Let me say this in a way so that I come off precisely nerdy: I love taxes. It’s my equivalent of studying game tape. This past fall, I spent an enormous amount of time thinking about and mulling over the concept of bucketing our money according to tax treatment.

I wanted to narrow in on how money can go in to our portfolio for the lowest tax rate, and how money will come out of our portfolio at the lower tax rate.

First, let’s review the three types of tax-treatments for money (per the tax man):

• Pre-tax: this bucket includes pre-tax 401k contributions, most pension plans, IRAs, and the employer match of your 401k. Money goes in to these accounts before taxes are taken out, so when money is taken out in retirement, taxes need to be paid on the distributions. The distributions will be taxed at income tax rates.
• Roth (after-tax): this bucket includes Roth 401k, Roth IRA, and HSA accounts. Roth money enters these accounts after taxes have been taken out, so when money is taken out of the account in retirement, taxes do not need to be paid again!
  • Note on HSA accounts: money saved into at HSA enters the account pre-tax, and if spent on a medical expense, leaves the account without being taxed! It’s a great account to built a balance into and leave to grow for retirement – as long as a high deductible health plan can suit your healthcare needs.
• Non-qualified (aka taxable): this is regular money saved into a brokerage account. It is money that has already been taxed at income tax rates. Any investment growth on this money will be taxed when you sell an investment.

To date, our FIRE asset collection plan could be quickly summarized with: Save As Much As Possible.

Pre-tax Strategy:

As I mentioned earlier, getting money out of a pre-tax account means paying current rate income taxes. When we are in FIRE, our only income will be from our portfolio, so we will be able to convert $89,450 (2024 figure) a year out of our pre-tax account and into our Roth account while staying inside the 12% tax bracket. Thinking about doing that conversion annually made me realize that I do not want to spend too many years of retirement making these conversions! I don’t want to be 75 years old and still keeping track of how much I need to convert every year. So for this reason, I do not want to accumulate more than $900k in our pre-tax accounts.

No big deal, right? That’s an enormous amount of money! Well, we have already got a snowball-rolling-downhill situation in those accounts. Since we will still shield a large portion of our bonuses from taxes with the pre-tax 401k option, AND our employer matches are going into the pre-tax account, AND my pension is pre-tax money, we were moving full steam ahead at way too much pre-tax retirement account money!

Roth Strategy:

The Roth accounts are where many FIRE-ees source their annual spending from.

Since Roth accounts are funded with after-tax money, the government is a little more relaxed about the money in those accounts since they’ve already gotten their cut. Once contributions have been in a Roth account for 5 years, contributions can be taken back out of the account tax and penalty free! That is the high-level concept behind funding FIRE annual spending before we turn 59 and a half and can access all of the money in our Roth accounts penalty free. Each year, convert 89k from pre-tax to Roth, and then starting in year 6, we can take the first conversion out of the Roth IRA penalty free.

The rule is called the “5-year rule” and the strategy is known as setting up a Roth Conversion Ladder if you are interested in Googling deeper down the rabbit hole.

I have been funding a Roth IRA annually since 2016, and my partner funded his first last year. Our original plan was to keep at that and let the chips fall where they may. Now, since we don’t want to surpass too much pre-tax money, we will plan to switch some of our 401k contributions over to Roth 401k. Depending on what contribution limits shake out to be over the next several years, we should be on track to have about $500k in our Roth accounts.

Non-Qualified Strategy:

Collect $100k, use it to fund the first 5 years of FIRE while we wait for the Roth Conversion ladder funds to be available starting in year 6.

We honestly struggle to collect non-qualified money. I don’t want to put pressure on us by making this goal too high or unattainable. If we get to the 100k with no mortgage, we should be good in FIRE.

Overall Strategy and Takeaways:

But what about years 1-5 while we wait for the first juicy conversion to get ripe? Exactly.

Here are the levers we will have available to fund those first 5 years:

• Roth IRA contributions made prior to 5 years before our FIRE year. This will be about $80k.
• Roth 401k contributions (rolled into our Roth IRA at FIRE). This will be about $80k.
• Non-qualified account balances. We are targeting to have that $100k balance.
• Each year, another set of Roth contributions will vest. It will be about $14k/year.
• Expense control: these first 5 years of FIRE we will be very mindful of our expenses, keeping them under $60k annually (includes housing, taxes on the conversion, and spending)

I love the idea of the challenge of living minimally during the first 5 years of FIRE. I like change, so having a lifestyle of going to the library, hiking, getting a couple of annual memberships and spending our time using them, taking more road trip adventures – that all sounds awesome! And after 5 years, our money frees up to allow us to travel and adventure a lot more with annual expenses near the 80k mark from our conversions. And then before we know it we will be 59 and a half, and our annual expenses can settle in at around $90k! Frankly that sounds like funny money to me today ha considering our annual expenses are $55k and do everything we want already.

All of this analysis, and these are the final takeaways for our tax planning:

• We put a cap on the amount of pre-tax money that we want to accumulate!
• We have switched our bi-weekly 401k paycheck contributions to now go into the Roth 401k.
  • Our bonuses will still go into the Pre-tax 401k.
• We relaxed expectations on non-qualified savings, but it will be important to find our forever home soon and to tackle the mortgage on it (wink wink – plan for 2024 – fingers crossed!!)