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Early Access to 401k – Roth IRA Ladder

Accessing retirement accounts isn’t straightforward but there are various ways around the tax codes and traditional retirement ages, I talked about the 72t method a few weeks ago.

A 401k (similar to a Traditional IRA, 403b etc), to use as an example, is pre-tax money that is set aside from a gross paycheck into an employer sponsored account. It can be kept mostly in cash investments or stocks, bonds etc.

Investing the money is wise, if history has any valid future extrapolation, because if the investment grows through dividends and increased stock prices the stash won’t be taxed during its growth.

Once a person reaches age 59.5 they would be able to withdraw the money without the 10% penalty, Though any money withdrawn will be considered income which means income taxes would have to be paid on that money according to that year’s income tax rates.


Avoiding the 10% penalty

The purpose of this post is to get around that 10% penalty as well minimize taxes owed on that conversion. This Roth IRA ladder system does this very efficiently and still gives you full control over your money. Your investments don’t have to suffer and you don’t have to wait until age 59.5.

Let’s assume I have $300,000 in 401k’s and $150,000 in taxable savings. When I say taxable savings, that’s any after-tax money that I invest in a private brokerage account.

If I wanted to retire today, either because I’ve had it with work, or I got busted by the wife sexting one of my coworkers, or my medical license got suspended because I kept showing up to work drunk, then the $150k is easy to access, if it’s invested then I could possibly sell appreciated stock and take out some dividends for somewhere around $6k per year, after accounting for taxes etc. Selling appreciated stock is taxed differently than dividends which is another topic for another post.

You could access the tax-deferred money, the 401k money that is, either through the 72t method, or by eating the 10% penalty as well as paying the appropriate income taxes. Because this money was put into the 401k before taxes were taken out, income taxes must be paid when the money is withdrawn – hence the term tax-deferred, and not tax-free; the taxes are deferred to a time in the future.


Roth IRA ladder

Another method is to structure a IRA ladder, which is best done in the years of early retirement when your income is minimal to non-existent.

When your income is low then your tax bracket is low, and your tax bracket dictates the rate at which your capital gains is taxed. If you have $300k in your 401k and roll it over into an IRA then you won’t pay any taxes.

An IRA has very similar rules to a 401k, therefore it cannot be accessed until the IRS mandated retirement age of 59.5.

Roth IRA contributions (or conversions), however, can be accessed before age 59.5 without a penalty. To clarify, if $100k is put into a Roth IRA only $100k can be taken out… if the value grows to $120k, then that $20k will be hit with that 10% penalty.

If the IRA is converted to a Roth IRA then the amount converted is taxable. If you have no other income the taxes on the conversion is negligible. You can play around with Taxcaster to see how the numbers play out. If you have $300k sitting in your 401k, you would roll it over into an IRA, then convert a few thousand every year into a Roth IRA. This, of course, would bypass the 10% penalty.


Roth conversions

Because we have a progressive tax code in the US, it’s best to not convert too much all at once. If you convert the whole $300k in one year you would owe nearly $80k in federal income taxes alone, not including state taxes.

If you converted $10k in a year in which you don’t have any other income you would owe nothing, actually you would get $367 from the federal government. What would you live on? Either savings or your sugar-mamma.

the 5-year rule

There is also this 5-year rule which I should mention, this is the time it takes for a converted IRA to reach maturity, also called a seasoned account. If you convert an IRA to a Roth IRA then you must wait 5 years before you can access that money.

This is where the ladder concept comes in.

Let’s say in 2016 you convert $20,000 into a Roth IRA (and pay $998 in taxes). You need to wait until 2021 before withdrawing any money from that particular account. But in 2017 you can do this again. Then again in 2018, 2019 and 2020. By 2021 you can start taking out money without any penalty and of course without paying taxes.

How This Applies To You

Once I start the conversion orgy I could continue making conversions annually until age 59.5, by which point I can access the rest of my money without any concerns for owing penalties.

If you find yourself being able to retire early but have the majority of your savings in tax-deferred retirement accounts then either this IRA ladder method or the 72t method might help you access your funds without getting penalized or taxed excessively.

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