Nick, one of our readers, is starting a new job and he plans to roll over his 401k to an IRA at Vanguard. He wants to invest everything in a target-date fund because they require virtually no maintenance. He can focus on saving as much as possible without having to worry about rebalancing or timing the market. This is a great idea. Nick can always reallocate his investment later if he wants to invest in other funds. As for me, I rolled over my 401k to Vanguard when I retired from my engineering career in 2012. After 7 years, I’m still happy with this decision. Passive index funds performed pretty well over that period.
Anyway, Nick has a question.
Would it be better to rollover a 401k to a Traditional IRA or Roth IRA if your goal is to retire early?
The great thing about the Roth IRA is that you won’t have to pay any tax when you take distribution from the account (once you’re over 59 and a half.) The bad thing about rolling over the 401k to a Roth IRA is that you will have to pay tax at the time of conversion. If the amount in the 401k is significant, it will push Nick up the tax bracket and he will pay more taxes next April.
Some Roth IRA rules
- The capital gain is tax-free once you’re 59.5 years old. This is a huge advantage especially if you start early.
- You can withdraw your contribution to the Roth IRA anytime, penalty free. However, the rule is different for the capital gain. If you are under 59.5, you will have to pay tax and a 10% penalty on any gains. There are some exceptions, but generally, you’ll have to pay the penalty.
- When you make a conversion or open a new Roth IRA, you will have to wait 5 years before withdrawal to avoid the 10% penalty.
- You don’t have to take RMDs, required minimum distributions. With the 401k, you will have to withdraw the minimal required amount once you are 70.5 years old.
- You can pass your Roth IRA on to your kids. They won’t have to pay tax on this account.
You can read more here – How to start contributing to a Roth IRA.
Roth IRA conversion ladder
In my opinion, Nick should rollover his 401k to a traditional IRA and defers the tax.
You don’t want to pay tax now if you don’t have to. Once Nick retires early, then he can minimize taxes by building a Roth IRA conversion ladder.
I hope I didn’t lose too many readers up to this point. The Roth IRA conversion is a pretty obscure concept if you aren’t changing jobs or planning to retire early. Nonetheless, it is a rare gift from the IRS. Everyone should learn about the Roth IRA conversion ladder even if you are not quite ready to retire yet.
Okay, the 2 main points are:
- You pay tax at the time of conversion from 401k to Roth IRA.
- You have to wait 5 years to avoid the 10% penalty on the earnings.
The beauty of the Roth IRA conversion ladder is that it is perfect for early retirees. When you retire, your income will drop and you will be in a lower tax bracket. Nick can figure out how much money he needs to fund his lifestyle and convert that amount every year. He will pay much less tax this way than if he rollover his 401k to a Roth IRA in one shot.
Let’s look at our account for example.
We have about $1.2M in our tax-deferred accounts, 401k and Traditional IRA. Our annual cost of living is around $50,000. If Mrs. RB40 retires next year as planned and I quit blogging, then we won’t have much income. Each year, we can convert $50,000 from our tax-deferred account to Roth IRA and we won’t have to pay much tax. Let’s put it in a table.
Basically, you move one year worth of expenses from your 401k to your Roth IRA every year. After 5 years, you can withdraw from the Roth IRA penalty-free.
I gave us a 5% raise every year on this table. The cost of living will inevitably increase. It’s already really optimistic to think our annual expense will stay at $50,000 in 5 years. Our passive income should make up for any shortfall so I’m not worried.
Also, it’s good to move some money from the tax-deferred to the tax-free bucket. You’ll have to take minimum distributions from your traditional IRA when you turn 70 and a half. We already have $1.2 million in our tax-deferred accounts. If we let it build up for 25 more years, the RMDs will be huge. It’s best to spread out your retirement savings in all 3 categories – taxable, tax-deferred, and tax-free.
The tax estimator at H&R Block shows we’ll have to pay the IRS just $739. That’s a very low tax rate for the $50,000 conversion + $20,000 from dividend income.
- Conversion (I put this in earned income) $50,000
- Dividend: $20,000
- Standard deduction
- Number of dependents: 1
Effective tax rate: 1.05%
The effective tax rate is ridiculously low at just 1.05%. Also, we won’t pay any tax on our $20,000 dividend income because we will be in the 2 lower income tax brackets.
If we convert the whole $1,200,000 in one shot, then we’d owe the IRS $387,809! That’s a 31.7% effective tax rate. That’s your own personal stock market crash right there, courtesy of the IRS. I’d like to avoid it if at all possible. We’ll be pushed up to the highest tax bracket that year. It doesn’t make sense to convert your whole 401k at once. The tax code is a lot more favorable if you convert a little every year. The Roth IRA conversion ladder is the perfect fit for early retirement.
Early Retirement Planning
Of course, there are a couple of gotchas.
The 5 years lag time
If you want to avoid the 10% early withdrawal penalty, then you need to wait 5 years before withdrawing. This is why you need some funds in your taxable account. We have about $500,000 in our taxable portfolio. That will be plenty to cover the first 5 years of early retirement. We also have some previous contributions in our Roth IRA that we could draw on. Nick probably should build up his taxable accounts before he retires or finds some other ways to generate a little income. Here are some options.
- Invest in rental real estate.
- Part-time work, consulting, freelancing, or other enjoyable work
- Real estate crowdfunding. This is a great way to generate passive income. You can invest in real estate projects across the USA and don’t have to deal with tenants. Being a landlord is a great way to build wealth, but it can be stressful sometimes. See how I’m doing with RE crowdfunding here.
- Build a dividend portfolio. I particularly like this option because of the tax synergy. You can’t beat the 0% tax on dividend income. You just need to make sure you stay in the bottom 2 tax brackets every year.
- Negotiate a separation package. (Don’t quit your job until you read this book.)
The other problem is inflation. We don’t really notice inflation much from year to year, but it is a big problem when there is a 5 year lag time. We spend about $50,000 per year, but we need to add inflation if we’re planning for 5 years down the line. I increased our conversion by 5% every year. This works for us because our tax-deferred account is pretty big. As long as your investment outperforms inflation, you will be okay.
Nick’s Roth IRA conversion
So for Nick, here are some steps that he could take to prepare for early retirement.
- Rollover his old 401k to a Traditional IRA.
- Try to max out the 401k at his new job. Also, max out the Roth IRA.
- Slowly build up his taxable accounts
3 years before early retirement
- Figure out his retirement budget. Estimate how much money he’d need to spend after retirement by tracking his expenses.
- Figure out how to pay for the first 5 years of early retirement. He probably should try to boost his taxable account at this point.
1 year before early retirement
- Build up his cash position.
- Take his retirement budget for a yearlong test drive.
- Rollover the latest 401k to his Traditional IRA.
- Set up the Roth IRA conversion ladder. I’m sure Vanguard can help with the partial conversion. They were always very helpful when I called.
- Nick might want to talk this through with a good tax advisor.
- Enjoy early retirement!
If you need help with tracking your expenses and net worth, then check out Personal Capital. They have a great site that will help you figure out your early retirement.
RB40’s Roth IRA conversion plan
For us, it doesn’t make sense to do any conversion at this point. Mrs. RB40 is still working and our household income is not low enough. Mrs. RB40 plans to retire in 2020 and we will revisit this topic then. Even if you don’t plan to retire early, this is useful information because you might have some years with low income. You can make some conversion on those low-income years and move some money to the tax-free bucket. Everyone needs to have a good tax strategy. It’s one of our biggest expenses and it’s unavoidable.
That’s it. I hope this is helpful for Nick. Do you any advice for him? If you retired early, how did you access your tax-deferred account?
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Image credit: Luis Vidal
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.
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