Dmitry Demidovich / Shutterstock.com · Dmitry Demidovich / Shutterstock.com
Index funds have basically become the default recommendation for retirement investing, and for good reason, as low fees, broad diversification, and decades of data showing they outperform most actively managed funds. The FIRE (financial independence, retire early) movement has built entire retirement strategies around accumulating index funds and living off systematic withdrawals.
Index fund withdrawals with 65% embedded gains lose nearly 10% to capital gains taxes.
Roth conversion ladders require five years before penalty-free access. Early retirees need bridge funding from other sources.
Tax-optimal early retirement spreads $1.5M across $400K taxable, $300K Roth and $800K traditional accounts.
A recent study identified one single habit that doubled Americans’ retirement savings and moved retirement from dream, to reality. Read more here.
What gets glossed over in most of these conversations is taxes, as everyone focuses on the accumulation phase by maxing out your 401(k), funneling money into accounts like the Vanguard Total Stock Market Index Fund, and watching your net worth compound. However, when you retire early and need your portfolio to generate income, the tax bill can be significantly higher than you planned for, particularly if most of your money is in tax-deferred accounts or you’ve accumulated large unrealized gains in taxable accounts.
The math that looks great on a spreadsheet largely assumes no taxes, so it’s a lot less appealing when you realize that a $50,000 withdrawal will generate a $7,500 tax bill. The same goes for accessing your 401(k) before you turn 59.5, which requires navigating a pretty difficult Roth conversion ladder that can take 5 years or more to set up. The reality is that you can retire early with index funds, but you have to keep a tax strategy in mind as much as the investment strategy, and getting it wrong can cost you.
Index funds are tax-efficient during the accumulation phase because they generate minimal taxable distributions, and most of the returns come from unrealized capital gains that aren’t taxed until you sell. This is fantastic news while you are working and contributing, but it creates a problem if you want to retire early and need to start selling shares to generate income.
Let’s say you retire in January 2026 at age 45 with $1.5 million in a taxable brokerage account, all invested in broad market index funds. Your cost basis across all positions is $800,000, so you have $700,000 in unrealized capital gains. If you need $50,000 per year to live on and you start to systematically sell shares, you’re not just withdrawing $60,000, you’re also triggering capital gains taxes on the appreciation embedded in these shares.
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Assuming your gains are roughly proportional across the portfolio, you’re recognizing almost $28,200 in long-term capital gains annually. At the 15% federal long-term capital gains rate, this is $4,230 in federal taxes, and this is before you have to consider state taxes. Now, your $60,000 withdrawal just became $55,770 in spending power, and if you live in a state with income taxes, you’ll be left with even less.
The tax burden here gets even worse in the case your portfolio grows, which is the hope, and if index funds appreciate over the next 20 years and your cost basis as a percentage of your portfolio value shrinks, you might be recognizing 60% to 70% gains on every dollar withdrawn. A $60,000 withdrawal with 65% embedded gains triggers $39,000 in cap gains and a federal tax bill of $5,850, so as much as 10% of your withdrawal disappears to taxes.
Most early retirees have significant balances in tax-deferred accounts like traditional 401(k)s and IRAs because that’s where their employer contributions and tax deductions went during working years. The problem is that withdrawing from these kinds of accounts before you turn 59.5 triggers a 10% early withdrawal penalty on top of ordinary income taxes, which makes them nearly unusable for early retirement without careful planning.
The workaround, and thankfully, there is a workaround of sorts, is the Roth conversion ladder, which involves converting traditional IRA money to a Roth IRA, paying taxes on the conversion, then waiting five years before you can access that converted money penalty-free. If you retire at 45 in 2026, you’d need to start conversions immediately, but you can’t access this money before 2031, which means you’ll need to plan for five years of living expenses funded from somewhere else, either taxable accounts, Roth distributions, or cash. For someone with $1 million in a traditional 401(k) and only $200,000 in taxable accounts, this creates a serious bridge problem that could mean delaying retirement or taking penalty taxes that everyone would love to avoid.
Roth IRAs are better for early retirement because contributions can be withdrawn anytime without taxes or penalties, though earnings are subject to the five-year rule and age restrictions. The thing is, most early retirees don’t have $500,000 sitting in Roth accounts because the contribution limits are low ($7,500 in 2025) and many high earners are phased out of direct Roth contributions entirely. This tax-free growth is valuable, no question about that, but it doesn’t solve the access problem for people who accumulated much of their wealth in traditional 401(k)s and taxable accounts during their working years.
If you are committed to retiring early with index funds, the tax-optimal strategy likely means spreading money across account types rather than concentrating in tax-deferred or taxable accounts, including enough money to bridge the first five years of retirement. A realistic allocation for someone retiring at 45 with $1.5 million might look like $400,000 in taxable index funds for immediate access, $300,000 in Roth IRAs, and $800,000 in traditional 401(k)/IRA money.
Alternatively, you can look at a different tax-smart move by adding dividend-producing assets like the Schwab U.S. Dividend Equity ETF (NYSE:SCHD) or Vanguard High Dividend Yield ETF (NYSE:VYM), which will generate qualified dividend income that reduces how much you need to sell, lowering your capital gains and preserving more shares for future growth.
Most Americans drastically underestimate how much they need to retire and overestimate how prepared they are. But data shows that people with one habit have more than double the savings of those who don’t.
And no, it’s got nothing to do with increasing your income, savings, clipping coupons, or even cutting back on your lifestyle. It’s much more straightforward (and powerful) than any of that. Frankly, it’s shocking more people don’t adopt the habit given how easy it is.