If you’re on a mission to retire early, you’ve probably heard about the FIRE movement. Short for “financial independence, retire early,” this movement focuses on an aggressive savings and investing strategy to make work optional.
Understanding how to manage and multiply your money is crucial, but there are hidden opportunities that you can unwrap if you’re brave enough to tackle tax strategies too. If you’ve been on your FIRE journey for a while, you’re probably comfortable with your employer-sponsored retirement accounts and how to maximize your tax benefits at work. Here are two other ways to claim a tax victory that can make your early retirement goals even sweeter.
Contribute to a Roth IRA if you qualify
A workplace retirement plan may offer many perks that can set you up for a nice retirement, but a Roth IRA (individual retirement account) will give you the freedom to design your investment strategy on your terms.
A Roth IRA is a vehicle that you can use to house your favorite assets. This can include exchange-traded funds, individual stocks, and index funds.
As long as you have earned income and don’t exceed the limits, you can make direct contributions to your Roth IRA using after-tax dollars. In a nutshell, you pay your taxes upfront and lock in tax-free growth and withdrawals as long as you follow the rules. This could lead to a million dollars of tax-free money when you reach 59 1/2 and have met the five-year rule.
But if you need to tap into your money now, that won’t be too big of a deal. Your Roth IRA can also double as an emergency fund, even if you’re too young to tap into your Roth IRA without incurring taxes and penalties.
Let’s say you have contributed $55,000 over the last 10 years. Your Roth IRA balance has grown to $100,000. Although you can build your portfolio faster if you keep all your money in your account until retirement, the IRS allows you to take out your $55,000 of contributions without worrying about taxes or penalties. This comes in handy if you experience an unexpected financial emervency and need extra cash.
Getting dividends in taxable accounts
If your retirement accounts are temporarily locked up, you can use your taxable brokerage account to fund your lifestyle too. This is possible through dividend stocks. If you start now, you can create a dividend income strategy that aligns with your expenses. On top of that, you may be able to get a tax deal depending on your total income and the type of dividends in your account.
Ordinary dividends are taxed like the income you earn from your job. They’re subject to ordinary income tax rates, but you can get a sweet deal on your tax bill if your dividends fit the bill to be qualified dividends. Here are the qualified dividend tax rates for 2022.
2022 qualified dividend tax rates
| For Single Filers With Taxable Income of … | For Married Joint Filers With Taxable Income of … | For Heads of Households With Taxable Income of … | The Qualified Dividends Tax Rate Is … |
|---|---|---|---|
| $0 to $41,675 | $0 to $83,350 | $0 to $55,800 | 0% |
| $41,676 to $459,750 | $83,351 to $517,200 | $55,801 to $488,500 | 15% |
| Over $459,750 | Over $517,200 | Over $488,500 | 20% |
Data source: IRS.
Let’s say you’re married and rack up $70,000 in qualified dividend income. If you aren’t earning any other money during early retirement, your qualified dividend tax rate could be 0%. This is something you need to keep in mind as you plan out your FIRE goals. It’s even better if you can reinvest your dividend income and take advantage of a dividend reinvestment plan, or DRIP, to multiply your dividend income over time.
Get excited about your FIRE tax strategy
Although taxes may not be the most exciting topic in the world, they can be a game changer on your FIRE journey. Learning how to reduce your tax bill and take advantage of the perks available will save you money. The tax laws and thresholds are constantly changing, so you’ll have to stay on top of them to ensure you’re making the best moves. But once you start to unlock these tax advantages, every penny you keep can go toward funding your dream lifestyle.
