30 Day Investing Challenge, Day 26: The Roth Conversion Ladder and FIRE
Now that you’ve entered into the world of advanced investing strategies, I also want to share with you a path that I am personally on. It’s called the FIRE movement, or Financial Independence, Retire Early. Basically this path is about increasing your savings rate to 50% or more so that you can retire well before age 65. Many folks who founded the movement retired in their 30s because of the long bear market (meaning: an up market) over the past 15 years. To be honest, the stock market trajectory since the mid 2000s was well out of the ordinary to say the least. But don’t take my word for it — here’s a chart that shows the stock market over a 40 year period and notice the sharp upward climb on the right hand side starting in 2008:
Why am I telling you this? Because if you decide to become part of the FIRE movement I don’t want you to get discouraged if you can’t retire in your 30s. If you didn’t start investing during the Great Recession when everything was at rock bottom prices for years — meaning you’d have owned a ton of company shares and therefore your portfolio grew exponentially between 2008 and today — then it’s unlikely you’ll retire in your 30s unless you start at age 20. Most of us don’t though and most of us can’t save 50% in our early 20s. Let me show you another chart — this time of my salary history over the past 20 years — and you’ll see why investing in your 20s is downright impossible for some of us (especially if you’re an art major living in NYC like I was):
I averaged about $25,000/year while I was in NYC and paid $1000/mo in rent with $65,000 in student loan debt and $7,000 in credit card debt. There was no way I could invest in my 20s. It all changed when I switched careers to tech though, and as you can see once I did that my salary sky-rocketed. To be fair, 2023 was an odd year for me: my company was bought so I got buyout money, then they laid me off a few months later, which came with severance, then a new job I got gave me a sign on bonus. Plus I had some side hustles going on. My 2024 income will probably be about the same as 2023 if not a little lower because I’m not expecting any windfalls this year.
Okay let me get back to the point here: I didn’t find the FIRE movement until February 2019 and I was in a good place financially. Technically speaking I actually had heard of FIRE in my early 20s by reading an article by Mr. Money Mustache, but when he mentioned saving 50% of your income to retire early I wrote him off immediately. How the hell was I supposed to live on $17,500 a year (pre-tax might I add)?? So I came to the movement when I was ready and that can be you too. If you’re not ready for a 50% savings rate, that is totally fine! Save what you can. But if you’re like me and see a vision of your life where you make the rules, you work when you want to and for who you want to, and you aren’t beholden to any company… Then you’re in for a treat.
The Essence FIRE
Here is the basic formula for retiring early:
Invest 50% of your income.
Live on the other 50%.
Do that for about 15 years and build a portfolio that fits the 4% rule (we went over this on day 3).
Retire early and live the life you want to live — which of course could include work if you want.
Here’s an example using real numbers:
Say your income is $100,000/year.
You save $50,000/year.
You live on $50,000/year (gross - post tax it’ll be around $43,000).
You do this for 15 years in a total stock market or S&P 500 index fund that returns an average of 8% annually.
Over that time you’ll build your portfolio to about $1.44 million dollars.
Once you early retire you can withdraw 3.5% per year without fear of losing that money for the rest of your life. You could bump it up to 4%, but you run the risk of maybe running out of money because your retirement timeline is so long (it’s a slim chance though given that your portfolio will keep growing over time).*
How Do I Access My Retirement Accounts Before 59 1/2?
Because you’ll be retiring before age 59 1/2 you need a way to access your retirement money without incurring penalties. But how do you do that? One way is using the Roth conversion ladder. Here’s how it works:
Contribute to pre-tax retirement accounts during your earning years (401k, 403b, 457, Traditional IRA, etc.).
Save 5 years of living expenses in a brokerage or high yield savings account (or even an HSA) during that time as well.
Retire early — meaning stop earning an income (this is important for step 5 so you don’t incur unnecessary taxes).
Rollover all 401k, 403b, and 457 money into a Traditional IRA — if you’ve been only investing in a Traditional IRA and have $0 in any other pre-tax retirement accounts you can skip this step.
Initiate a Roth conversion from your Traditional IRA to your Roth IRA — this will prompt the IRS to charge you taxes on the converted amount, so it’s best to consult the tax brackets for the year you’re doing the conversion when you do this to make sure you’re not paying too much in taxes (you can Google “tax brackets for [insert year of conversion]” to find them).
Repeat steps 4-5 for 5 years while living off savings.
After 5 years, you can pull from your converted Roth dollars tax and penalty free while repeating steps 4-5 in perpetuity — this is the “ladder” concept because you’re pulling the Roth dollars you converted during that first year.
Why This Works
It’s very important you remember to do a conversion and not a transfer or some other type of transaction because conversions are what allow you to do the above steps. When you convert Traditional IRA money to a Roth, you’re paying the taxes up front so the IRS is getting their cut. The rule is you can’t access that converted money for 5 years though, so that’s why you want to have 5 years of savings to live off of. You also want to create a ladder, meaning you do these conversions every year, even once you start pulling from the converted Roth dollars.
Example With Real Numbers
Let me show you an example:
You have $1.5 million saved in a pre-tax 401k.
You also have 5 years of cash saved up in a high yield savings account.
You retire early at age 45.
You rollover all of your pre-tax 401k to a Traditional IRA once you leave your employer. Make sure you keep it invested in stocks (and bonds if you want) and not leave it in cash or a money market account.
You convert $47,000 to a Roth IRA and pay 12% in taxes (based on the 2024 tax brackets), so your Roth IRA now has a balance of $41,360. Important: make sure you invest this converted money in a balanced portfolio of stock and bond index funds. A 70/30 stock/bond split should do the trick, but if you want to be more conservative you can go for the traditional 60/40 split.
You repeat step 5 for 5 years and live off your high yield savings account.
After 5 years you start drawing from your Roth account starting with the first Roth conversion amount — tax and penalty FREE — and continue to do conversions based on your tax brackets each year.**
My Personal Early Retirement Exit Plan
I definitely want to stop working at age 45, hopefully sooner. Here’s what I’m doing now to get there:
Max out my company’s traditional 401k every year.
Max out my Roth IRA every year until my income prevents it — then I’ll switch this money to a brokerage account.
Max out my HSA every year.
Contribute to a taxable brokerage account, usually around $1000/mo.
This brings me to around a 56% savings rate.
The reason I’m diversifying my accounts is because I want a lot of places to draw from when I pull the early retirement trigger. Here’s how each account is going to work for me when I reach FIRE:
Once I start early retirement: live off my brokerage account for 5 years (or more depending on how much is in it***) while I rollover my 401k to a traditional IRA and do the Roth conversions.
Then I’ll pull money from my HSA, Roth, and brokerage accounts while continuing to do the Roth ladder until all of my traditional retirement dollars are fully converted.
Once I reach 59 1/2 I’ll be able to pull from the Roth IRA I had been contributing to (not converted dollars, just regular contributions) tax and penalty free.
Once I reach age 65 I’ll be able to pull my HSA money penalty free without having to tie it back to medical expenses. I will pay taxes if I do this, so the longer I can use the receipt method the better. Another option I’ll consider is simply paying for my current medical expenses directly from this account, which will be penalty and tax free.
Once I reach age 70 I’ll start taking social security and pretty much be able to live on any account I want.
Of course this plan is flexible, which is why I contribute to so many different types of accounts. Because I’m not following a traditional retirement path that flexibility will be key in pulling this off and not paying too much in taxes or — god forbid — penalties.
So what do you think? Are you intrigued by the FIRE movement? Comment below and tell me your thoughts!
I’ll see you here tomorrow for challenge 27: Tracking your goal progress.
*This is because the 4% rule is only based on a 30 year timeline and since your timeline may be much longer than that the FIRE community suggests a 3.25-3.5% withdrawal rate when you early retire to be ultra conservative. However, the 4% rule is also based on a 60/40 stock/bond portfolio and if yours is more aggressive than that then your chances of running out of money are slim to none. The key is to stay flexible in your early retirement, especially in the early years. If there’s a down market year, withdraw a lower percentage from your portfolio. In up years you can withdraw the full 4% without fear.
**Once you get to the age where you start taking social security things start to get a little complicated. Social security is considered income so you’ll probably need to either lower your Roth conversion amounts so that you stay within a low tax bracket, or be okay with paying more in taxes. One way or another you will have to pay more in taxes once you reach retirement: you’ll either be in a higher tax bracket because of social security or because you’ll be required to take minimum distributions after a certain age (usually in your 70s) from your traditional retirement accounts. My suggestion is to continue with the Roth ladder until all your money is in a Roth account.
***I mentioned this on day 9, but brokerage accounts are the unsung heroes of early retirement because you can pretty much pay $0 in taxes if you stay within a certain tax bracket for long term capital gains. Refer back to day 9 for a refresher.
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