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.
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.