Federal Tax
Understanding the tax code can aid those participating in the FIRE movement
Issue 2
April 22, 2022
By Terrell R. Bell, CPA
Everyone dreams of waking up without alarm clocks, on sunny beaches and no longer having to go to work. People have realized that they can make this a reality without working into their sixties and seventies through the FIRE lifestyle. FIRE stands for Financial Independence, Retire Early. One element of FIRE involves living frugally, budgeting and saving. Besides how one manages their money, is the need for an individual to understand how the tax code can work in their favor. The tax code has several tax breaks for those that use retirement accounts. Understanding the rules related to tax deferment and withdrawal policies can aid in making wise decisions for those that hope to retire early.
One of the most popular retirement saving vehicles is the Individual Retirement Account (IRA). There are two types of IRA accounts specifically for retirement. The traditional IRA account allows individuals to invest funds that have not been taxed in the year earned, thus creating savings. The Traditional IRA then allows the invested dollars to grow tax-free as they are held in the account, resulting in more savings and only taxed once when withdrawn. The Roth IRA account differs because investors pay the taxes during the year that the income is earned. The invested Roth IRA dollars then grow tax-free in the account to create savings, and when withdrawn no taxes are paid, which creates savings. The Roth IRA tends to be a favorite among those in the FIRE movement. You can withdraw the contributions you have made tax-free before 59 and a half without penalty. Find out more information in the IRS publication 590-A.
Another retirement saving vehicle that has gained attention from those in the FIRE movement is the Health Savings Account (HSA). The HSA account allows an individual to save for medical needs. The HSA account allows for an individual to contribute income pretax creating savings. The HSA account then allows the funds to grow while in the account tax-free leading to more savings. Finally, the funds can be withdrawn tax-free for medical expenses creating even more tax savings. An individual can begin to accumulate all medical receipts from when they first open this type of account and receive reimbursement in any future year. There are funds available before reaching 59 and a half if one has a receipt for a qualified medical expense that was incurred after the creation of the account without penalty. The ability to withdraw these funds at a younger age is ideal for someone with the hope of retiring early. Find out more information in IRS publication 969.
A third retirement saving vehicle that is popular for those participating in the FIRE movement is the 401k. Most 401ks are not Roth. Most 401k plans, however, allow an individual to invest pre-taxed dollars in the stock and bond market creating tax savings. The biggest benefit to the 401k is the matching funds that are often provided by employers. The matching funds allow an individual to earn money by merely participating in the company's 401k. The 401k is important to those participating in the FIRE movement because there is a provision that allows for an individual to roll over the funds from a 401k to a Roth IRA. First, the funds from the 401k must be placed in a traditional IRA. After placing in a Traditional IRA, the funds can then be transferred to a Roth IRA. The 401k allows an individual to save more money per year than an IRA while receiving favorable tax treatment. For instance, in 2022, you can contribute $20,500 to a 401k while only being able to contribute $6,000 to an IRA. Find out more information in IRS publication 525, Taxable and Nontaxable Income related to 401ks.
IRAs, HSAs and 401ks take advantage of the equity and bond markets. There are elements found in the tax code that aid in early retirement through investing in real estate and becoming a landlord. Investing in real estate is considered passive income by the IRS. Passive income allows an individual to receive income with minimal effort. One is not exchanging time for money. Owning investment properties allow those in the FIRE movement to continue to work while making other income they can invest. In addition, several tax deductions go with owning real estate. A person can deduct PMI, interest, taxes, insurance, repairs and maintenance, mileage to and from the property and depreciation. Being able to deduct depreciation is particularly important because it is a non-cash expense that reduces tax liability. Beyond the minimal effort to be a landlord and the many deductions, real estate values appreciate adding to a person's net worth, an individual can take advantage of increased values and equity by selling investment property and reinvesting the gains from the sale in a new property and avoiding capital gain taxation using 1031 exchanges creating tax savings. Find out more information about 1031 exchanges in IRS publication 523.
In addition to understanding the provisions in the tax code that allows for deferment of tax consequences, those that understand the FIRE movement understand that while the federal tax code is uniform across all fifty states, each state has its own rules for taxation of individual income. Some states do not tax individual income at all. More importantly, some venture outside of the United States once they are "FIRED" (financially independent and retire early) because those countries have even more favorable tax laws. In addition, to different tax laws that could potentially lower the individuals' cost of living once retired is the fact that the cost of living is different depending on where one is located; therefore, giving the dollar more or less buying power based on location.
In conclusion, understanding the complexity of the tax code, including tax deferment, 1031 exchanges, and how state and city taxes vary, depending on location, can aid in helping an individual retiring early. Perhaps an eager client will walk into your office one day, ready for early retirement; you can help them reach their goals.
About the author: Terrell R. Bell, CPA, is employed at the Tennessee Board of Regents. He also serves as the treasurer for the Nashville Resolution Conflict Center.
