Service. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs): Exceptions.”

  4. Internal Revenue Service. “IRA FAQs.”

  5. Internal Revenue Service. “Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs): When Can You Withdraw or Use Assets?

  6. Internal Revenue Service. “Retirement Topics — Required Minimum Distributions (RMDs).”

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