Withdrawing Our Money from a Roth IRA
Welcome to the final lesson in our Fundamentals of Early Retirement series.
In the previous 4 lessons, we’ve learned…
- why reducing our monthly cost of livingis so important.
- how much money we’ll need to save before kicking our 9-to-5 job to the curb.
- where to save our retirement nest egg.
- how to build a Roth IRA Conversion Ladder so we can avoid paying taxes on our retirement nest egg.
Now we’re ready to learn the best part – how to access our money!
You’ll remember from Part 4 that we now have our nest egg in a Traditional IRA and are moving chunks of that money into a Roth IRA each year.
Eventually we’ll have large portions of our nest egg in our Roth IRA, and at some point, we’ll want to get that money out so we can pay the light bill, buy groceries, travel, start a business, or any number of awesome things that early retirees do.
Of course, when we’re talking about a retirement account governed by our sweet US tax laws, let’s just say “easy” isn’t really how the government rolls.
Luckily, we’re not afraid of a few weird government rules, and we’re not afraid of learning how to navigate them.
So let’s get started.
Know Your Roth IRA Rules
All retirement accounts have certain rules and Roth IRA’s are no different.
Before withdrawing money from a Roth IRA there are 4 critical rules we should be familiar with to make sure we’re set up for success.
We’re going to dive into each of these rules in a moment, but first, we need to understand the two types of money that live inside our Roth IRA account.
Contributions and Earnings
All investment accounts, including Roth IRA’s, have two types of money in them; the contributions and the earnings.
1. The Contributions
Just like it sounds, this is the money we’ve contributed to the account. If I put $5,000 into a Roth IRA, that $5,000 counts as contribution money. Pretty simple, huh?
Pro Tip: The total contribution amount is often referred to as the “basis” of the account.
2. The Earnings
The earnings are the amount of money that is earned based on the growth of the investment within the account.
If I put $5,000 into a Roth IRA and the investments in that account earn an additional $500, my Roth IRA account will show a balance of $5,500. But it’s important to know that $5,000 is the contribution amount and $500 is the earnings amount.
We have to know about these two different categories of money in our account because some rules apply to the contributions and other rules apply to the earnings, and now you know what those two things are.
Awesome!
Now that we understand that there are contributions and earnings within our Roth IRA account, now we can take a look at the 4 critical Roth IRA rules and what they mean for us.
Rule 1: Contributions can be withdrawn at any time tax and penalty free.
This is a little known rule about Roth IRA accounts.
We are allowed to withdraw the money that we’ve contributed at any time tax and penalty free.
So let’s say we’ve been putting $1,000 into a Roth IRA each year for the past 3 years.
Then one day we check our balance and see our Roth IRA has $3,300 dollars. We know that $3,000 is our contribution and $300 is the earnings.
Based on Rule 1, we can withdraw up to $3,000 at any time completely tax and penalty free. This is good to know, although not always a good idea.
During our wealth-building years, we want to avoid withdrawing money from our Roth IRA
We want our retirement accounts to grow us as much money as possible, and they don’t do that when we remove money from them.
But the fact that we can withdraw our contributions tax and penalty free will come in quite handy during early retirement.
Rule 2: Earnings cannot be withdrawn tax and penalty free until after age 59 and a half.
While the contributions can be accessed at any time, the earnings money is locked up until this mystical age of 59 and a half.
(I love how the government throws that extra
If we are under age 60 and withdraw the entire $3,300 from the example above, then we are going to get hit with taxes and penalties on the $300 of earnings. So we need to keep track of our contributions and be careful not to touch our earnings.
Again, it’s best just to leave it alone during our wealth-building years so it can keep growing more money.
Rule 3: Earnings cannot be withdrawn tax free even after age 60 unless the Roth IRA account is at least 5 years old.
This is a weird rule, but basically, our Roth IRA has to be 5 years old before we can withdraw the earnings tax free, even if we are over the age of 60.
We can’t open a Roth IRA at age 60, then withdrawal the earnings
This rule really only comes into play for those that are within 5 years of age 60 and are just opening their first Roth IRA.
The age of a Roth IRA account starts on January 1st of the year of the first contribution to the account. So if I contribute $1,000 to a Roth IRA on October 15, 2019, the 5-year clock starts as of January 1, 2019. The account will turn 5 years old on January 1, 2024.
Rule 4: The Roth Conversion 5 Year Rule (a.k.a. The Other 5 Year Rule)
Do you know what’s better than one 5-year rule?
Two 5-year rules.
No, wait. That’s worse. Much worse.
See what I mean about the government and complexity.
This other 5-year rule, sometimes referred to as the “Roth Conversion 5 Year Rule” applies to funds that are rolled into a Roth IRA from another retirement account, such as a Traditional IRA. (Sound familiar?)
This rule states that dollars contributed to a Roth IRA as a conversion must remain in the account for 5 years before they can be withdrawn tax and
And just like the other 5-year rule, the clock starts as of January 1st of the year the conversion is made.
So let’s say we convert $24,400 from our Traditional IRA to our Roth IRA on December 15, 2019. That $24,400 is subject to the 5 Year Conversion rule.
The clock starts on January 1, 2019, meaning the money won’t be available to withdraw tax and
As aspiring early retirees, this is the rule we really need to be aware of as we start our Roth IRA Conversion Ladder.
All the money that we convert from our Traditional IRA to our Roth IRA is going to have to sit there for 5 years before we can withdraw the money tax and penalty free.
In preparation for early retirement, knowing that we’ll have to wait 5 years before we’ll be able to access any of our retirement money, means we’ll need to make sure we can still feed our family during those years.
This is where the Taxable Brokerage Account comes in.
Taxable Brokerage Account to the Rescue!
During our working career
But extreme early retirement simply doesn’t work unless we’re also flush with funds to cover us for the first 5 years after we retire.
A taxable brokerage account is an investment account we can open at just about any brokerage firm such as Vanguard, Fidelity, Schwab, etc.
Ideally, we would want the account to be at the same brokerage firm we’ll be using for our Traditional IRA and Roth IRA later on, though that’s not an absolute necessity.
As far as taxes, a taxable brokerage account basically has no tax benefits whatsoever.
The money we put in a taxable brokerage account is all after-tax money that we’ve already paid income taxes on, so we don’t pay any taxes when withdrawing the contributions.
However, we will pay taxes on the earnings each year regardless of whether we withdraw the money or not.
Let’s Look at an Example
Let’s say we put $10,000 in a taxable brokerage account and over the course of the year it grows by 10%.
We’ll now have $11,000 in our taxable brokerage account and we’ll be required to pay capital gains taxes on that $1,000 we made, even if we don’t withdraw the money.
This is obviously not the most tax-efficient account for growing a significant amount of wealth. That’s what our Extreme Early Retirement Account is for!
But the one critical benefit of a taxable brokerage account is that we can withdraw the money at any time without having to do any conversions or jumping through any hoops.
It’s our money and we can do with it as we like without Uncle Sam getting in the way.
This makes a taxable brokerage account one of the best accounts for building up our 5 years of living expenses in preparation for early retirement and starting our Roth IRA Conversion Ladder.
How Much Money Do We Need In Our Taxable Brokerage Account?
We’ll need at least 5 years of living expenses in our Taxable Brokerage Account to cover us while we wait for our Roth IRA conversions to mature.
Let’s say we know that our family can live on $40,000 a year. (Remember, we already took huge steps to reduce our monthly cost of living, so we got this number as low as possible.)
If we multiply that number by 5, we’ll see that we need $200,000 in our taxable brokerage account in order to live for 5 years before our Roth Conversions become available.
Plus, with $200,000 in our taxable brokerage account when we retire, we’ll have available spending money without having an actual income.
No income means more money we’ll be able to convert from our Traditional IRA to Roth IRA each year.
When to Load Up Our Taxable Account
Ideally, depending on how fast it will take us to build up 5 years worth of living expenses, we’ll want to wait as long as possible before loading up our Taxable Brokerage Account for 2 main reasons.
- We want to focus on growing our retirement assets as quickly as possible. Since there’s only so much money to go around, every dollar we put in our taxable brokerage account is a dollar (plus tax-advantaged earnings) we can’t contribute to our pre-tax retirement accounts.
- Given the tax inefficiency of the taxable brokerage account, having significant amounts of money hanging around in there for years and years before retirement is not ideal. Every year we’ll be paying taxes on any growth in the account, and while growth is a good thing, we would rather have it occur in a tax-favored account if possible.
Therefore, we generally want to wait until our retirement accounts are all loaded up, then spend a couple of years as we wind down our career loading up our taxable brokerage account.
Reducing Risk as We Near Early Retirement
Finally, as we near retirement, we don’t want to risk our 5 years of living expenses in high-risk investments inside our taxable brokerage account.
It’s best to convert this money to something more fitting for our short term monetary needs.
We could leave the money in cash in our brokerage account, but that’s not a great solution.
A better option is to move the money into a high-yield online savings account like Marcus or Ally where we can earn about 2% annually on our money.
The intent isn’t to grow us a lot more money, but to ensure our short-term cash pile won’t get wiped out by a swing in the stock market.
Now that we know how we’ll feed our family for the first 5 years of retirement, we can focus on setting up our Roth IRA Conversion Ladder so large portions of our retirement money will be available completely tax and penalty free starting in year 5 of retirement.
Conclusion – Accessing Our Own Money Is Possible!
It’s a bit of a winding road, but if we’re willing to put in a little effort, we can move our money from 401k to Traditional IRA to Roth IRA, all without paying a cent in taxes or early withdrawal penalties.
It may seem like a lot of work, but the truth is it only takes a few hours to set up each year. And the cost savings is more than worth it when we consider the amounts of money we’re talking about.
This Fundamentals of Early Retirement series certainly hasn’t provided every detail of the journey, but I hope it’s given you a better understanding of one of the common frameworks early retirees use.
And, of course, it’s the method we’re using as well.
Over the previous 5 lessons, we’ve learned…
- why reducing our monthly cost of living is so important.
- how much money we’ll need to save before kicking our 9-to-5 job to the curb.
- where to save our retirement nest egg.
- how to build a Roth IRA Conversion Ladder so we can avoid paying taxes on our retirement nest egg.
- and today we learned how to access our retirement funds before age 60 completely tax and penalty free.
As you can see, there’s still quite a bit to do after making the leap from your job.
The wealth-building phase is its own kind of work. Building up your nest egg takes time, but if you’re focused and diligent, you will get there.
And now that you have a better understanding of the entire framework, I hope you’ll feel more comfortable as you continue creating your path to financial freedom.
You’ve completed the Fundamentals of Early Retirement series. If you missed any of the lessons, you can find them all here. I know you’ve likely still got some questions, so please leave me a comment. I would love to hear thoughts on your own early retirement plans, or fill you in on more of ours.
