I’ve put it off long enough now. I need to get started on the Roth IRA Conversion Ladder. It seems to be the only solution to my western world problem. The problem of having too much in my 401(k). The Roth IRA Conversion Ladder will allow me to gradually convert funds from my 401(k) to a Roth IRA, in turn, allowing me to withdraw WITHOUT PENALTY when I really need it. The catch: You need to start this at least 5 years prior to the first withdrawal.
Is there such a thing as too much in a 401(k)? For most of you who will retire at a comfortable age of 59.5 or higher: No, no such thing as too much. Maxing it out as much as you can won’t hurt you. For the few of us that plan on retiring early, too much is possible. I am the prime example.
To illustrate, here’s a snapshot of my retirement plan, as of today (You can try for yourself here).
I no longer contribute to my stock accounts or retirement accounts. I’ve been retired for 3 years now and my investments now pay the bills. The retirement calculator identifies the problem very accurately. “Your cash and stock balances are depleted prior to Mar 27 2030 when you can legally start withdrawing from your retirement accounts” (no that is not based on my exact birthday, but close enough). The Red arrow points at 12/2024, the month my stock accounts are depleted. After that I can’t get to my money, without incurring serious penalties. The blue arrow indicated the date I can start withdrawing from my 401(k). Clearly there is a gap of some 5 years where I can’t withdraw penalty free.
This is where the Roth IRA Conversion Ladder comes into play. It will allow me to cover that gap dipping into my retirement account without incurring penalties. I first read about the Roth IRA conversion Ladder over at rootofgood.com and it does a really good job of explaining the process but let me do it here again.
At the core of the Roth IRA Conversion Ladder is the process of being able to convert your 401(k) to a Roth IRA allowing you to withdraw from it after 5 years, penalty free. So if you have 5 years you can circumvent the 10% penalty your 401(k) would apply were you to withdraw from it.
Couple of caveats:
- You have to wait 5 years after opening your account before you can start withdrawing.
- When converting from your 401(k) to Roth IRA you WILL PAY regular income tax over the money withdrawn.
- After 5 years you can only withdraw from the principal penalty free and tax free.
Start on time
Caveat 1 implies that if you need to dip into your Roth IRA at some time, you need to implement this process 5 years prior. There is no procrastinating. Like everything else in proper financial planning you have to think ahead. rootofgood.com seems to imply that you can only withdraw the principal that was deposited 5 years ago, however based on my broker’s documentation, the only criteria seems to be that the account was opened at least 5 years ago. I need to get clarification on this.
UPDATE: Emily at johnjanedoe.com confirmed Justin at rootofgood.com and a little digging at RothIRA.com shows the following: However, this is not the case with a Roth IRA conversion; the five year rule clock restarts with every conversion with the amount and date it was converted.
Don’t jump, use a ladder
Caveat 2 is probably the most important one and what leads to it becoming a conversion ladder as opposed to a simply conversion. You have to pay regular income tax on the amount converted from 401(k) to Roth IRA. Remember the Roth IRA is different from the regular IRA and 401(k) in that you pay taxes upfront. I could today convert my entire 401(k) into a Roth IRA. At close to $600,000 it would land me in the 39.6% tax bracket. I would end up paying some $40,000 in state taxes and over $200,000 in federal taxes. Based on the documentation at my 401(k), those taxes have to be paid from a different source then the conversion amount. It would be financial suicide.
This is where the conversion ladder comes into play. Instead of one giant conversion that will ruin early retirement, you make smaller annual conversions within lower and more manageable tax brackets. All you need to do is figure out how much to convert each year in the time you have left to do so to cover your expenses while in the retirement gap. Depending on deductions you will have to dip in other resources to cover these taxes.
Convert the right amount(s)
Caveat 3 is something you just need to be aware of when planning how much you will deduct. Your Roth IRA will grow undoubtedly in the next 5 year or more but you are only allowed to take out what you put in. Don’t think you can convert $300,000 in the next year to cover a gap of $400,000 (even if it may grow to that).
What it means for me
So here is what I need to do to get my financial future back in order. My stock account will run out in December of 2024 (that is if the market behaves). That gives me 7 years to implement the ladder. Based on my current expenses of around $65,000 a year and inflation I need to convert a little over $350,000 to accumulate enough principal to withdraw. How much I contribute annually depends on how I want to distribute my tax payments.
Based on some simulations I find that if I convert $40,000 for the next 9 years, I’ll have enough to cover the gap and remain within a favorable tax bracket (10%-15%) allowing me to incur capital gains tax-free and remain in ACA (if it survives).
I already opened a Roth IRA account with my online broker so technically speaking I can start withdrawing penalty free with some years to spare. Next I will need to start converting. My broker allowed for opening the account without immediate funding which means, I have some time to get the conversion from my 401(k) lined up. Based on my numbers I would convert over the next 9 years and start withdrawing starting in 2024.
The numbers will look as follows:
In 2030 I can start withdrawing penalty from my 401(k). At that time I’ll have choice whether to keep withdrawing from the Roth IRA or 401(k).
What about taxes
401(k) conversion to Roth IRA is subject to taxes. It is my understanding that the distribution is subject to regular income tax. The exact implications are, as of yet, a bit fuzzy. I had a quick look at TurboTax and found, I won’t be “walked through”. It involves form 1099-R which is something that looks like it needs entering manually. If I alter this year’s tax returns with all of its deductions, substitute $40,000 capital gains with a $40,000 Roth IRA conversion, it looks like I may owe maybe $2,000 more, not too shabby, considering I owe $0 today (0% capital gains, when in the 10-15% bracket). The form seems to have some holders for capital gains, which I’m not entirely sure about how it is calculated, if at all.
Since the taxes have to come from another source than the actual conversion, my annual expenses will rise by at least that amount. Not something to be overlooked when planning.
Final thoughts
Well the train has left the station for me. I’ve started the Roth IRA Conversion Ladder by opening the Roth IRA account. I will convert as soon as I have figured out how. I would have preferred to have left my money in my 401(k) as long as possible. You will find 401(k)s are much better protected as they fall under federal law. When you get into IRA’s and Roth IRA you are subject to state rules and state protections which tend to be less than the federal ones. All that said I have little choice in the matter. I fell for the line “Max out your 401(k), ALWAYS”. Don’t make the same mistake. Contribute enough to get the maximum matching (free money) but beyond that, plan!! if you are planning early retirement, your 401(k) might not be the best place to keep your money.
I’d love to hear your thought on this. I’d really love to hear from someone who’s actually done it before. At this point I read about a lot of “planning to..” but haven’t seen any actual implementation. I surely can’t be the first.
Good luck reaching your financial goals.
Turbotax should handle a 1099-R pretty easily, it’s a common form used for all IRA and pension distributions. It has a distribution code on it that usually needs to be entered so you might need to poke around to figure out how to get the software to enter it correctly.
but Justin’s right about what you can withdraw without tax penalties. It’s the contributions that have been in the account for at least 5 years that can be withdrawn without tax. Under current law, if you withdraw the gains before age 59 1/2, the gains are taxable. So if you want to take larger distributions, you may have to convert larger amounts.
Thx, I figured he had it right. and just confirmed it based on RothIRA.com. For regular contributions the start date of Roth counts. For Conversion, the date of each conversion count.
I tried TurboTax and there were no questions leading to it. When I search TurboTax it did generate the 1099-R (apparently you can add 20). I assume the broker/bank will send a statement with all the right boxes to fill out?
Since I have 7 years till date and 5 years of a gap I don’t have to dump the full 65K each year in the next years. 40K a year will get me enough to get through (all of this of course assuming the market goes up).
Thanks for sharing this, Maarten. There are a few different five year rules pertaining to Roths and Roth conversions. If you shout out Justin @ root of good on Twitter I’m sure he’ll comment.
Another interesting fact is that you get a do-over. If you convert from a traditional IRA to a Roth and change your mind, you can put the money back. I believe you’re allowed to do this once a year. The process is called a “recharacterization”. We had an interesting talk with my brother about this over the weekend. This do-over is a real plus for tax purposes. If you convert a fund thinking it’s at a low, and it goes even lower, you can convert it back and reduce the taxes you initially paid on the conversion (and then convert it at the lower amount).
Ha, Loopholes abound. I wonder if we should worry about any tax reform. I hope if it comes, it won’t affect us mere mortals.
Love this post. Thank you, Maarten. We were lucky. When we started investing we put more money into our brokerage account and Roths rather than into our 401(k) and 403(b). Don’t ask me why. We didn’t start maxing out our 401(k) and 403(b) until the last two or three years of gainful employment. As a result, we entered retirement with roughly a third of our portfolio in traditional IRAs (after our workplace rollovers, of course). So we have plenty of penalty-free money to tap before we turn 59.5. I’m curious to see how the Roth ladder will affect your Obamacare subsidy. Mrs. G and I would like to do some laddering, but it might not be worth the subsidy cut. We’ll see. Keep me posted, my friend.
Thanks. I started out early on maxing out. The last years I stopped, I just added enough to the 401(k) to get the maximum matching. The damage was done however. As for the ACA credits, it won’t have an impact. I was basing my income on additional (excess) capital gains. Instead of incurring 40K in capital gains this year the Roth IRA conversion 40K should take care of that income. In my case I need to keep my income at a certain level to get both kids covered. If my income is too low, they would end up in CHIP. Although for most there is nothing wrong with that, in our case of T1D we need the “best coverage” possible.