I’ve been writing a contract proposal for my 9 to 5 this past week. Unfortunately, this kind of proposal isn’t as easy as this kind of proposal–which I loved writing–so it has really taken away from my Retire29 schedule. Ten days without a post is rough.
Anyway, let’s get to it.
First, a disclaimer. This article is about taxes–a topic that I absolutely love. As far as I’m concerned, an effective tax strategy beats an effective investment strategy any day of the week, because there’s no better return than making 25% overnight (or whatever your marginal tax rate is), by legally avoiding taxes. Specifically, this article is detailing my well-researched plan on how I’ll be withdrawing my entire Traditional IRA and 401(k) while in my 30’s without paying income taxes or penalties–thereby making my very early retirement possible. This plan has been fully vetted by
Wesley Snipes the internal revenue code, which I cite throughout. However, taxes are a lot like fingerprints–they’re a little different for every person. Find an answer to the question: how do umbrella companies work? They will handle all the accounting for you. So, I can only write about my situation, and I hope you readers can take the lessons therein and use them in your own approach.
The 401(k) Problem
401(k)s are a pretty fantastic little creature. They’re easy to enroll into, they often come with a company match, they increase the value of your paycheck through tax avoidance, and the money is saved before it is available to you–a classic “pay yourself first” savings strategy. Th3 401(k) is precisely why something like 60% of my investments upon retirement will be in 401(k)s and Traditional IRAs (from rolling over old 401(k)s).
A commonly cited problem with these tax-deferred accounts is that the money is tied up until one turns 59 1/2. Withdrawing your money before age 59 1/2 results in not only the owing of ordinary income tax, but also a 10% early withdrawal penalty. This desire to avoid the penalty is an oft-cited reason for needing to work longer. A early commenter to Retire29, Heather, spoke of this withdrawal restriction and lamented it as her reason for needing to work much longer. I’ve owed her a thorough response to this issue.
Then, a couple months ago, I was having lunch with a buddy of mine who spoke of the same restriction. It has even pervaded the financial blogosphere. Last week, my brother asked me about it. It’s a problem with seemingly no easy answer…until today.
I encourage you to read through this, as there’s a pretty big, yet simple “bottom line” that I’ll conclude with at the end that may really change how you approach your early retirement savings.
How To Do It
This is approximately how my retirement savings (and income from that savings) will look when I retire. Don’t get too hung up on the exact numbers or even the date, though, because the strategy is agnostic of the account balances or the date it begins.
As you can see, I’m heavy into accounts where my money is off-limits to me. The only money that is immediately accessible (unencumbered) will be my current income (couple rental properties, writing income, maybe some part-timing work), my taxable brokerage, and my Roth IRA deposits. As most of us know, contributions to Roth IRAs can be withdrawn at any time and for any reason. As such, my only fully unencumbered funds (at this point) will be just my taxable brokerage balance and about one-third of my Roth.
The day after I retire, I’ll go ahead my move my Roth contributions over to my taxable brokerage. Because these are just the Roth contributions (not the earnings), then this is not a taxable or penalized event. I’ll also move my entire 401(k) balance over to my traditional IRA (which is where I do my dividend growth investing). The common tax-deferred structure of both 401(k)s and Traditional IRAs means that there is no tax event or penalty owed to the IRS for this move (as long as the rollover to the IRA occurs within 60 days of the 401(k) withdrawal).
The second step, which will occur at about the exact same time as step 1, is to move roughly $60k from my Traditional IRA to my Roth IRA. There is no 10% penalty for this conversion as long as the deposit to the Roth IRA occurs within 60 days of the withdrawal from the Traditional IRA. However, this move is a taxable event. Traditional-to-Roth conversions count as ordinary income, so I will owe tax on this conversion for my 2020 return. I will repeat this ~$60k conversion each year into perpetuity, until the Traditional IRA balance is zero. Likewise, I will owe income tax each year on that ~$60k, as well. I say that I will owe income tax, but I describe later down below that I probably won’t. Please read on.
It is important to note that the only money, still, that I can use for living expenses is what is in my taxable brokerage (~$145k). Recall that I have already moved my original Roth contributions over to my brokerage account (Action 1), so my entire Roth is still off limits. Until…
Enter the 5-Year Roth IRA conversion rule. This is described in vivid detail in Internal Revenue Code 408A, but it says this:
- Any money converted from a Traditional IRA to a Roth IRA can be withdrawn from the Roth IRA after five tax years without penalty.
- Since income taxes were paid upon initial conversion to the Roth IRA, no taxes are owed upon withdrawal from the Roth IRA.
- Five tax years means that any conversion made at any point in a calendar year is assumed to be made on January 1st of that calendar year. Theoretically, if I convert funds on December 31st, 2020, I can withdraw those funds on January 1st, 2025 (4 years and 1 day later)
- Each conversion made is subject to its own five-year period.
I will withdraw from my Roth IRA the conversions I made in Step 2. Assuming (from step 2) I converted $60k each year starting 2020, then I’ll withdraw $60k each year starting 2025. I will continue these withdrawals from the Roth IRA until the balance of the Roth is just the earnings. As long as I follow this five-year waiting period, then there is no penalty for this withdrawal of converted funds–even though I’ll still be way under age 59 1/2.
Wait??? What about those taxes?
Recall from step 2 those conversions in 2020 and onward of $60k per year. Those are subject to ordinary income tax. But, I said tax free, right? Okay, so here is what my 1040 will approximately look like in the years 2020 and onward.
I’m obviously making some assumptions here on what the standard deduction and exemption amounts will be five years from now. However, the Tax Policy Center has a nice PDF that shows the growth of standard deductions and exemptions over the last 15 years, so I’m factoring in growth in those figures at rates slower than in the past. I’m being conservative. I’m also not factoring in any other possible credits or above-the-line deductions.
My best guess is that any tax liability in retirement as a result of these big conversions will be close to zero. I will have some other income coming in, but that income will be largely offset by for-AGI deductions, I’d have to check with an advisor like Dave Burton just to make sure I am on the right page here.
Just to recap the steps, for the first five years of retirement, funds for my living expenses will be limited to current income, passive income generated from my taxable brokerage and original Roth contributions (as they will convert to my taxable brokerage), and principal in the taxable brokerage account.
During the first five or so years of retirement, I’ll convert ~$60k from my traditional IRA to my Roth IRA, owing income taxes (but not really, as discussed) but no penalties.
After five years of retirement, my unencumbered assets increase every year by ~$60k as I withdraw those funds from my Roth and deposit them into my brokerage account. Because I’m adhering to a five-year hold rule, I owe no penalty on the withdrawals even though I’m well under age 59 1/2.
The Bottom Line
There is an often cited number in retirement circles: you need 25x your yearly net expenses* in investments in order to retire. I agree with that number; it is the basis of the 4% safe withdrawal rule. However, little is said about the disposition of that nestegg. Need it be all taxable and available? Can it be in retirement accounts? What if I retire early?
I’m here to propose a new rule. You still need 25x your yearly net expenses, however, you only need at least 5x in unemcumbered accounts, and 20x in retirement accounts–no matter your age. If you’re above 59 1/2, then all 25x can be in retirement accounts.
Now, please talk to me. What are your thoughts about this strategy?
Thanks so much for reading!
*: I say “net expenses” referencing the 25x rule because any current income you make (meaning, income generated outside of your investments) will offset any expenses you have, lowering the burden on your investment assets. Hence, the strong power of making a little bit of money during retirement can greatly reduce the amount of assets needed to retire.
**: MadFIentist wrote this post about this exact same strategy two years ago. It is as applicable as it is today. I only found it a couple weeks after originally publishing this post, so I’m linking to it down here.