If you follow a Financial Independence and Early Retirement (FIRE) PlanYou’re probably already aware of the importance of minimizing your expenses and maximizing your savings. However, it’s also important to consider the tax you’ll pay when you withdraw those savings in retirement — and that’s where a Roth Individual Retirement Account (Roth IRA) between.

Roth IRAs are similar to Traditional IRAsthe biggest difference between the two being how they are taxed. Roth IRAs are funded with dollars after tax; this means that contributions are not tax deductible. Once you start withdrawing funds, the money is tax-free. Traditional IRA deposits are made with dollars before taxes; you typically 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.

Roth Conversions

There’s nothing wrong with using a Roth IRA as standard, 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 Roth IRA contributions before age 59½, but you must wait until after that age to withdraw your investment earnings. Otherwise, you will pay an early withdrawal penalty.

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

There are other exceptions for withdrawing money from a Roth IRA, such as using it to pay for a first home purchase or qualified education expenses. However, when it comes to 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 rolled over into a Roth IRA. This is called a Roth IRA Conversion. Contributions to these accounts are generally tax-free, and because 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 work and withdraw that money from your Roth IRA tax-free, even if you retire early.

This is not to say that Roth conversions are free. You will have to pay ordinary income tax on any retirement savings transferred to a Roth IRA in the year of conversion.

For example, if you roll over $40,000 from an old 401(k) plan to a Roth IRA and you are in the 12% range tax bracket in 2024, the first $11,600 will be taxed at 10% and the remaining $28,600 at 12%. As a result, you will pay $4,568 in income tax on the $40,000 converted, as shown below:

• 10% at $11,600 = $1,160
• 12% at $28,400 = $3,408
• Total tax = $4,568 or ($1,160 + $3,408)

However, people with a FIRE plan will typically have a certain number of years of early retirement (before reaching age 60), during which they may have low income and therefore be in a low tax bracket. During these years, you can convert money into your Roth IRA and create a tax-free income stream for your later retirement years.

Roth IRA in early retirement

When FIRE investors talk about Roth IRAs, it’s usually in regards to the type of Roth conversions we described above. However, Roth IRAs have other benefits for FIRE investors, even without a conversion strategy.

For example, a Roth IRA can act as an effective (and tax-advantaged) contingency or emergency fund. Since Roth contributions can be withdrawn without penalty (again, not earnings, just your original contributions), they can be used to cover a year in which your other investments have not grown as they should or if you are faced with an unexpected expense.

Likewise, Roth IRA withdrawals can be used as a source of additional cash flow without impacting taxes or health care premiums. FIRE investors will generally maximize their income to stay either in a particular tax bracket or within a particular bracket for health premium purposes. Access to other types of retirement funds – selling shares of taxable accounts or making a 401(k) distribution if you are over 59½ but under 65 and not yet under Medicare – triggers taxable events. Withdrawing your contributions from a Roth account doesn’t trigger anything.

Finally, Roth IRAs are a good way to build your inheritance. If part of your FIRE plan involves passing wealth to your children (or grandchildren or great-grandchildren), Roth IRAs are a good vehicle for that. Indeed, unlike some other retirement accounts, Roth IRAs have no required minimum distributions during the owner’s lifetime, so that the money inside them can continue to grow tax-free.

The essentials

Most FIRE investors view 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 the event of early retirement. However, Roth IRAs also have other benefits for those with a FIRE plan, acting as a source of emergency income in retirement or as a way to pass on wealth to your heirs.

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