Why Early Retirement Means Paying Less in Taxes

22:02So 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 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 concepts at the same time to really have a successful retirement with clarity and confidence.

22:36Yeah, Scott, I'll just mention a couple of the tactics, right? So if we think we pay less tax 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 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.

23:10but 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 in 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.

23:48So we call those in the book the compelling three, traditional 401k or other, 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.

24:35They'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 you might modify based on your extensive research and being true professionals in this space with the tax taxed certifications to back them up. So we have a thousand dollar emergency reserve paying off any high interest rate debt. The tax tail does not wag the investment dog here.

25:06We got it. 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. Love that. Then any 529s of college planning is 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.

25:42What do you guys think? Is this the right kind of classic order of operations for financial independence, the typical pathway? Yeah, I think that's a great general order. I would say this order, there's this idea of flexibility versus tax optimization. There are a few things on that list that are really focused on risk management and flexibility and access to funds quickly. So that emergency fund, the time horizon for emergency could be as little as a moment's notice. So typically, yeah, like building an emergency fund, that's certainly a risk management tactic that's focused on flexibility. Really, I want liquidity and stability.

26:17I don't want this money volatile, tool, but I also want access to it quickly if my car breaks down, etc. I definitely believe in that, you know, the high interest debt being not necessarily like your hair is on fire, but making 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.

26:45So So you'll notice the employee stock purchase plan, the ESPP, that qualified ESPP, that's not going to be offered 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 a 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. Oh, I got a couple of thoughts to share.

27:14First one, Scott, is you are a very brave man. You put fully fund 401k ahead of a Roth IRA. And in other personal finance forums, 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 that there's a lot of Roth IRA rabid 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 on this, but let's cover that because there's going to be seven or eight versions of this order of operations.

27:52And 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 hack or real estate investment in there. And you're forgoing these. And 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 fully funding the 401k or the Roth versus the Roth IRA.

28:30My belief is that 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, they're likely going to have an opportunity in a low income tax year, maybe when they have a 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 people in the quorums going with the Roth IRA component.

29:02It'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 a so-called hidden Roth IRA.

29:43Like 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 can 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.

30:19Your 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 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 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, maybe leading up to the holiday season with Halloween, we can kind of talk about now and later, right, as a candy.

30:59But 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 might contribute to the Roth IRA at home, like Sean mentioned. But in terms of 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.

31:28And 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 sweet spot, like that very traditional path, the middle to upper middle class earner looking for fire in a 15, 20 year period, maybe in their 40s, for example.

32:03What 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? 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, 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.

32:54And another 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 their 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 absolute 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.

33:32I think there's a lot of people who, again, in the BiggerPocketsMoney community who, again, a third of the members of the BiggerPocketsMoney 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 do much. And there's a big third and a small third and a medium-sized third 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.

34:16What would you advise that person? One of the fascinating parts about this is, you know, going into early retirement, let's say you do build like a really awesome, successful business with lots of income. What's really nice is, you know, one part is you're switching from a W-2 earner to a Schedule C, you know, self-employment, you have a lot more opportunities for deducting your expenses. So ironically, they're moving into early retirement and starting a business. Those first few years of starting your business, you might actually have fantastic opportunities to deduct as you know, startup cost, starting a business is often more expensive than, you know, you're running it ongoing.

34:48So one example here, you know, I left a W-2 job to launch my financial planning firm back in 2021. And my first year income, I left there kind of half year, I actually had income from self-employment when I was building my business, but I had a lot of deductions, right? I had to register my business. I had to file all the things. I had to pay for all 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 growing that business in retirement.

35:21All right, this is our final ad break, and then we'll be right back to this not very taxing conversation in a minute.

35:53closer to being financially independent or you get closer to hitting your financial independence number. The thing that makes that practical now is Ethos, a platform that helps you find life insurance all 100 % online. Same day coverage, no medical exam. You just answer a few health questions online, up to$3 million in coverage, some policies as low as$30 a month. So building a two or three layer ladder that used to take a month of appointments is something you can knock out before your coffee gets cold. Get your free quote at ethos.com slash bpmoney. That is E-T - H-O-S dot com slash BP money.

36:26Application times may vary and rates may vary. When's the last time you enjoyed checking your finances? Well, Monarch is trying to change that. Open it up and in a couple of minutes, you know exactly where you stand with your spending, your goals, your net worth, your investments, everything all in one place. And it goes wherever you go. Quick check in on your phone between meetings or check the bigger picture on your laptop on Sunday night. Everything syncs, everything refreshes whenever you want. Use the code pockets at monarch.com to get your first year of Monarch Core half off at just$50. That's 50 % off your first year at monarch.com with the code pockets.

37:11Mindy Jensen:Let's jump back in. There's this concept that we are getting credit for inventing, which we did not invent, but we've talked about here on BiggerPocketsMoney 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. Live your life 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.

37:42And that creates, I think, a bridge problem to that future state, right? Folks who have 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-advantaged ways to begin practicing or accessing these things in advance of leaving one 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.

38:17I 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 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, tax, or 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 gonna have at least a small, we talked about emergency fund was up in your list of order of operations.

38:56Typically when somebody retires, they're at least gonna 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 enough time to set up those distribution strategies, which thankfully don't take too much time to set up. I would say, though, your 401k, you're doing that trustee to trustee transfer from a 401k to your IRA. You might be doing 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.

39:27But I don't think you need like years of bridge to become an early retiree. 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 a SAPP 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 of the issue is, you know, you take these people that have, you know, a million to$2 million in net worth, and it's all in their house, their 401k and a little bit in their Roth.

40:03And 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' view? 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?

40:43And 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 in terms of maybe it's a three-month cash fund or six-month cash fund. I'm not big on mitigating so you can 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?

41:37That 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 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 rollover to an IRA, at least not initially. They can just take from their old plan as long as the plan has partial distributions.

42:12So that's going to be a potential option. Government 457, there are going to be some folks who have a governmental 457b where same thing, it 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 there that one of the concepts is like, how can you speed up that transfer? Again, you have 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.

42:46What I might want to do is rather than trying to send a 401k from Fidelity to an IRA at Vanguard, maybe I set up an IRA at Fidelity. So that sometimes, depending on the employer and how it's set up, sometimes that 401k to IRA transfer at the same custodian could be within the week. So if we want to get to our IRA quickly, and another thing to keep in mind is that moving an 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 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 traditional check in the mail for two months, kind of figuring out, okay, I can't retire till this, your 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.

43:37Certainly, 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 come to mind. We have average Joes, a median income earner starting out at, you know, in their very early years, no wealth whatsoever. And their equivalent, who we're calling Barb lately, there's been a lot of interest in Barb.

44:06This 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 jumpstart the income and wealth building journey. And that first$25 ,000,$30 ,000 of accumulation in cash can be used to either house hack or begin a business opportunity. And so I'm not anti-retirement accounts. People think that I'm anti-retirement. I 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.

44:50What's your reaction as a tax professional and CFP to that statement there? How heretical is that in your view? Just for the first two years. I do want to mention, so one thing you mentioned is a divorced mom, right? You know, like maybe they've been married 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. 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.

45:23But there might be a possibility to avoid the 10 % penalty if you do need access to liquidity quickly. Or even like Scott, like you mentioned, after a divorce, if you are splitting up some retirement accounts, don't feel like they're off limits now that you're kind of starting from the bottom up and catching up to FI as an individual now? I will say most Americans are not as entrepreneurial as Scott Trench is, right? So look, if you're setting up a business, I agree with you that absolutely the flexibility of having cash, checking account savings, and all Americans should have at least some emergency savings to a degree at least, particularly accumulators.

46:01But I also look at where people who are essentially just 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 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.

46:35And 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, OK, let's manage first for today's taxes. And then maybe in the future, we're going to have a tax issue in retirement.

47:07We 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 an employee to employer, self-employed. And one thing for me, as I mentioned, I haven't contributed to a 401k in the last five years. And everybody's like, oh, my gosh, like what? How can somebody who's such a big fan of 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 opportunities.

47:38You'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 exists. 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.

47:58Mindy Jensen: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 caveated that with, I did think about it. It was intentional.

48:32And 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 career on that. And that's what you're going to do, Cody.

49:01Mindy Jensen:Well, Cody and Sean, this was a super fun conversation. I learned a lot. I learned that I need to start planning my income and review that way earlier than I actually do. So 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 account. So I am super excited to talk to you guys again in just a couple of days. Tell us more about this book. What is the name of it? Where can people get it? Cody, I'm putting that on you.

49:42Yeah, 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 e-book. You can go to Amazon for that. But if you want to just easily go to measuretwicemoney.com slash book, and that'll have all the links ready for you.

49:59Mindy Jensen:Awesome. And Sean, where can people find you online? Thanks so much for having me today, Mindy and Scott. 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 that come into play, not relative to just the lower income tax brackets that most retirees find themselves in versus their working years.

50:41So 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.

51:00Mindy Jensen: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 Bigger Pockets Money podcast. My name is Mindy Jensen. He is Scott Trench. We'll be back next episode with more Cody and Sean. And I am saying for now, take a bow, Highland Cow.