How to retire early using a ‘bridge fund’ with after-tax savings

Many people are drawn to the FIRE movement – Financial Independence, Retire Early – for a simple reason: Early retirement can give you the opportunity to experience a fulfilling life beyond the hustle of a 9-to-5.

The problem for many aspiring early retirees is that Social Security doesn’t start until at least age 62, and retirement savings accounts generally require you to reach age 59½ before you can begin taking distributions without paying an early withdrawal tax.

“If you want to retire in your 40s or 50s, having money outside of your retirement accounts can be a critical component of your spending plan before you’re easily able to access your retirement savings and Social Security,” said Adam Frank, Head of Wealth Planning & Advice for J.P. Morgan Wealth Management.

After-tax savings and investments outside of a retirement account can act as your “bridge fund” – money you can access when you stop working, without having to jump through age-based rules. This is the basis of the FIRE movement: Spend conservatively and save aggressively during your working years so you can build up enough of a nest egg to last you through a retirement that could span 50 years or more.

While this saving does include retirement accounts, we’ll focus here on saving in nonretirement accounts. Here’s how you might need to save, invest and spend while you’re earning money, and what to know about withdrawals and taxes after you retire early.

How after-tax accounts can act as a bridge to early retirement

After-tax accounts offer a lot of flexibility. Because they’re funded with money you’ve already paid taxes on, there’s no limit to how much you can contribute – and you often have a wide range of options for how to save and invest. That can include a mix of cash-like vehicles (such as bank savings or money market accounts, CDs and Treasury bills) and investment holdings (such as mutual funds, ETFs, stocks and bonds held in a brokerage or managed account). Using more than one type of after-tax account can give you both accessibility for near-term needs and growth potential for longer-term goals.

What’s more, after-tax accounts can give you more control over when you take money out. You can sell investments and withdraw cash whenever you need the money without paying an early withdrawal tax (although you may owe some capital gains tax). That’s unlike retirement savings accounts, which generally charge early withdrawal taxes for distributions before age 59½ (although there are some exceptions). This magic number can make planning for early retirement tricky.

This is where “bridge funds” come in, by helping to cover early retirement spending. While you may still be required to pay taxes on realized capital gains – the profit you receive when you sell an asset for more than its purchase price – for after-tax investment accounts, it will generally be at a lower rate than you’d pay on your ordinary income (and on withdrawals from pre-tax retirement accounts) if you held the investment for more than a year.

“The biggest advantage of using nonretirement funds for an early retirement ‘bridge’ is that you don’t give up tax-deferred growth, like you would if you relied on a 72(t) distribution or otherwise tapped your retirement assets,” said Frank. The Rule of 72(t) allows you to withdraw money from retirement accounts without paying early withdrawal taxes. That rule is relatively inflexible and requires strict adherence to a complex payment strategy for at least five years or until you turn 59 ½, whichever is longer.

“72(t) is a decent bridge for people who have no after-tax savings, but using retirement money early means you’re not letting that money grow tax-deferred,” added Frank. “Tax-deferred growth can be valuable, and we usually encourage those who want to retire early to save some money outside of retirement accounts rather than relying entirely on retirement savings.”

And depending on your timeline and how you invest your after-tax money, you may be able to generate interest, dividends and returns that help your savings last longer – potentially preserving principal so you have more flexibility later, including when you begin drawing from retirement accounts.

After-tax accounts should complement retirement accounts

There are trade-offs, though – including no tax deductions for contributing and no tax-deferred earnings, benefits that retirement accounts offer depending on which one(s) you have – so you wouldn’t want to keep your whole retirement nest egg in after-tax accounts.

Many early retirees use a combination of accounts. This might include a taxable brokerage account, from which withdrawals can be made freely during the early years; “traditional” tax-advantaged accounts, from which contributions and earnings may be withdrawn without an early withdrawal tax after age 59½ (or before in certain special circumstances, including disability or death); and Roth accounts, from which earnings can be withdrawn tax-free when the account holder takes a “qualified distribution” (as defined by the Internal Revenue Code).

“There isn’t one right answer; what’s right for you may not be right for someone else,” said Sarah Daya, Central Division Lead of Wealth Planning & Advice for J.P. Morgan Wealth Management. “But having a holistic strategy that leverages different types of accounts is often more successful than having only one type of account, because you have flexibility to move among account types as your circumstances change, and you can adapt to changing tax or market environments.”

Investors with a large portion of their retirement funds held in pre-tax accounts might also want to use the “bridge years” of early retirement to do a Roth conversion. This involves moving money from a pre-tax retirement account such as a traditional IRA or 401(k) to a Roth account and paying income taxes at the time of conversion, which can reduce the amount of their retirement nest egg that’s subject to required minimum distributions (RMDs) and offers the opportunity for tax-free growth. It can also reduce the risk of Medicare premium surcharges and other income-related impacts.

How much do I need in after-tax savings to retire early?

Your after-tax pool can start very simply – an automatic transfer from each paycheck into a separate savings bucket, whether that’s a savings account, brokerage account or managed account, to name a few. Investing the money gives it the chance to grow over time and potentially last longer. That growth can benefit from compounding, meaning you may earn returns not just on what you’ve saved but also on the returns you’ve already earned.

To estimate how much you may need, try thinking in years of living expenses. For example, if retiring early means you need to cover five “bridge years,” your goal is roughly five years’ worth of spending in after-tax savings (plus a cushion). Then you can back into how long it may take based on your savings rate: At a savings rate of 10%, it takes about nine years of work to save for one year of living expenses; at 25%, it takes about three years; at 50%, about one year; and at 75%, roughly four months.

From there, you can personalize it by asking yourself what one year of your life costs and how many years you need your after-tax money to cover. Your lifestyle, housing costs, family needs, taxes and health insurance can all move that number up or down, so it’s worth revisiting as your plans get clearer. And if the bridge feels intimidating, consider starting with the first milestone – saving one year of expenses – because that’s when early retirement may start to feel less like a dream and more like a plan.

A hypothetical example estimating the balance you need for the bridge years

Let’s consider a hypothetical example. David is an unmarried investor who wishes to retire early at 50. He’ll spend nearly 10 years in early retirement before he can access his 401(k) and traditional IRA without owing early withdrawal taxes. He’ll also have to pay out of pocket for health insurance until Medicare kicks in at age 65, which can add substantial costs to his annual budget.

Thanks to his low-key lifestyle as a renter in a midsized city, David estimates his spending will be around $60,000 in his first year of early retirement. Here’s where he should consider thinking in years of living expenses: If he needs roughly 10 bridge years, that’s roughly 10 years’ worth of spending he’ll need to fund, while also remembering that costs tend to rise over time (especially healthcare), so he’ll probably want a cushion.

The key to achieving this is creating a thoughtful strategy across various buckets – after-tax savings, plus tax-advantaged retirement accounts. For example, David may keep the next one to two years of spending in more stable, easy-to-access after-tax money like a CD, while investing longer-term dollars for later bridge years – and then plan for retirement accounts to help cover spending once they’re available, with Social Security potentially adding support later on.

A general rule of thumb that he can use to start with the big picture is the 4% rule – planning to withdraw 4% during his first year of retirement and adjusting the dollar amount every year after as needed to account for inflation. From there, David can build a withdrawal plan that sequences after-tax and retirement accounts to match his timeline, taxes and risk comfort.

For a more precise plan using your actual spending, savings rate and account mix, it’s worth sitting down with a financial professional.

What to invest in for early retirement

You might want to consider a simple, diversified investment approach for after-tax savings meant to sustain you through early retirement.

In general, investments should be matched to your timeline, since the portfolio needs to produce a set amount of income every year, and your comfort level with ups and downs. Below are two approaches to consider, along with some reasons to have cash on hand.

Investing for growth

A growth-oriented approach prioritizes increasing the value of your portfolio over time by seeking to increase returns. This is usually achieved by having a larger share of equities (stocks) in the portfolio than bonds, though bonds may still be included for stability. Some returns can be paid out, while others will be reinvested.

Examples of investments for growth include broad-based mutual funds or ETFs that track the overall return of a market index, such as the S&P 500. Index funds are often passively managed, and they can help reduce investor costs and capital gains distributions.

Investing for income

If your goal is to preserve principal and rely more on what the portfolio generates along the way, you may need a more specific strategy to generate enough income to meet your annual target.

Potential investments include government bonds that pay predictable interest, dividend-paying stocks or ETFs, and money market funds.

In the same way that a mix of accounts and tax types can make sense as an overall bridge strategy, you may want to consider a mix of growth and income. Your portfolio can still take advantage of positive market moves, but you have some level of income that you’re certain will come every year.

Keeping cash on hand

In addition to investments, early retirees may want to maintain a cash emergency fund to cover at least a few months’ worth of expenses (six months is often used as a benchmark). Keep this money in a safe and accessible place, such as a cash management account, a high-yield savings account or a CD (preferably one that earns at least the rate of inflation).

How to withdraw and how to manage taxes

Any income you collect from after-tax investments will be taxable (except for income like that from municipal bonds). Nonqualified dividends and interest are taxed at ordinary income rates, while qualified dividends are taxed at long-term capital gains rates. Capital gains distributions can be taxed at either short-term capital gains rates (if held for one year or less) or long-term capital gains rates. (The former are identical to ordinary income tax rates, while the latter are often much more favorable at 0%, 15% or 20%.)

In many taxable investment accounts, you can choose whether to take dividends and interest in cash or to reinvest them. Your selection will depend on your overall investment approach. Consider using investment income to fund your expenses before selling assets. But if you need to sell appreciated investments to generate income (typical in a growth-focused approach), then you might want to consult a financial professional to identify suitable holdings to sell.

The bottom line

After-tax accounts can help fund early retirement, as they offer flexibility for investors who don’t yet have access to their tax-advantaged retirement accounts or Social Security benefits. They can help you avoid early withdrawal taxes and continue to generate income from investments, often while paying favorable tax rates.

But you may not want to use after-tax accounts as your only source of retirement savings, because you would miss out on the tax-deferred compounding provided by retirement accounts. If you plan to retire early, consider using traditional and Roth retirement accounts as well.

It’s important to note that there are many personal variables involved in retirement planning. Tax rules can also change, so examples shared here should be used only for educational purposes. Consider meeting with a qualified financial professional for personalized guidance.

View Disclosures