Setting up a Roth IRA Conversion Ladder
If you’ve made your way through your career and have taken advantage of all the benefits of the Extreme Early Retirement Account Everyone Needs to Know About, then you’re likely wondering how you’re supposed to access all that juicy retirement money way before age 59 and a half without paying crazy taxes and penalties.
Today we’re going to dive into some of the tricky rules of the IRS tax code to discover how understanding these rules can help us put together a plan to access our money years earlier than our 60th birthday, and all without paying any taxes at all.
Rules for Pre-Tax Accounts
As long as our money is in a pre-tax account like a 401k or Traditional IRA (accounts with money that you haven’t paid taxes on yet), it is subject to 2 big rules.
- The money is taxed as it is withdrawn.
- The money cannot be accessed until age 59 and a half without paying early-withdrawal penalties.
For the early retiree who leaves the workforce at age 45 or 40 or 35, that age 59-and-a-half rule often looks like the biggest problem.
How are we supposed to live for 15 to 20 years before we can access our own money?
This is where having a basic understanding of the tax code and the power of a Roth IRA come in handy.
Let’s look at the Roth IRA first and see why we even want to mess with it.
Roth IRA – The Traditional IRA’s Awesome Baby Brother
Unlike a Traditional IRA (or a 401k), money contributed to a Roth IRA account is contributed after taxes have been paid on it, often referred to, cleverly enough, as after-tax money.
When you contribute money to a Roth IRA, that means that you’ve already paid taxes on that money as part of your annual income tax bill, and now you’re putting some of that already-taxed money into your Roth IRA account.
Because you’ve already paid taxes on that money, when you withdraw the money, plus any of the earnings, from the Roth IRA it is completely tax free after age 59 and a half. That’s a pretty awesome feature. Tax-free withdrawals are one of the biggest benefits of the Roth IRA.
So why don’t I just contribute to the Roth IRA to begin with?
Great question. There are 3 main reasons we use a pre-tax retirement account like a 401k instead of starting with the Roth IRA.
- You get a 100% return on your money from your employer if they match any portion of your 401k contribution.
- Contributing to your pre-tax 401k account can lower your income tax bill each year you contribute?
- The maximum contribution limit for a 401k account in 2019 is $19,000. The maximum contribution limit for a Roth IRA in 2019 is only $6,000.
Both of those contribution limits may seem like really huge amounts of money, but as you reduce your monthly cost of living and start destroying debt and building margin between your income and your expenses, you’ll slowly get closer and closer to contributing the maximum amount to your 401k plan.
And benefits #1 and #2 are enough to make the 401k a more desireable option even if your current contributions are less than the $6,000 limit.
How Do We Get The Best Of Both Worlds?
So now that we know the key differences between a Traditional IRA and a Roth IRA, what we want is the best of both worlds. We want to spend all our working years building our wealth completely tax free in a pre-tax 401k account, but then be able to withdraw that money later completely tax free as well.
Is this dream even possible?
Introducing the Roth IRA Conversion Ladder
To achieve this beautiful tax-free dream, we’ll initiate a process of moving our 401k money into a Roth IRA, via a Traditional IRA, so we can get those sweet Roth IRA tax-free withdrawal benefits.
Here’s how it works
As soon as we leave our company, we’ll want to roll our 401k over into a Traditional IRA at a brokerage company of our choosing (Vanguard, Fidelity, Schwab, etc.)
If you’ve been through my Beginner’s Guide to Investing series, you may recall from Part 1 that every time you leave one company and move to another, you should roll your 401k money from the previous company into a Traditional IRA.
By the time your approaching retirement, early or otherwise, you’ll likely have done this a few times, which means you’ll already have a Traditional IRA account at a brokerage company where you’ve been rolling all your 401k money as you’ve moved companies throughout your career.
But if you’re one of the unicorns who stayed at one company for 15 or 20 years, then this might be the first time you’ve had to open a Traditional IRA account and rollover your 401k money.
Regardless, it’s important to get your money out of your work 401k and have it all stacked nice and neatly in a Traditional IRA.
A 401k account and a Traditional IRA account are both pre-tax accounts, so moving the money from one to the other is not a taxable event. As long as we roll the money directly to the Traditional IRA, we won’t pay any taxes on what is likely a sizeable amount of money.
Now we’re ready to build our Roth IRA Conversion Ladder.
Building Your Roth IRA Conversion Ladder
We’ve got our retirement nest egg all neatly stacked in our pre-tax Traditional IRA account.
The next step is to open a Roth IRA account at the same brokerage company.
Having our Traditional IRA and Roth IRA at the same company isn’t a requirement, but it will make things a bit smoother as we’ll be moving portions of our money from the Traditional IRA to the Roth IRA for years to come.
Keeping everything within one company is convenient, even if not truly necessary.
Now, moving money from our Traditional IRA to a Roth IRA is a taxable event.
Remember, that money in our Traditional IRA came from our 401k where we got to avoid paying taxes on it for all those working years.
As soon as we move the money out of the Traditional IRA, those dollars get counted as income, and we’ll be required to pay income taxes on them.
This means moving all the money from our Traditional IRA to our Roth IRA in one fell swoop isn’t going to work. That would be more of a Roth IRA Conversion Dump Truck.
If we do that, we’ll end up having to pay taxes on all our money in that one year, wiping out a huge portion of our nest egg and making us super sad.
Instead, we’re going to move our money over in smaller chunks each year, and if we can balance the amount we convert with our federal tax deductions, we can avoid paying taxes completely.
This is where having a basic understanding of the income tax code is handy.
IRA Conversions and Taxes
Let’s say we have $500,000 in our Traditional IRA that we need to convert to our Roth IRA.
If we do the Roth IRA Conversion Dump Truck method and move the entire $500,000 from our Traditional IRA to our Roth IRA, we’ve essentially just withdrawn $500,000 and we’ll have to pay taxes on that entire amount of money as income for the year.
This is going to be quite a huge tax bill and significantly reduce our $500,000 nest egg.
But instead of moving all the money from the Traditional IRA to the Roth IRA at one time, we’re going to move over smaller portions one year at a time.
To keep things simple, we’ll just look at the lowest tax bracket for 2019. That is a 10% tax on income up to $19,400.
So let’s say we’re retired (or voluntarily unemployed) and have absolutely $0 in income for the entire year.
This same year we move $19,400 of our $500,000 from our Traditional IRA to our Roth IRA.
That $19,400 will be counted as income and we will pay 10% in taxes, or $1,940.
Or will we?
With the latest tax reform bill passed in 2018, the standard deduction for a married couple filing jointly is $24,400.
This means that income taxes don’t kick in until we earn at least $24,400.
So in our scenario where we are retired and have $0 in income, we can actually move $24,400 of our $500,000 from our Traditional IRA to our Roth IRA.
When we file our taxes and claim the standard deduction for a married couple filing jointly, we will show an income of $24,400 and a deduction of $24,400.
This will show our taxable income for the year as $0, meaning we will pay exactly $0 in taxes.
We just converted $24,400 from a pre-tax status in our Traditional IRA to an after-tax status in our Roth IRA account, all while paying $0 in taxes.
We’ve just done the first rung on our Roth IRA Conversion Ladder.
Next year we’ll do the same thing, moving a portion of our Traditional IRA money over to our Roth IRA, being sure to stay below the standard deduction amount to eliminate the possibility of paying any taxes.
It’s also important to note any other tax deductions you may qualify for.
You may qualify for more than just the standard deduction, meaning you’ll be able to convert even more money from your Traditional IRA to Roth IRA completely tax free.
The amount we move will likely vary from year to year because our income may not stay at exactly $0 every year.
For example, let’s say in our early retirement years we start selling cupcakes at weddings. The next year we make $10,000 from our awesome wedding cupcake business.
Knowing that the standard tax deduction is $24,400, and we made $10,000 in income from our business, we’ll only be able to move $14,400 from our Traditional IRA to our Roth IRA.
That will show a total income of $24,400 for the year, which is again canceled out by the standard deduction, showing a taxable income of $0.
(But if you have kids, you’ll qualify for the Earned Income Credit and be able to deduct a couple thousand dollars more, allowing you to convert a couple thousand dollars more. The whole tax code opens up like a playground to find credits and deductions we qualify for, boosting our Roth IRA conversions.)
Conclusion – Roth IRA Conversion Ladder For the Win
That is the Roth IRA Conversion Ladder in action. Each year we transfer an amount from our Traditional IRA to our Roth IRA based on how close we can keep our taxable income to $0.
And we won’t just do this for 1 or 2 years. This will become our new routine every year until all of our Traditional IRA money is converted, or until we reach age 59 and a half, at which point we can withdraw money from our Traditional IRA completely
But we’re not quite finished yet.
All we’ve done so far is learn how to convert pre-tax money in a Traditional IRA into post-tax money in a Roth IRA, and do it completely tax free.
We haven’t actually withdrawn any of the money from the Roth IRA yet to do things like pay the light bill, or buy groceries, or travel to Jamaica.
So how do we get our money out of the Roth IRA completely tax free?
Now we’re ready to jump into the final lesson of our Fundamentals of Early Retirement series
We will discuss how to prepare before retirement, and the actions we’ll need to take to make sure we can access our money completely tax and