In Episode 4, we continue our discussion of retirement accounts from Episode 3, but now focus on IRAs and Roth IRAs – the “consumer retail” cousin of the 401k / Roth 401k.
We also show you how the Roth laddering strategy works, why for early retirees this strategy means it’s always better to contribute pre-tax upfront, and exactly how to implement the strategy.
What you’ll learn in this episode:
- IRA and Roth rules for contributions, tax deferral, withdrawals, RMDs, rollovers, loans, beneficiaries, creditors, inheritance
- How the Roth laddering strategy works and why it is the best method to avoid taxes entirely
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Links mentioned in this episode:
- Traditional vs. Roth spreadsheet template to quickly see how much you’ll personally save with a tax-deferred upfront strategy
- HYW episode 3: Everything you need to know about 401Ks
- HYW blog post: Traditional vs. Roth?
- HYW private Facebook community
Read this episode as a post:
Okay, thanks for tuning in today’s podcast.
I’m excited about today’s episode because we are going to be talking about a topic again in the invest pillar of my four by four FIRE framework.
The pillars remember, earn, save, invest and protect. Check out Episode Two for a fuller detailed explanation of what my four by four FIRE framework is. Definitely encourage you to do that.
So today we’re going to be talking about IRAs and Roth IRAs and how IRAs work in terms of contributions, tax deferrals, withdrawal rules, required minimum distributions, rollovers, all those kinds of things.
And in particular, we’re going to be talking about how Roth laddering works.
We’re going to be talking about a strategy around Roth laddering that can help accelerate your retirement by YEARS…if you follow the strategy early.
I created a freebie for this episode, which is a spreadsheet template that will help you run your own scenarios on the topic I’m going to teach day, which is all about building Roth ladders to get a triple tax advantage: tax free in, tax free growth, and tax free out for your retirement accounts.
So be sure to grab that spreadsheet template hackyourwealth.com/4 where you can get the Show Notes for this episode, as well as that freebie.
Also, I want to invite you as always to join my private Facebook group for HYW. Go to hackyourwealth.com/fb and join that group. Answer the few simple questions and I’ll let you in.
Let’s connect, let’s have a two way dialogue. I’m in there every day I respond to everything that comes in through that group.
And there are many members who are engaged in discussion there on topics related to financial independence, early retirement, tax strategies, real estate investing, side hustle income, online income, career transitions, and just generally asking for advice about personal finances.
Okay, on to today’s subscriber review.
Today’s review comes from “Engineer Dad” who writes: “I can’t wait for more, gives two thumbs up, did not know about certain withdrawal and rollover rules with his company 401k, and is happy to learn that his company / brokerage allows these roll ins” and he gave the podcast five stars.
Well thank you “Engineer Dad,” and I hope you stay tuned in to the podcast. There’s lots of good stuff along the way.
And to all other listeners out there, please consider writing review. It does help the podcast and helps other folks who are looking for this type of content find the podcast as well. Thanks so much.
Okay, I want to start off this episode by talking about strategy.
So, many years ago, there was this movie called Moneyball that came out. I think it came out in around 2011 or so.
It was a sports movie about how the Oakland Athletics baseball team was the poorest, least funded team in Major League Baseball.
And how the manager of the Oakland Athletics managed to, with that small budget, recruit a motley crew of baseball players that ended up like winning the World Series, the big championship.
And the way he did that, despite having very limited resources is that he used statistics and data about specific players, about their strengths, about their ability to get on base, running runs, to figure out how to assemble a team that would match the performance of even the best players or the best teams in the league.
And because he was very strategic, and was able to look at data and numbers and be extremely analytical in putting together the team, and managing the team, that actually was the competitive advantage that he had to actually win the World Series.
And I mention that because it’s a really good example of how, even when you’re the underdog, or even when you don’t have any particular competitive advantage otherwise, by simply being strategic in your planning, and being intentional and thoughtful, you can actually create an important advantage for yourself.
And when it comes to personal finance, that advantage is measured in how early you’re able to retire and how quickly you can achieve financial independence.
So last time, in the last episode, we got into all the gory details of how 401k is work.
And today I want to talk about the cousin of the 401k in detail, which is the IRA and the Roth IRA.
This is the consumer retail cousin of the 401k.
And I’m really excited about this topic, because I’m going to show you a specific powerful conversion and laddering technique that you can use to help you sidestep a lot of taxes and achieve retirement way faster than you might otherwise be able to do.
And this is the strategic part.
This is the link to the example I gave earlier around how in the movie Moneyball, strategy and planning was the secret sauce to winning.
And here, strategy and planning is YOUR secret sauce to becoming financially independent faster – and to being on track to retiring sooner.
I think it’ll be really valuable for you to be aware of this so you can strategize on how to take advantage of this technique when the opportunity is right for you.
Okay, so first an overview.
I’m going to try to breeze through this since we already covered a bunch of the framework last time in the 401k episode.
An IRA stands for investment retirement account.
It is a tax deferred investment account that is controlled by you for retirement purposes.
It’s different from a 401k because it’s not sponsored by any employer. It’s solely created and funded by you.
It’s tax deferred, which means you don’t pay taxes right now. You pay taxes on withdrawal.
This of course, you already know.
Most brokerages offer IRA account options so it doesn’t matter if you go with Fidelity or Vanguard or Wells Fargo or Schwab or Merrill Lynch, it really doesn’t matter.
They’re all pretty much the same.
Just choose one based on how you like their customer service, their user friendliness of the website, don’t dwell on it too much.
In terms of contributions, as you know, contributions are tax deductible if your income does not exceed a certain threshold.
Once you start exceeding a certain threshold, which I’m going to describe momentarily, then your ability to contribute to an IRA starts phasing out and eventually gets eliminated entirely.
But assuming you’re under those thresholds, then for 2019 and 2020, the maximum amount you can contribute to an IRA is $6,000.
And then if you’re 50 or older, you also get a bit of an additional amount you can contribute as a catch up contribution: that’s going to be $1,000.
So if you’re 50 or older, you can contribute up to $7,000.
And that’s true for both 2019 and 2020.
In 2020, the income phase out thresholds of your income before you start getting phased out of the ability to contribute to an IRA are going to be…we’ll first talk about single filers and then married filing joint.
If you’re single, you can contribute the full amount up until you make $124,000.
And then between $124,000 and $139,000, you’re going to start to get phased out linearly.
Once you exceed $139,000 as a single person, as a single filer, you’re not allowed to contribute at all anymore to an IRA or Roth IRA, you’re phased out entirely.
Now, if you’re married filing joint, it’s a little bit different. You can contribute the full amount to an IRA, up until you make $196,000 in 2020
And then between $196,000 and $206,000, again married filing joint, you will get phased out linearly.
And then once your income exceeds $206,000, you’re no longer allowed to contribute at all, pre-tax to an IRA and you’re no longer allowed to contribute at all to a Roth IRA.
However, regardless of how much you make, you can always contribute after tax money to a regular IRA, only a regular IRA.
You cannot contribute after tax money to a Roth IRA if you bust the income thresholds.
But anybody, even if you make a million dollars a year can contribute after tax money to a regular IRA.
And the amount that you can contribute is the same. It’s up to $6,000 in 2019 and 2020, and another thousand dollars catch up contribution if you’re 50 or older.
Now, the only reason why you would do this, just like I talked about in the last episode on 401k Roth conversions, is to do a Roth conversion.
Otherwise, there’s no benefit to contributing after tax money because when you then subsequently withdraw that money, it would be taxed at ordinary tax rates.
All the gains would be taxed at ordinary tax rates, which are generally higher than capital gains tax rates.
So the only benefit to do this is to then immediately convert it to a Roth so that all the future growth becomes tax free.
So this is generally called the backdoor Roth contribution.
And so if you have a high income, which many listeners of this podcast and followers of the blog do, then just know you should absolutely be taking advantage every single year of contributing, maxing out a regular IRA contribution, even if it’s after tax, so that you can immediately convert to a Roth right afterward.
But there’s one thing you have to be very careful of, and that’s the pro-rata rule.
In the old days, you could actually select which specific dollars you wanted to convert to a Roth IRA and so only dollars that didn’t have any gain yet, namely the dollars that you contributed after tax, you could actually cherry pick those and only convert those dollars and pay no taxes.
But now there’s this thing called the pro-rata rule which says that you have to take a pro-rata proportion of the after tax dollars that you put in, plus any pre-tax dollars you have in the account.
And the tax that you pay is going to be in proportion to those two amounts.
So if you have a bunch of IRA money maybe from earlier in your career, or maybe even when you were a student, that you contributed, pre-tax…let’s say you have an IRA that has 60% of the money, as pre-tax contribution and 40% of the money as after tax contribution.
Maybe because you had IRA money that you contributed when you were younger, when you didn’t make as much money, or maybe even when you were a student.
Either way, you have basically money that’s mixed together.
Now, some of it is pre tax and some of it is post tax: 60/40 in this example.
Then, when you convert money from your IRA to your Roth, it doesn’t matter how much you convert…60% of that conversion amount is going to be taxable.
That’s basically what the pro rata rule says.
And so because of the pro rata rule, and because it’s so easy to get caught by this and be liable for taxes, even though you put in after tax dollars, which are then trying to convert to Roth, the solution, the workaround for this is simply that before you make your after tax contributions, you need to sweep out all your pre tax dollars out of your IRA.
And the way to do that, without incurring any withdrawal penalties is simply roll them over to a 401k.
A 401k is not considered part of the pro rata rule.
It’s not factored into the pro rata rule.
So if you move your money from an IRA into a 401k, which I think most 401k plans will allow you to do, then you will have cleaned up all the pre tax dollars in your IRA.
Then just use your IRA as a holding tank to take after tax dollars, which you can then immediately convert to Roth with no tax consequences.
And then those dollars grow tax free forever.
Very important: Don’t think you can avoid this simply by opening up another special IRA, which you only use for this backdoor Roth strategy.
Because the IRS, when it enforces the pro rata rule, looks at the totality of ALL your IRA accounts combined together.
It doesn’t just look at a single IRA and look at whether there’s mixed dollars in that one IRA.
It’s actually going to look at all the IRAs you have together and do a pro rata tax based on the sum total of ALL dollars across ALL those IRAs.
And that’s why you need to clean up your IRA by first rolling over all the pre tax money into a 401k or other similar type of investment vehicle. It just has to be out of the IRA.
Okay, when it comes to tax deferral, this is a simple one. Obviously, you know, that while your IRA is accumulating and compounding, it grows tax free, but when you withdraw, the entire amount is taxed at ordinary rates upon withdrawal.
And that assumes that you contributed with pre tax money, the entire amount, both the original contribution and the gain is taxable at ordinary tax rates, not capital gains tax rates, and that’s because you got a tax deduction when you made the contribution initially.
You shouldn’t have after tax dollars in your IRA when you withdraw because the whole purpose of contributing after tax is to convert to Roth.
So make sure that when you withdraw from your IRA, it is cleared of all after tax dollars.
And your Roth IRA, as you know, grows tax free, not just tax deferred.
And when you withdraw that money, you also pay no taxes on it because you contributed after tax dollars to it in the first place.
Okay, when it comes to withdrawal, just like a 401k, there is no penalty when you withdraw once you turn 59 and a half.
But if you withdraw before 59 and a half, just like a 401k, you will pay a 10% penalty on the entire withdrawn amount, both principal plus any growth on that amount.
And that could exceed your returns.
So, if you didn’t make 10% on your IRA, maybe you contributed one year and then withdrew from it just a couple years later, maybe you don’t even have 10% returns, then that 10% penalty is actually going to start to eat into your principal.
So you want to be very careful about not withdrawing money from your IRA once you put money in.
You will still pay ordinary taxes on any withdrawal. But that’s not a penalty. That’s regardless of when you withdraw, whether it’s before or after 59 and a half.
There are a few exceptions to the 10% penalty when you withdraw before 59 and a half…for example, if you’re using your IRA money to pay for medical insurance premiums after a job loss.
But one of the two most notable exceptions are the first time homebuyer exception and the qualifying higher education expense exception.
Now I’ll note that unlike the 401k, where you could borrow against your 401k and pay it back over five years with interest, there is no loan option with an IRA.
That only exists with a 401k. So you cannot borrow money from your IRA. Full stop. You cannot.
But there are a few exceptions, the notable ones being the first time homebuyer and qualifying higher education expense exceptions, where you can simply withdraw the money, pay your ordinary taxes, but pay no 10% penalty.
Now the first time homebuyer rule says you can withdraw money from an IRA to help with the home purchase if you are a first time home buyer.
Strangely, the IRS defines first time homebuyer pretty loosely.
It says you’re considered a first time buyer if you and your spouse, if you’re married, haven’t owned a home at any point in the last two years.
But it’s specifically about principal residences.
So if you owned a principal residence five years ago, but you sold it more than two years ago, then you’re going to meet the first time home buyer requirement.
And the key word here is principal.
That also means that if you own a vacation home, or maybe had a timeshare with a property, even if it was during the last two years, you might still qualify for the first time home buyer rule.
So long as you didn’t have a PRINCIPAL residence within the last two years.
That’s a very important distinction.
Also, one counterintuitive thing is that you don’t have to actually be the person who’s buying the home.
You can tap into your IRA and qualify for the exemption if the money is to help an eligible child or grandchild or even a parent buy their home, so long as THEY did not have a principal residence in the last two years.
And that’s even if you yourself are a homeowner.
Right now, if you qualify for the first time home buyer exception, then you can withdraw up to $10,000 from your IRA, to use that money to buy or build or rebuild a home, and you’ll avoid that 10% penalty.
But of course, you’re still going to have to pay income taxes on the withdrawal.
That $10,000 exception, by the way, is a lifetime limit.
So you can’t use that home buyer exception again and again, in the future, even if you use a different IRA.
That $10,000 cap is linked to you as a PERSON, not to any specific account. And it’s a lifetime cap.
So it’s not a ton of money. Obviously $10,000 is not going to buy you a lot of house, but it’s one financing option that is good to be aware of.
In terms of higher education expenses, the qualified higher education expense exception says that for certain expenses, like tuition, fees, books, supplies, equipment, and even room and board, as long as the student is enrolled at least half time in a degree program, then you can withdraw money from your IRA to pay for those expenses without incurring the 10% penalty for early withdrawal.
So again, you’re going to pay ordinary taxes on the withdrawal, but no penalty.
But one thing you should note is that when you withdraw that money, then the next year, if you’re filling out the FAFSA application, the federal application for student financial aid, then that could impact your financial aid amount.
It could reduce it because that will be considered income
It will be imputed income when you withdraw that money.
Now, when it comes to withdrawal rules for a Roth IRA, the rules are a little bit different.
And one of the factors you have to keep in mind is that you have to have had the Roth IRA account open for a certain amount of time before some of these withdrawal exceptions become eligible.
But first things first, you can withdraw all your Roth contributions, tax free and penalty free, at any time for any reason, because you’ve already paid taxes on those contributions.
So the IRS doesn’t care if you want to take those contributions out.
However, once you withdraw your contributions, any gains that are in the Roth IRA, those gains cannot be taken out before you’re 59 and a half without incurring a penalty. Generally speaking of course.
There are some exceptions, again, for Roth IRAs as well. And for the first time home buyer exception, for a Roth IRA, once you’ve exhausted your contributions, once you’ve withdrawn all your contributions, you can withdraw up to $10,000 of GAINS on top of the contributions without paying the 10% penalty.
That’s how the first time home buyer exception works on a Roth IRA.
If it’s been fewer than five years since you first contributed to the Roth, then you’re going to owe taxes on the earnings.
But if you have had the Roth open for at least five years, then all of the withdrawn earnings are going to be tax free and penalty free.
So that’s the point that I made earlier about how long you’ve had the Roth account open actually makes a difference.
The magic number is five.
Once you’ve had it open for five or more years, then when you fall into one of these exceptions, like the first time home buyer exception or the qualified educational expense exception, then as long as you’ve had the account open for five years or more, then in addition to the contributions which you can always withdraw tax free penalty free, you can also withdraw any earnings on top of those contributions, tax free and penalty free for those for those exceptions.
But if you’ve had the account for less than five years, then you’re going to at least pay taxes on the earnings but no penalty.
Now just like for a 401k, you should think twice before actually taking one of the exceptions because, by taking out money from an IRA, you’re going to lose out on the compounding benefit of tax deferred or tax free growth.
So, I generally don’t recommend taking money out even under the exceptions from an IRA or Roth IRA, but just know that that is a financing option available to you.
Okay, now, when it comes to RMDs, required minimum distributions, again, that’s only required for regular IRAs, not Roth IRAs.
And your RMD for regular IRAs starts to kick in once you turn 70 and a half years old.
And it’s calculated by dividing your account balance by your life expectancy factor, which works exactly the same way as a 401k.
That life expectancy factor decreases with each passing year such that your RMD will actually increase as you get older each year.
And it uses the exact same mortality tables as the IRS uses for 401ks.
OK. Other topics.
When it comes to beneficiaries, remember for 401ks, because they are governed under ERISA, your spouse is automatically considered your 401k beneficiary, even if you didn’t name them as a beneficiary – say, because you weren’t married at the time when you created the 401k.
And even if you DID name a beneficiary who isn’t your spouse, your spouse will always take precedence for 401ks.
And if you want to name someone other than your spouse as a beneficiary on your 401k, again you need a written spousal waiver.
But IRAs are not regulated under the ERISA law.
So they don’t require you to name your spouse as beneficiary.
You can name anyone you want as a beneficiary and you don’t need your spouse’s permission, at least at the national level.
But your state may give your spouse some rights to your IRA.
For example, if you live in a community property state like California or Texas, there may be state level rules that require you to give your spouse some part of your IRA, even if there are no national rules that say that.
When it comes to creditors, unlike 401k plans, IRAs are not regulated under ERISA, as I’ve mentioned a few times already.
So you will not get the same level of creditor or bankruptcy permissions on your IRA as you would get for your 401k.
But there is still some protection under federal bankruptcy laws.
So with IRAs, you get up to a million dollars of protection under federal bankruptcy laws.
And that million dollar number is indexed for inflation every three years.
But importantly, these protections for IRAs and Roth IRAs are only available only if you actually file for bankruptcy.
Whereas 401k protections under ERISA do not require you to file for bankruptcy.
The $1 million protections for an IRA are only available if you do file for bankruptcy under the federal bankruptcy code.
One other note to be aware of is that inherited IRAs do not get this bankruptcy protection.
Only the original owner of the IRA is protected.
So if your beneficiary, for example, has problems with creditors, you might want to consider naming a trust instead of that individual directly as the beneficiary of your IRA.
And then that trust can, in turn, have a beneficiary, which is your actual intended beneficiary, if that makes sense.
So, if you put it in a trust, then your beneficiaries creditors cannot come after the IRA.
But if you name that beneficiary directly, then that person’s creditors might be able to come after the IRA.
When it comes to rollovers, you can roll IRA money into a 401k plan, like with an employer.
And some of the considerations or benefits of doing that are, as I just mentioned, 401k are regulated by ERISA so you get stronger creditor protections.
And also the RMDs, the required minimum distributions, only kick in when you turn 70 and a half years old AND you’re actually retired.
So, if you’re working at an employer, after 70 and a half years old, you don’t have to withdraw.
There are no required minimum distributions so long as you continue to work.
Whereas with an IRA, once you turn 70 and a half, no matter if you’re working or not, you’re going to have to start taking required minimum distributions.
So that’s an important distinction between how 401k RMDs work and how IRA RMDs work.
With the 401k, you can also take out loans as I mentioned in the last episode, and you can withdraw money earlier.
There are some additional exceptions that you have for early withdrawal from a 401k, the rule of 55, for example that I mentioned in the last episode.
You can also roll over money from a 401k into an IRA, you know in the other direction.
And the benefits of doing that are you get more investment selection, because 401k generally has limited investment options that are negotiated by your employer.
In an IRA, you can also make early withdrawals with this first time home buyer exception or qualified higher education expense exception.
But on the flip side, there are no ERISA protections when it comes to creditors.
In terms of other benefits, like Social Security, unemployment benefits, financial aid, distributions from your IRA will not impact Social Security benefits because it’s considered non-wage income, same as a 401k.
But IRA distributions can result in your Social Security benefits getting taxed at a higher rate because the taxation of Social Security does factor in income from other sources, including distributions from your retirement account.
So that’s just something to be aware of.
For unemployment benefits, if you personally funded your IRA, then you can generally withdraw money from your IRA without losing unemployment benefits.
You’ll still pay taxes, ordinary taxes, on any money that you withdraw.
And you might be subject to a 10% penalty if you withdraw early. But it generally will not impact your ability to get unemployment benefits.
Additionally, you can withdraw IRA funds without penalty if you have been unemployed for 12 weeks, if the purpose of that withdrawal is to pay for health insurance premiums.
So there’s a little bit of an exception there, in terms of the penalty, where if you’ve been out of work for a while, 12 weeks, you can take money out of your IRA to pay for health insurance premiums, and pay no penalty as a result.
Still going to pay taxes, but no penalty.
And then when it comes to financial aid, balances in your IRA are generally not going to be reported as an asset on your FAFSA applications.
But any contributions you make during the base year, which is the year before you fill out the FAFSA application, will count as untaxed income, if you made a pre tax contribution to an IRA, which has a similar impact on your eligibility for financial aid as taxable income would
And then Roth contributions don’t have any consequence because that’s after tax dollars anyway.
So that money that you contributed to a Roth will have already been accounted for as taxable income for FAFSA.
So basically, in the year before you file FAFSA, any contributions you make will be factored in for purposes of financial aid.
Okay, so now let’s shift gears and talk about strategy – about the Roth ladder strategy in particular.
And so I often hear this question of: which type of retirement account is better to contribute to.
A traditional tax deferred account? Or a Roth account?
And a lot of advisors will say, it depends.
If you believe taxes are going to be higher now then later then contribute to a traditional account and get a tax deduction now.
Whereas if you believe taxes are going to be higher in the future, then contribute to a Roth account, take the tax hit now, and then enjoy tax free withdrawals later.
And whether taxes are higher now versus later is going to depend on how much you earn now versus how much you expect to earn later, or in retirement, plus what tax rates are right now versus what you predict they’re going to be in the future.
So that’s all conventional wisdom.
But I want to show you that contributing to a traditional account up front is always superior.
For nearly all taxpayers, especially if you plan to retire early.
And the key is this. After you contribute to a traditional account up front, you can then slowly convert to a Roth IRA account after you retire.
And that lets you get the best of both worlds.
It means you can avoid taxes on money going in, avoid taxes on the growth, and avoid taxes on the conversion if you do it right and you time it right.
And then finally, avoid taxes on withdrawal. Completely tax free pass through.
In tax planning, a completely tax free pass through like that is the Holy Grail.
And to execute this correctly, you have to be really strategic. You have to plan ahead. You have to time things correctly. But it is possible.
And the reason why you should care about this is because taxes are your single biggest expense. Throughout your life, they’re going to be the biggest expense you pay.
More than housing, more than transportation, more than food.
And that’s why it’s super important to be as efficient as possible when it comes to tax planning.
And tax advantaged retirement accounts are your key mechanism for executing that strategy.
If you follow this strategy early in life, and you execute it properly, then the taxes you save are going to end up allowing you to accelerate your retirement by YEARS.
Okay, so exactly how does it work?
Let’s talk about the mechanics.
Step one. First, you’re going to contribute pre tax money to your traditional accounts during your working years.
This is typically going to mean maxing out your 401Ks and or your IRAs every single year to make your pre tax contributions as big as possible.
You want to maximize your tax savings there.
Step two. You’re going to do a Roth ladder once you retire.
Ideally, you’re retiring early, before 59 and a half years old, so that you have a little bit of a runway where you can do these conversions before you are able to start withdrawing things.
And so the year after you retire, hopefully again, early retire, you’re going to start doing a Roth ladder conversion, where you are converting a little bit each year from your traditional account over to your Roth accounts.
How much should you convert?
Well, the conversion amounts are taxable events. That part you cannot avoid.
But if you convert up to the standard deduction amount, which is $24,400, for a married couple filing joint, half that amount if you’re filing single, then you can move THAT money into your Roth account and pay zero taxes.
Because everybody gets that amount as a tax free deduction.
So once you retire, and your income goes to zero, you can start converting and moving money over from your tax deferred accounts to your Roth accounts, up to the standard deduction amount, and pay zero taxes on it.
Unlike IRA contributions, which are capped annually, and subject to income phase outs, there are no such things when it comes to Roth conversions.
There’s no cap, no income phase outs.
So no matter how much you make, or how much you want to convert to a Roth IRA, there are no restrictions on that.
Now, I mentioned earlier that you always have the option, you’re always free to withdraw your original contributions to a Roth IRA tax free penalty free.
But when you do a Roth conversion, there’s a little bit of a twist.
You have to wait five years before you can withdraw those original contributions when you do a Roth conversion.
And that is where the Roth laddering comes in. The Roth ladder concept.
So each year you convert an amount exactly equal to the standard deduction.
And then five years later, you start withdrawing those contributions tax free.
And that takes us to step three. Which is covering your first five years of expenses from other sources.
Because the Roth ladder has this five year waiting period where you have to ladder things over, you’re going to have to cover your expenses for those first five years from other sources.
Now that can be from unemployment, or withdrawing prior Roth contributions tax free penalty free.
Could be from rental income or side hustle income, dividend income from a taxable account, which is especially attractive because qualified dividends and long term capital gains are taxed at zero if your taxable income is less than around $79,000 married filing joint, half that for single filers.
Remember taxable income is after the standard deduction is taken.
So in other words, after doing the Roth conversion up to the standard deduction, of $24,400, married married filing joint, you can then withdraw and live off nearly $80,000 in dividends and long term capital gains paying zero taxes.
That’s six figures in completely tax free income every year.
Just think about that for a second.
That is one of the mother of all loopholes and benefits, perfectly legal, that you can take advantage of, if you are an early retiree, if you’re strategic about it, if you time things right, and pay zero taxes on at all.
Then five years after starting your Roth ladder, you can then begin withdrawing your ladder conversions tax free, and any earnings on those Roth investments.
Remember, they have to stay in the account until you’re 59 and a half before the earnings can start to be withdrawn, penalty free.
So if you follow all of this and you execute the strategy, then it means you enjoy tax free contributions, tax free growth, tax free conversion to Roth, tax free withdrawals.
Complete tax free pass through. That is literally the Holy Grail.
It is definitely achievable. There is a whole cottage industry of people, early retirees who are plotting out their retirement timelines, and their even their income, timing their income, just to take advantage of this strategy.
Okay, well, that’s a wrap.
This was another packed episode. But hopefully you learned a lot about some of the unique features of IRAs and how to do a Roth ladder to capture this triple tax advantage of tax free in tax free growth tax free out.
To review, we covered an overview of how IRAs work in terms of contributions, tax deferrals, withdrawals, RMDs, rollovers, other topics.
And we also learn how to do a Roth ladder. Namely, during your working years, max out your 401ks and your traditional IRAs and all that.
Take the tax deduction up front. Let it grow tax free.
When you retire early, start converting an amount equal to the standard deduction, tax free over to your Roth.
And for 401ks, you’ll have to roll over to a traditional IRA first, before you convert to a Roth IRA. Remember that. It’s just one extra step.
And then you’re going to have to cover the first five years of living expenses on your own.
And if you do that through qualified dividends and long term capital gains, you can actually take out nearly $80,000 a year paying no taxes.
Again, if you play the cards right.
After five years, you can start withdrawing your Roth principal contributions tax free, too, should you need them.
And then your Roth gains have to stay in the account until you’re 59 and a half in order to avoid the 10% penalty.
So hopefully that gives you a good grasp on all the rules and around IRAs and Roth ladders.
Again, be sure to grab my freebie for this episode, which is the spreadsheet template I created to help you run your own scenarios on this in a spreadsheet.
Grab it at hackyourwealth.com/4.
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Thanks for tuning in. Next week, I’m going to have an expert guest on the show to talk about advanced strategies when it comes to retirement accounts and financial planning and a whole bunch of other cool topics.
So you don’t want to miss that.
We’ll see you next time.
Related: be sure to also check out our companion post on: How to take a year off, earn 6 figures, harvest capital gains, do Roth conversions…and pay zero taxes on it all!