I’ve mentioned in passing a few times in the last couple of months, but I’m crushing on Retire by 40. Joe does a tremendous job of covering early retirement and staying on track of the topic. I’m envious that he’s able to do that… a large part of me wants to blog about the TV show Best Time Ever with Neil Patrick Harris last night.
I’m going to resist that temptation and write about something equally fun… Roth IRA Conversion Ladders!
What’s that? I don’t blame you for asking. I hadn’t heard of them either. You’d think in years of reading Kiplingers and Money magazine it would come up multiple times. Maybe I just missed it.
The idea with Roth IRA Conversion Ladders is that you can minimize taxes if you are retiring early. I should note that this makes sense if you have a limited income. That “limit” isn’t that low though.
Let’s pretend that you’ve been reading Lazy Man and Money for years. You’ve read, “Maximize out your 401k plan!” a thousand times. If you took that advice over a lot of years, you may have hundreds of thousands of dollars in there. (I hope you do.)
The “problem” is that you saved that money tax-free and now you have to pay taxes on it. I put “problem” in quotes, because many people would be envious of the situation of paying taxes on a large sum of money.
If you are retiring early, you typically can’t withdraw money from your 401K or traditional IRA without penalties. You are also going to pay taxes on it of whatever your current tax bracket is. It’s not a particularly good plan.
However, if you are planning to retire early, you can convert the money to a Roth IRA. When you do, you’ll pay taxes of your current tax bracket, but then be able to withdraw it tax-free in the future. If your income is low in early retirement, which it likely would be since you aren’t working, you’ll be in a low tax bracket. If you are married and filing jointly, this could be about 15% if your income (and the conversion) is under $74,900.
The idea is to convert some money while in this low tax bracket. You can do this for years while you are in a low tax bracket. You can’t take the money out of the converted Roth IRA for 5 years, but after that you avoid withdrawal penalties.
I’m still learning about this strategy myself. I suggest reading the articles on Retire by 40 and Root of Good, which go into it in more details. Root of Good has a particularly thorough breakdown.
How does this factor into our potential early retirement? I’m not sure. Between the wife’s potential military pension, our investment properties, and my side businesses, we may have too much income to make it work. At the same time, we might be able to limit the income of our investment properties by improving them and I’m sure I could offset income of the businesses by investing in growth that will hopefully pay off in the future.
I’m not quite sure how it shake out down the road, but it’s comforting to know that there’s a tool like this available if it is helpful.
Seb Brantigan says
Great post, going to check out Retire by 40! I like the strategy, we get taxed on everything nowadays so if there is a way around it, we should definitely follow that route. look forward to next article :)
Lazy Man says
Good try Seb, but I deleted your link to your YouTube video pushing your pyramid scheme training.
Dividend Growth Investor says
I have seen a lot of attention paid to roth conversion ladders. I myself am a fan too. Which is why I am sorry that I am leaving what some may consider to be a “debbie downer” comment..
The downside I see here is if we have a change in laws and regulations concerning IRA conversions into Roth (disallowing it) or maybe taxing certain amounts in tax-deferred accounts above a certain dollar amount.
Though I doubt this will be the case in the US in the next 20 – 30 years, in some countries they have “nationalized” private pension schemes in an effort to curb traditional social security plan shortfalls.
Lazy Man says
If laws get it disallowed, then it goes away. I would hope that people using it get grandfathered in.
If laws are suggested that tax-deferred accounts need to pay an addition tax above a certain amount, I would hope that people (peacefully) revolt.
With these accounts, taxpayers have made a bargain… They will put money away for the future and undertake conditions of early withdrawal penalties, to secure their future. I’m don’t see Congress fighting this. If they need more money, I’d think they adjust the income tax brackets.
Dividend Growth Investor says
I usually try to think in terms of what could go wrong, and then devise a plan to mitigate expected risks. I like Roth Conversion ladders, and Root of Good has inspired me to pay as little in tax as possible.
I have been maxing out any tax-deferred vehicle on pre-tax basis like 401 (k), SEP IRA, HSA since early 2013. My goal is to eventually have low enough income to gradually convert into Roth IRA.
The nice thing is that even if a married couple earns $75,000 in qualified dividend income per year, and converts $20,000 from 401 (k) or IRA into a Roth IRA per year, they will owe zero dollars in tax at the Federal Level in 2015.
Who said that knowledge wasn’t power ;-)