Curious About FIRE? Here’s How to Set Up Your Retirement Accounts Now to Avoid Hefty Penalties Later, According to Experts

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You don’t need an astronomical salary to retire early. 

What you do need is a clear strategy on how to pull from retirement accounts without leaving money on the table. In fact, the way you leverage your IRA or 401(k) as you pursue FIRE (Financial Independence, Retire Early) status could make or break your personal finance goals.

“I have seen people achieve a FIRE lifestyle when each member of the partnership makes $45,000 to $50,000 a year,” says Cait Howerton, a certified financial planner (CFP) with Facet Wealth, a firm dedicated to unbiased, conflict-free financial planning.

As you inch closer to financial independence, you’ll eventually want to make withdrawals from your IRA or 401(k). If you’re under the age of 59 ½, however, this action comes with notoriously hefty penalties that can leave thousands of dollars on the table and throw off your “freedom number” (the amount of wealth you need to retire early) completely. 

Here are your options and how to proceed if accessing retirement funds early is on your mind. 

When Should You Try to Access Retirement Funds Early?

Proponents of FIRE aim to retire years or even decades ahead of schedule. But there are other scenarios in which you may want to tap into your retirement accounts sooner than expected: Financial hardship, big career pivots, or self-funding the launch of a new business are common reasons to dip into these accounts. 

Whatever your situation may be, it’s good to be aware of what financial planners call retirement fund diversification. Your long-term savings plans usually fall into one of three buckets: 

  • Tax-deferred accounts: Traditional 401(k)s and traditional IRAs that may or may not have an employer match plan. Your contributions are not taxed, but you pay income tax on withdrawals.
  • Taxable accounts: These include after-tax investments in brokerage accounts. You pay capital gains tax on net gains when you withdraw.
  • Tax-free accounts: Roth IRAs and Roth 401(k)s allow for “tax-free” growth of your investments. Your Modified Adjusted Gross Income (MAGI) needs to be under $144,000/year if you file taxes as a single person, and under $214,000/year if filing jointly. Your contributions are post-tax, and you pay no capital gains or income tax when you withdraw.

To achieve FIRE, Howerton says, folks in lower salary tax brackets do focus on cutting expenses as much as possible. But they also employ investing strategies that can help anyone tap retirement accounts early without resorting to extremes.

Pro Tip

Retirement accounts are important for achieving financial freedom, but many people delay setting up a strategy until it’s too late. Maximize your savings across taxable, tax-deferred and tax-free accounts to set yourself up for whatever surprises and opportunities come your way.

One couple “Took advantage of maxing out one of the partners’ 401(k)s,” says Howerton. “Then they took advantage of contributing to Roth IRAs and putting money into brokerage accounts so that they had tax diversification.”

Dawn Dahlby, a CFP and behavioral financial advisor, agrees. “Diversification creates a ton of flexibility for the pre-retiree, and it helps balance tax ramifications throughout your life.”

So what accounts should you tap, and in what order? Here’s the pecking order that will help you maximize your savings.

For Early Retirement, First Prioritize a “Roth Conversion Ladder”

Roth IRAs have the most restrictive contribution limits. In addition to the income ceilings mentioned above, the maximum annual contribution for a Roth is $6,000 per year ($7,000/year if you’re age 50 or older). But if you plan ahead, you can use these accounts to withdraw money completely tax-free.

The workaround here is to be aware of Roth conversions. In a Roth conversion, you can move money from a tax-deferred retirement account, like a Traditional IRA or 401(k), into your Roth account. There are no income or contribution limits on Roth conversions.

You’ll have to pay taxes on the amount you move between accounts, but you won’t pay early withdrawal penalties (And you would have had to pay tax on this money anyway, since the contributions were pre-tax). This money can then grow tax-free in your Roth account, and you can withdraw it after a five-year waiting period without penalty. 

Because a Roth conversion is a taxable event — one that not only raises your taxable income, but could also bump you up into a higher tax bracket — you may want to split the move into multiple conversions over several years. 

This is known as a Roth conversion ladder, and it’s a fantastic way to maximize savings while also pursuing your FIRE aspirations. The Roth conversion ladder is an example of how strategic savings and tax planning can get you to your retirement goals faster.

“Maximize your tax-free income over time,” says Janet Galloway, a CFP with B&B Strategic Management. “Let’s pay what we legally have to, but not pay more than we actually have to.”

Roth conversion ladders have several steps and require careful planning with a financial expert. For example, the five-year waiting period applies to each conversion, so you’re limited on when you can withdraw funds from your Roth accounts based on when and how you opened them. A financial planner can help you determine how much you’ll need each year in retirement before 59 1/2 and set up a strategy to make sure you have access to the funds you need at the lowest cost possible.

Next, Withdraw Retirement Funds Strategically

A Roth conversion ladder is a multi-year strategy that can save you thousands or even tens of thousands of dollars in the long run. As Dahlby points out, though, there’s an opportunity cost to withdrawing funds from a Roth IRA early: Missing out on tax-free gains.

“In a perfect world, we don’t like people to take money from their tax-free accounts,” she explains. “We put clients’ most aggressive investments in the Roth because they grow [tax-free]. She recommends first tapping taxable accounts, such as an investment account with a brokerage, because they don’t come with penalties or limitations. Additionally, the capital gains taxes you’ll pay are lower than the income taxes you’d pay on traditional retirement accounts.

After that, it becomes about weighing the cost of an early withdrawal penalty from your tax-deferred accounts against the opportunity costs of pulling from a Roth account.

“Just pulling from your Roth right away might not always be the best idea,” says Dahlby.

Withdraw Retirement Funds Directly From Your 401(k) as a Last Resort

A traditional 401(k) — the most common retirement plan available through an employer — comes with plenty of options for pulling your money out early in case you need it. These options come with major drawbacks.

Withdrawing money from a 401(k) before you’re 59 1/2 years of age comes with a 10% penalty in most cases. The penalty is tacked onto your tax bill for the year on top of the income tax you’ll owe on your withdrawal. The IRS makes exceptions to this penalty: You can withdraw due to financial hardship, take out a 401(k) loan if the plan allows it, or take distributions if you leave your job at 55 or older.

“You’re robbing Peter to pay Paul,” says Galloway. “You’re taking away from your retirement lifestyle to fund your current lifestyle.”

However, as Dahlby says, you have to weigh this penalty against the potential gains you’d forgo by withdrawing early from a tax-free account.

“Paying a 10% penalty might not be the end of the world,” she says. “Sometimes paying the 10% penalty isn’t as bad as you think it is for having the opportunity to get access to those funds.”

Set Up Your Early Retirement Account Access Game Plan Now

The most important thing you can do — especially if you have the advantage of starting early— is give yourself options. Don’t rely on one type of long-term savings account; it might not meet your needs down the road.

“Life changes every three to five years,” Dahlby suggests. “So it’s never too early to plan.”

If you find yourself forced to stop working early — or suddenly become able to because of a windfall — having both taxable and tax-free accounts to tap into without penalty could help you maintain your lifestyle in early retirement. Work with a financial planner to understand your options, and use your available resources strategically.

“We live in an uncertain world,” says Dahlby. “Our goals and plans change constantly. You want to be able to pull different levers and pull different money from different buckets based on what’s going on.”