Somehow we missed the Roth IRA boat. Assuming Mrs. Need2Save wants to stay married to me, our current income exceeds the contribution limit for married filing jointly. For 2017, you can’t contribute to a Roth IRA if your married filing jointly income exceeds $194,000. There are ‘Back Door’ Roth IRA options, but our existing Traditional IRA accounts seem to complicate that approach.
When our income was lower, I guess we were busy saving for other things – like home purchases and our kid’s 529 college accounts. We’ve always been good about contributing to our 401(k) accounts (contributing since 1995, getting full company match, and maxing out contributions for the last 10 years). However, we aren’t giving up on Roth IRAs yet. Enter the Roth IRA Conversion Ladder.
Quick Background on Roth IRAs
Most of you are likely already familiar with Roth IRAs, but let’s review a few of the key benefits and a some of the disadvantages.
Roth IRA Benefits
- Although you contribute with after-tax money, the earnings and withdrawals are tax-free. Given a long time horizon, the tax advantage of not paying taxes on the earnings and withdrawals has the potential to be HUGE! If you’ve read our earlier post on a sobering look at 30 years of paying taxes, hopefully you can understand that we are looking to reduce our future tax burden.
- No Required Minimum Distributions (RMD) at age 70 1/2. Other retirement accounts such as your 401(k) and Traditional IRA require minimum distributions when you reach age 70 1/2.
- Beneficiaries of Roth IRAs do not pay income tax on the distributions.
- Contributions can be withdrawn penalty-free at any time.
- After five years, up to $10,000 of the earnings (in addition to contributions) can be withdrawn for a first-time home purchase.
Roth IRA Disadvantages
- Yearly contributions are limited to $5,500. Those over 50 can contribute an additional $1,000. If a Roth IRA is your sole retirement savings account, then you may not be able to save enough. The yearly contribution limits to a 401(k) are much larger at $18,000.
- As we mentioned in the first paragraph, there are yearly income limits in regards to contributions. I know it’s a tough problem to have :-), but you may make too much money and not be able to contribute.
- Similar to other retirement savings plans (e.g. 401(k), Traditional IRA), you must be 59 1/2 to avoid paying penalties on any earnings. Furthermore, you must have the account open for 5 years.
Roth IRA Conversion Ladder
So what is a Roth IRA conversion? Basically, you are converting some portion of an existing Traditional IRA to a Roth IRA. Currently, there is no income limit to convert a Traditional IRA to a Roth IRA. Sounds like a no-brainer right? Keep in mind that contributions to a Traditional IRA were likely tax deductible (pre-tax money) and Uncle Sam wants to get his money. So when the conversion takes place, you will be taxed at your current tax rate. Given that our marginal federal tax rate is currently 33%, it doesn’t make sense for us to do these conversions now while we are working.
Once we stop working, we are going to start a Roth IRA conversion ladder. The ladder concept is basically performing conversions year-after-year, a little-at-a-time as shown in the figure below. Note that as mentioned above, you need to wait five (5) years after each conversion to withdraw the corresponding contribution for favorable tax treatment and avoid penalties.
Building Up Our Roth Ladder
Most FIRE bloggers (see links below) seem to use the Roth IRA Conversion Ladder to access money penalty-free from tax-advantaged accounts. This gives them income during those extended early retirement years before they reach 59 1/2, when they can access their tax-advantaged accounts penalty-free.
Our approach is going to be slightly different. If you’ve read our Numbers Game – Part Two post, you’ll see that we plan to retire early in 7 years at age 51 1/2. We plan to fully fund our gap years before we stop working, so we don’t think we will need any of the conversion money before reaching 59 1/2. That should allow 8 years worth of Roth conversions. We may consider doing more depending on our finances when we turn 60. We also like the idea that even though we don’t think we’ll need it during our 8 “Gap Years”, we could start to use the converted funds if we had to starting in year 6 of our ‘ladder’.
Since we aren’t looking to use the Roth IRA funds before reaching that magic age of 59 1/2, we are hoping to take advantage of significantly reduced income during our Gap Years. This will allow us to reduce the future tax burden on our tax advantaged accounts. You can’t forget, that it will also reduce the impact of RMDs once we reach 70 1/2 (Let’s hope we all make it way past 70 1/2 !). The RMDs could have a meaningul impact on us because we have been high-earners for some of our career (thus good savers) and we may be forced to withdrawal more than we need to live on in our 70’s if we don’t pursue the Roth conversions when we are younger.
Also, the idea of having some income tax free money available to our sons and possibly grandchildren (?), isn’t such a bad thing.
Hypothetical Roth Conversion Ladder Example
At the time we stop working, we will already have some money in Traditional IRAs (from prior employers). We will consider whether converting the rest of our 401(k) accounts to Traditional IRAs makes sense. If you can believe the numbers behind our Numbers Game – Part Two post, we should have around $2,000,000 in tax-advantaged accounts when we stop working in 7 years at age 51 1/2. Let the climbing begin!
Who knows what income taxes will look like in 2024 and beyond, so this example just uses 2017 tax information. Our goal is to stay within the 15% marginal tax rate bracket. Assuming tax laws don’t change, that should allow qualified dividends and long-term capital gains (from our gap years brokerage accounts) to be tax-free. The figure below shows the personal exemption and standard deduction for a married couple filing jointly (MFJ). The first $20,800 of earned income is tax-free thanks to the Personal Exemptions and Standard Deductions. The next $18,650 would be taxed at 10%.
The key to minimizing our tax bill is to be extremely careful to stay under the top of the 15% Income Tax Bracket. We will need to have a good idea of how much other earnings we may have to report such as Interest/Dividend income and earnings from part-time jobs (if we choose). To stay in the 15% tax bracket, we need to keep our taxable income under $96,700.
At the beginning of our gap years, we are hoping to have around $580,000 in our brokerage and savings accounts. The table below shows hypothetical income during the start of our conversion process.
|W2/1099||$6,000||Occasional teaching, consulting, seasonal work?|
|Interest||$6,000||Interest from bonds, savings accounts, etc.|
|Dividends & Capital Gains||$12,000||Dividends and capital gains from brokerage accounts. Amount will decline over time as we pull money from our brokerage accounts|
|Total||$24,000||Total reportable income per year|
To keep things simple, I’m considering the dividend and capital gain income to count towards our taxable income. After some basic math ($96,700 – $24,000) we should be able to convert $72,700 per year and remain in the 15% tax bracket. Hopefully, we may be able to do a little more than that once you consider the likely increases in the standard deduction, personal exemption, and consideration of preferential tax treatment on the dividends and long-term capital gains.
The part-time income is illustrative. Our Early Retirement plans don’t depend on any additional earned income, but we think we may want to do some occasional work such as teaching part-time at community college, for example. Plus, if we do have some earned income, we could move some or all of those earnings directly to a Roth IRA if we choose to.
So over an 8 year ladder period, we are hoping to transfer around $580,000 into tax-sheltered Roth IRA accounts!
Here are some good articles on Roth IRA conversion ladders from other FIRE bloggers
The Green Swan: Never Pay Taxes Again
And if you want to read what the IRS has to say about it
I sure hope Congress doesn’t change the benefits associated with Roth IRAs or the ability to do these conversions. Transferring over $500k into Roth IRAs is going to provide great flexibility for us in the future. Given that Mrs. Need2Save is always pushing to retire sooner. I’m a bit surprised that she isn’t suggesting that we follow other FIRE bloggers path and use some Roth funds during our gap years.
If the tax brackets are collapsed, we will revisit our tax/conversion planning to adjust accordingly.
Did we miss anything in our analysis?
Do you plan on implementing a Roth IRA Conversion Ladder as an Early Retiree?
If so, would you do so in order to retire earlier?