Laura answers a listener question about the Roth IRA conversation strategy and how it could be used to retire early.
Laura answers a listener question about the Roth IRA conversation strategy and how it could be used to retire early.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
Have a money question? Send an email to money@quickanddirtytips.com or leave a voicemail at 302-365-0308.
Find Money Girl on Facebook and Twitter, or subscribe to the newsletter for more personal finance tips.
Money Girl is a part of Quick and Dirty Tips.
Links:
https://www.quickanddirtytips.com/
https://www.quickanddirtytips.com/money-girl-newsletter
https://www.facebook.com/MoneyGirlQDT
https://twitter.com/LauraAdams
Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Cindy D., who says:
"I'm 38 and late in retirement planning, but I am lucky to have a job with substantial earning potential. I built my retirement account from zero to $100,000 in three years.
I have a 401(k) with employer matching that I'm maxing out. I can also make in-plan mega backdoor Roth conversions up to the $69,000 limit. I have some brokerage accounts, a high-yield savings, and a health savings account.
My goal is to retire by age 50 or 52. I'm curious if I should be using non-retirement accounts. Also, would you talk about using a Roth IRA conversion ladder to achieve early retirement?"
Thanks so much for your question, Cindy. I love that you've gotten serious about investing and planning to retire early. In this post, I'll review a Roth ladder and ways to create income as an early retiree.
Welcome back, everyone, and thanks for joining me on episode 875! I'm Laura Adams, an award-winning author, female finance spokesperson, money speaker, founder of The Money Stack, a Substack newsletter, and host of the Money Girl podcast with over 43 million downloads.
If you're getting value from the free content we love creating, subscribe and consider submitting a 5-star rating or review on your podcast app of choice! If you have a question about money for the show, leave it on our voicemail at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
What is a Roth IRA?
Before we review a Roth ladder, here's a quick review of Roth IRAs. A Roth IRA is an individual retirement account available to anyone with qualified income under certain limits.
You fund a Roth with after-tax money. In other words, you pay income taxes on Roth contributions the year you make them. For 2024, you can contribute an amount equal to your qualified income, up to $7,000 or $8,000 if you're over 50.
The significant benefit you get from a Roth is that your account earnings grow tax-free. So, when you withdraw in retirement, your original contributions and account growth are entirely tax-free!
However, you can only contribute to a Roth IRA if your income is below an annual threshold. For 2024, single taxpayers with modified adjusted gross income (MAGI) of $161,000 or more, and married couples filing jointly with MAGI of $240,000 or more can't contribute to a Roh IRA.
Another benefit of a Roth IRA is that you can withdraw your contributions tax and penalty-free any time. However, withdrawing account earnings before 59.5 would result in income taxes plus an additional 10% penalty, unless you qualify for a penalty exemption.
In general, once you reach 59.5 and your Roth IRA has been open for at least five years, you can withdraw contributions and earnings tax and penalty-free.
READ ALSO: 4 ways to fund a Roth no matter your income
What is a Roth conversion?
Since a Roth IRA has a relatively low annual contribution limit and prohibits high-earners from making contributions, a workaround for boosting your Roth balance is called a Roth conversion. A conversion allows anyone with a pre-tax, traditional retirement account, such as a 401(k) or IRA, to pay income taxes on funds you move to a Roth IRA, regardless of your income.
While voluntarily paying taxes on retirement funds may seem unappealing, once they're converted to a Roth IRA, they grow entirely tax-free, which could save a massive amount of taxes over the long term.
Consider the following benefits of a Roth conversion:
RELATED: When should I do Roth conversions?
What is the Roth conversion five-year rule?
However, Roth conversions are subject to a five-year rule, which says you must wait five years before you can withdraw any portion of a conversion penalty-free.
While you can withdraw regular Roth IRA contributions tax and penalty-free at any time or age, that's not the case for converted funds. Once you make a Roth conversion, a five-year clock starts, and the funds must stay there for at least that long.
If you withdraw your converted principal or earnings early, it triggers a 10% early withdrawal penalty. Plus, you'd owe income taxes on the earnings portion.
The five-year period starts at the beginning of the year you do a conversion. For instance, if you convert traditional IRA funds to a Roth IRA in November 2024, your clock starts on January 1, 2024. That means you could withdraw the money without penalty anytime after January 1, 2029.
What is a Roth IRA conversion ladder?
Building a Roth IRA conversion ladder can help avoid penalties and create a wise tax savings strategy. It's a series of conversions or rungs on a ladder that become available to you penalty-free on a rolling basis after their respective five-year periods are complete.
A Roth ladder is also a tax savings strategy where you make multiple Roth IRA conversions over several years instead of one large conversion. That's critical because each conversion increases your taxable income for the year.
For instance, if you're single, earn $45,000, and do a $30,000 Roth conversion, you now have $75,000 of taxable income. For 2024, a single taxpayer with earnings up to $47,150 pays a tax rate of 12%. However, amounts above that limit get taxed at 22%.
So, your conversion bumped you into the next higher tax bracket, causing you to pay 22% tax on $27,850 ($75,000 - $47,150) of your $30,000 of your conversion.
Converting all your funds at once may require you to pay taxes at a higher rate than is necessary. A better strategy is to make several smaller conversions over multiple years, breaking up the taxes so you stay in the lowest bracket possible based on your income and tax filing status.
How do you build a Roth IRA conversion ladder?
Since each conversion has its own five-year clock, as I mentioned, you must start building your ladder at least five years before you plan to retire. That ensures you'll avoid taxes and penalties if you must tap your Roth IRA for income before age 59.5.
For example, Let's say you're 45 and want to retire early at 50, like Cindy. To build a Roth IRA conversion ladder, you'd start by doing your first Roth conversion at age 45. That would allow you to withdraw those funds without penalty when you're 50.
You might continue building your Roth ladder by doing a conversion each year until you're 55. The funds you convert at 55 would be penalty-free when you're 60.
Remember that once you're 59.5, you no longer need a conversion ladder to tap your Roth penalty-free because you've reached the official retirement age.
As I mentioned, you must carefully make every Roth conversion so you don't push your taxable income into a higher tax bracket than you like. You might make smaller or larger conversions each year based on how much room you have to fill up your highest tax bracket.
READ ALSO: Think you’re too rich for a Roth? Think again
What are the pros and cons of Roth IRA laddering?
The main reason to consider a Roth ladder is that you create a source of tax-free income before age 59.5. Plus, making multiple smaller conversions can reduce taxes when strategically keeping your taxable income from jumping into a higher tax bracket.
Roth conversions allow you to put as much money in a tax-free account as you wish, even if you earn too much to make Roth IRA contributions.
The downsides of laddering include paying income taxes on converted amounts. Plus, you must have enough already saved in a traditional retirement account to fund conversions in the first place.
And, due to the five-year waiting period, if you don't start early enough, tapping your Roth IRA before each conversion is "seasoned," you'll owe a 10% early withdrawal penalty plus income taxes on your post-conversion earnings.
What are other income sources for early retirees?
In addition to building a Roth IRA conversion ladder, there are other ways to create income when you retire early. Cindy mentioned having access to a 401(k) with in-plan Roth conversions, known as a mega backdoor Roth. Don’t miss episode 835, How to Use a Mega Backdoor Roth Conversion, to learn more about that powerful strategy.
Cindy also mentioned having a health savings account or HSA. I cover how to use an HSA in retirement in episode 803, HSA Hacks–How to Optimize Your Health Savings Account.
Cindy also asked about investing in a non-retirement account, such as a taxable brokerage. That should definitely be part of any early retirement plan because it's incredibly flexible and penalty-free.
Additionally, you may have a workplace pension or purchase an annuity in retirement for lifetime income. If you qualify for Social Security retirement, you must carefully consider the right time to claim benefits.
What is a 72(t) plan for early retirement?
There's also a little-known rule to avoid early withdrawal penalties regardless of age, known as a 72(t) payment plan. It allows you to set up a plan to take substantially equal periodic payments from your retirement account, such as a traditional IRA or a Roth IRA. You can also set up a 72(t) distribution for a workplace plan, such as a 401(k) or 403(b) if you no longer work for your employer.
The problem is that a 72(t) comes with restrictions and negative consequences if you don't use it correctly. It's important to understand that once you begin taking 72(t) distributions, you can't stop taking them for a certain period.
Once the plan begins, you must take the periodic payments for a minimum of five years or until you turn 59.5, whichever is longer. In other words, if you start a 72(t) at age 50, you'd have to continue payments for 9.5 years.
After you complete a series of five-year distributions or reach age 59.5, you can take retirement distributions any way you like. However, for most traditional accounts, once you reach age 73, you generally must take annual required minimum distributions, whether you used a 72(t) plan or not.
Another consideration is that you can't make new contributions to your retirement account or add rollovers while you take 72(t) payments. And, of course, all distributions that weren't previously taxed will be subject to ordinary income tax.
Taking 72(t) payments can be a smart way to tap your retirement funds early without penalty. However, figuring out the allowable payment schedule is complex, so get help from a qualified tax professional.
Taking too little, too much, or missing a 72(t) distribution deadline can result in owing income tax and paying a 10% early withdrawal penalty plus interest calculated from the original date you made an error.
So, every early retiree should weigh their options carefully and get help from a qualified financial or retirement planner. You must have a solid plan that ensures you never run out of money, no matter how long your retirement lasts.
Before we go, here's a quick reminder to subscribe to The Money Stack, my weekly newsletter, when you visit LauraDAdams.com. It's filled with money tips, tools, news, challenges, and things I enjoy! You can subscribe for free or become a paid member with access to live educational events.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
Money Girl is a Quick and Dirty Tips podcast, and I want to thank our fantastic team!
Steve Riekeberg audio-engineers the show. Brannan Goetschius is our director of podcasts, Holly Hutchings is our digital operations specialist, Morgan Christianson is our advertising operations specialist, Davina Tomlin is our marketing and publicity associate, and Nathaniel Hoopes is our marketing contractor.