For those of us in the FIRE (financial independence / retire early) community who want to strive for early retirement and who are also lucky enough to make it happen, it’s really important to have a funding plan with accessible money for those early retirement years.
Everyone has their own FIRE strategy. But for most people that starts with saving enough in traditional retirement accounts to fund later retirement years. Perhaps that includes maxing out tax deferred accounts, like a 401k and IRA if you’re in the USA. Maybe that also includes saving to a tax free account like a Roth IRA. In our case we focused on power saving in our employer sponsored 401k’s and our Traditional IRA’s, but we didn’t open our Roth accounts until we were at the end of our career years. If we knew then what we know now we would have started saving to Roth accounts much earlier.
A complete FIRE strategy also needs some puzzle pieces specifically designed to cover early retirement years, from the month of a person’s last paycheck until they reach the age that allows full access to all of the funds in those magical traditional retirement accounts. Some people have rental income or a consistent side hustle to help with that early retirement gap. Other people try less traditional ways of accessing funds in traditional retirement accounts. But there is one more account that doesn’t get as much hype for its use in early retirement — a taxable brokerage account.
Early Retirement Withdrawal Options
Once we found the FIRE movement in 2014 we started learning more about some popular early retirement withdrawal options for tapping into retirement accounts, including the Roth conversion ladder concept. We absorbed every early retirement blog post and podcast we could find because we wanted to explore all of our options for funding our early retirement years.
In 2016 as we neared our retirement date we were concerned about having enough early retirement funds. We did another round of research and number crunching so we could make our own plan and put it into action. And we promised to stay open to all of the various ways other people were covering their expenses during early retirement in case there was an idea out there that we could roll into our own plan.
The main early retirement withdrawal options we considered were:
First, the Roth IRA 5-Year Rule (Roth Conversion Ladder)
The Roth IRA 5-Year Rule, commonly referred to in the FIRE community as a Roth conversion ladder, allows you to convert money from your tax deferred IRA to your tax free Roth, pay your taxes on the converted amount, wait five years, and then withdraw that same converted amount (the converted principal but no growth). The Roth IRA 5-Year Rule allows you to control the amount and how many times you make conversions, and you can keep converting funds annually and withdrawing the conversions one year at a time after each five year waiting period. The withdrawals are then penalty-free and tax-free since you have to pay taxes in the year of the conversion. And if you’re the type of early retiree who plans way ahead you can start the conversions five years before you retire so you can use the converted funds in your first early retirement year. Knowing all of that we understand the appeal of using a Roth conversion ladder.
The Roth conversion ladder trick didn’t appeal to us. We didn’t like the idea of the five year waiting period because a lot can change in five years, including our income needs. But we also didn’t like the idea of tapping into those IRA funds without letting them bake longterm in Roth accounts. As soon as we retired we each rolled our 401k’s into traditional IRA’s to separate our money from the 401k plan managers and their fees. We also started annual Roth conversions to reduce future required minimum distributions (RMD’s) from our IRAs. But at this point we want to leave those funds to grow tax free in our Roth accounts until our later retirement years.
Second, the 401K/403B Rule of 55
The Rule of 55 allows people who leave or lose a job between age 55 and 59.5 to withdraw funds from their tax deferred 401k or 403b without the usual 10% penalty for early withdrawals. The Rule of 55 only applies to the employer-sponsored retirement account you have when you quit (or get fired or laid off) between age 55 and 59.5. This rule allows you to withdraw funds from that same employer’s 401k or 403b without penalties even if you get another job and open a new 401k or 403b. Best of all, if you’re a public safety worker including firefighters, EMT’s, and police officers, the IRS allows the Rule of 55 to start even earlier for you at age 50. However, if you roll your 401k or 403b into an IRA like I did, the Rule of 55 would no longer be an option for those funds since the Rule of 55 doesn’t apply to IRA’s. And of course the Rule of 55 doesn’t wipe out the requirement to pay your taxes, it just removes the 10% early withdrawal penalty. You just withdraw funds, pay taxes, and enjoy having access to your money. You can control the amount you withdraw and you can keep making withdrawals under this rule until you reach age 59.5 when you have full access to your 401k even without this rule.
The Rule of 55 is a very cool option for people who retire in the age window of 55 to 59.5, but it’s not applicable for people like us who retire even earlier. We had already delayed our early retirement enough by the time we pulled the plug on our careers in 2018, so the idea of waiting any longer just to make this rule applicable for us was not appealing. So we chose to roll our 401k’s into our IRA’s and now we’re doing our best to move those funds to Roth accounts.
Third, the IRA Substantially Equal Periodic Payment Exception (Section 72(t) Distribution)
The Substantially Equal Periodic Payment (SEPP) exemption is a mouth full, and it’s complicated. In order to access funds from your tax deferred IRA using the SEPP exception you first calculate an annual withdrawal amount that will have to remain substantially equal every year for as long as you’re making SEPP withdrawals. The IRS allows three methods for determining your SEPP: the required minimum distribution method, the amortization method, and the annuitization method. The general concept is that you would choose one determination method and stick with those results, though you are allowed a one-time change from either the amortization method or the annuitization method to the required minimum distribution method. The biggest catch is that once you start SEPP withdrawals you’re required to continue them every year for at least five full years or until you reach age 59.5 (whichever is longer), in order to avoid penalties on every distribution. You just calculate your withdrawal amount, check in with your CPA to make sure you’re following the complicated SEPP rules, withdraw your set SEPP amount of funds, pay your taxes, keep withdrawing funds for at least five years, keep paying your taxes, and enjoy having access to your money.
We talked more about the SEPP exemption than the other two options above, and we could imagine committing to five years of SEPP withdrawals from Alison’s IRA since she’s 10 years older than me. But we wouldn’t want to commit to longer term SEPP withdrawals in my case. If I had started taking SEPP withdrawals from my IRA upon retirement I would have had to keep taking that distribution essentially unaltered for 16 years, even if our circumstances changed and our income needs changed. But our main concern is that all of those withdrawals during early retirement, some withdrawals surely being made during down markets, could cut an IRA off at the knees and cost us the longterm compounding growth we’re counting on. So we decided the SEPP exemption doesn’t jive with our All Options Considered strategy of having control over the amounts and timing of our withdrawals and the flexibility to change our plans as needed.
Last But Not Least, Taxable Brokerage Account
Brokerage accounts are amazing for longterm investments because anyone can open a brokerage account regardless of the type of job they have/had, they’re accessible at any time regardless of your age, they have no income or contribution limits, withdrawals never have penalties, investments can grow tax free depending on what you invest in, original contributions are never taxed again, gains are only taxed when they are withdrawn/sold, longterm gains are taxed at more favorable capital gains rates rather than ordinary income tax rates, and this is the only one of our accounts that will get a step up in cost basis allowing for tax free inheritance.
So here’s the bottom line – we didn’t try any of the options for taking early withdrawals from traditional retirement accounts. We stuck with saving to our brokerage account to fund our early retirement years.
We opened our brokerage account with Schwab in 2005 to diversify our retirement savings. The original appeal of a brokerage account for us was that we had spent too many years either not having access to a 401k at all or only investing the suggested 15% of our income in a 401k without matching funds from an employer. We weren’t making enough money for 15% of our incomes to make a big splash, and our 401k’s were underwhelming. So the only way we could see to save extra towards retirement was to focus a bit more on our personal IRA’s and a lot more on investing into our brokerage account.
I didn’t have access to 401k’s (let alone matching funds) from my earlier jobs, and in my last job before retiring my employer offered me a very limited 401k with no matching funds. Luckily in the middle of my career, I had one super awesome employer for 13 years that gave me matching funds plus some bonuses in my 401k. Since Alison is 10 years older than me she had a longer career than mine, but for most of her career she wasn’t able to max out her account and didn’t have access to matching funds. In fact, Alison only had employer matching funds in her 401k for the last five years of her 30 year career.
Our brokerage account was a great tool for us while we were learning how to invest and learning how to manage our own portfolio, and it has become the perfect early retirement funding tool for us as well. We had a much bigger variety of investment options and much lower fees in our brokerage account compared to the 401k’s we had at the end of our careers, so our brokerage account was actually a better performer as an investment vehicle.
To a large degree we stuck to the standard advice of saving to our traditional retirement accounts first and our brokerage account last. Looking back we shouldn’t have worried at all about maxing out our 401k’s. In our case we were better off saving our extra dollars to our brokerage account. Ironically, we benefited from the fact that traditional retirement accounts have contribution limits and brokerage accounts do not, and we made more substantial investments in our brokerage account. In 2018 we bumped things up a notch and consolidated our savings, sold our car, sold some of our furniture, and banked all of that money in our brokerage account. Then we sold our condo in Seattle and invested half of those proceeds into our brokerage account. We set the other half of our condo money aside separately in case we decided to buy a rental property or personal home in a lower cost of living area (and we made that home purchase about six months ago). By the end of 2018 our brokerage account had about 15 years of living expenses in it, as both invested funds and cash, and that’s what made us feel ready to schedule our resignations and retire early.
We love that our brokerage account comes with a huge amount of flexibility. We get to manage our own investments with very low fees, and we can access that money at any time, in any amount we choose, for any reason. Our brokerage account turned out to be the perfect investment vehicle for our FIRE plan because it gives us the ability to access our money without penalties, at more favorable long term capital gains tax rates, and without depleting our traditional retirement accounts during our early retirement years.
Our Plan (for now)
Our five account portfolio includes our two traditional IRA accounts (combined with our old employer sponsored 401k’s), our two Roth IRA accounts, and our taxable brokerage account. With our 10 year age difference our traditional retirement accounts become accessible at different times giving us a staggered waterfall system to withdraw from. Each year our plan evolves a bit more so we can see what kinds of jobs each of our accounts will be responsible for over time.
Brokerage account. When we retired in 2018 our brokerage account had about 15 years of living expenses in it as both invested funds and cash. After withdrawing a couple of years of living expenses and enough money for a nice new-to-us used SUV, our brokerage account still has more than 15 years of living expenses in it because the account’s growth rate is higher than our withdrawal rate and the account is generating income on its own. Originally we planned to live 100% off of our brokerage account until it was empty, only switching to our IRA’s after that. Our latest plan is to start tapping additional retirement account income streams as they become available to us, allowing our brokerage account to recover from our early retirement withdrawals so it can keep growing and continue producing income at lower capital gains tax rates.
Dividend Income. Our portfolio of low cost index fund ETF’s is geared more towards passively managed broad market growth rather than on funds that generate the most dividends. Why? Because we’re longterm index investors and a growth focused portfolio will more closely match the index and perform better than a yield focused portfolio. During our first two years of retirement our portfolio generated about $40k in dividends each year, with about $22k in dividends from our brokerage account alone. Our brokerage account dividends are not high enough to fully cover our annual living expenses but when we combine our dividends with capital gains and cost basis from our brokerage account our living expenses are fully covered. At this point we can’t/won’t withdraw the dividends being generated in our IRA’s and Roth’s since we’re too young to withdraw those funds without penalties, and instead of automatically reinvesting them we use those dividends for rebalancing.
IRA withdrawals. We’ll definitely consider starting distributions from Alison’s IRA when she’s 60 years old, and then 10 years later we can start taking withdrawals from my IRA when I’m 60 years old. We’ll be especially open to starting Alison’s IRA withdrawals when she’s 60, even if our brokerage account can still cover our living expenses, if we aren’t able to make large enough Roth conversions before then. If we start taking some money out of our IRA’s when we each turn 60 that will help us lower our future RMDs. The key is being able to choose which account we pull money from and what size of withdrawals we make, which will depend on our needs in any given year. Our IRA withdrawals will also be wet to stay within the 12% tax bracket because we want to avoid having to increase our budget just to pay more taxes.
Social Security. Our main plan for Social Security is NOT to rely on it, which is why we didn’t calculate any Social Security into our FIRE numbers. If we do end up with Social Security benefits we plan to consider taking them early when we each reach age 62. This is another one of those ideas that seems to shock people but it makes sense to us. Taking Social Security early will allow us to decrease the size of withdrawals from our investment accounts, which will allow our portfolio to continue growing. Taking Social Security early could also be a good hedge against sequence of returns risk, reducing our need to sell investments in a down market.
Charitable Giving. Financial gifts are a substantial part of our annual budget and giving is one of the elements of our retirement that gives us the most joy. We’ve increased our giving budget every year so far, and also moved all of our stimulus money into our giving budget. If things go according to plan our account balances will start to seem excessive compared to our spending needs by the time I turn 60. And at that point we plan to give even larger financial gifts so we can see our money doing more good while we’re alive. That includes gifts to our nieces, nephews, and chosen family, donations to charitable organizations, and donations to political causes and candidates as well.
Insurance. We’re all about having good health insurance since we live in the USA where health care costs are unreasonably high compared to other countries. We had global health insurance during our first two years of retirement since we were living as international nomads, but now in our third year of retirement we’re using ACA health insurance because we’re in the USA full time and health insurance is wealth insurance in this country. We also have good home owner’s insurance since we recently bought a house and we have good car insurance since we bought a car three months ago. But that’s it. We do not see life insurance as a rational or reasonable purchase for our circumstances, and the same goes for long term care insurance in our case. We are self insuring for our individual “life care” and death related needs using our investment portfolio and our Roth accounts specifically.
Roth conversions. Our goal is to move as much of our IRA money as possible to Roth accounts where it can grow tax free. We plan to keep making annual Roth conversions until we’re each 72 years old and RMD’s begin. We made large Roth conversions in our first two years of early retirement, $62k in 2019 and $58k in 2020, but our plan changed this year in 2021 since we’re now using ACA health insurance with a large subsidy. We set our income for 2021 to include a small $6k Roth conversion, low enough to allow us to benefit from a $1,536/month ACA subsidy. Thanks to the American Rescue Plan’s ACA provisions we’ll have a little more wiggle room for slightly higher Roth conversions in 2021 and 2022 and we’re excited to boost our conversion amount beyond the $6k we had originally estimated. We won’t know until December exactly what our Roth conversion amount will be for this year because we need to see our final income numbers first including dividends, capital gains, and cost basis. Each year we’ll set our Roth conversion amount based on our annual income needs and ACA subsidy levels, while also trying to stay within the 12% tax bracket (or the equivalent as the tax brackets change).
Roth withdrawals/life care. According to the U.S. Department of Health & Human Services, 70% of adults in the USA who live past age 65 develop severe long term care needs before they die. We’ve learned from what our parents and grandparents experienced and we want to be ready to self insure for anything we might need to deal with when we’re old and can’t pretend we’re 25 any longer. And that’s why we’re so focused on annual Roth conversions. Our plan is to start tapping into our Roth accounts when we really need it, after Alison’s hair finally turns gray (if it ever does). For now we’re estimating that by age 85 we’ll each be depending on our Roth account funds to cover our health and medical costs when we’re elderly. Our life care needs when we’re elderly could include anything from assisted living in our own home, to skilled nursing in an assisted living facility, to buying in at a retirement community with a full range of senior care health services.
We Can’t Control the Future, But…
We can’t accurately predict how things will go in the future, but we are planners at heart so we’ll do our best to put plans in place. We know whatever plans we do make will probably have to change and we’re ok with that. If we don’t make any plans at all we definitely won’t be ready for what comes our way. So we’ll keep charting our course and we’ll try to be ready to change direction as needed.
That’s Our Plan (for now)
We’re in our third year of retirement as I write this post. In fact today is the three year anniversary of Alison’s retirement date!! In our second retirement year there was a black swan event and we bought a house. Three months ago we also bought a car. We had access to the cash we needed in our brokerage account for our major one time purchases and all of our regular daily living expenses, and we didn’t need to touch our traditional retirement accounts. After all of our early retirement cash needs so far, and because the stock market is crazy, our portfolio is still just as healthy and growing strong. For us that’s a sign that even though our plans keep changing and we went from being nomads to homeowners in our first years of early retirement, so far things are going according to plan.
We’re grateful to have our brokerage account for our early retirement years. And to be able to preserve our traditional retirement account funds during early retirement. In Alison’s words, “Pulling contributions out of our retirement accounts too early would be like drinking weak tea.” We’d rather let our tea steep so it’s strong like our favorite Scotch Whisky and we can really enjoy it. Come to think of it, our withdrawal plan is like a fun cocktail. Three parts brokerage, two parts IRA, one part Roth, and a dash of Social Security. Hold the olives since Alison really hates olives!
What’s Your Retirement Withdrawal Plan?
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