Nick, one of our readers, is starting a new job and he is planning to roll over his 401k to an IRA at Vanguard. He is thinking about putting everything in Vanguard’s target date fund because they require virtually no maintenance. He can just concentrate on saving as much as possible without having to worry about rebalacing or timing the market. I think 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 my 401k over to Etrade in 2012 to get a $1,000 bonus and then transfer it to Vanguard a couple of years later.
Here is his 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 large, then it will push Nick up the tax bracket and he could be paying a lot of taxes next April.
Some Roth IRA rules
- You can withdraw your contribution to the Roth IRA anytime tax and penalty free. However, if you are under 59.5, you will have to pay tax and a 10% penalty on the earning. 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 would 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.
Roth IRA conversion ladder
If Nick plans to retire early, then it’s best to rollover his 401k to a traditional IRA and defer the tax. You don’t want to pay tax now if you don’t have to. Once Nick retires early, then he can minimize tax 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 boring topic if you aren’t changing jobs or planning to retire soon. It’s a great gift from the IRS, though. Everyone should learn about this even if you are not quite ready to retire.
Okay, so 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 most likely pay much less tax this way than if he rollover his 401k to a Roth IRA and pay all the tax in one shot.
Let’s look at our account for example.
We have about $800,000 in our tax deferred accounts, 401k and Traditional IRA. Our annual cost of living is around $50,000. If Mrs. RB40 retires and I quit blogging next year, then we won’t have much income at all. We can convert $50,000 from our traditional IRA to Roth IRA and we won’t have to pay much tax. Let’s put it in a table.
*I borrowed this table format from Justin’s Roth IRA ladder article at Root of Good.
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.
The tax estimator at TurboTax shows we’ll have to pay the IRS about $1,500. That’s a very low tax rate for the $50,000 conversion. For completeness sake, I added $10,000 income from our dividend portfolio. I also deducted $6,000 for child care expense, $10,000 for mortgage interest, and $5,000 for property tax.
- Total Income $60,000
- Total Deductions $15,000
- Total Exemptions $12,000
- Taxable Income $33,000
- Regular Taxes $2,531
- Alt. Minimum Tax $0
- Additional Taxes $0
- Tax Credits $1,000
- Tax Payments $0
- Your Refund $-1,531
- Marginal Tax Rate 15%
You can see that the effective tax rate is ridiculously low at just 2.5%. Also, we won’t pay any tax on our $10,000 dividend income because we will be in the 15% income tax bracket.
If we convert the whole $800,000 in one shot, then we’d owe the IRS $262,066! We’d also be pushed up to the highest tax bracket that year. That’s your own personal stock market crash right there. So you can see that it doesn’t make sense to convert your whole 401k at once if it’s a large amount.
Early Retirement Planning
Of course, there are a couple of gotchas here.
The 5 years lag time
If you want to avoid the 10% penalty, then you need to wait 5 years before withdrawing. This is why you need some fund in your taxable account. We have about $300,000 in our dividend portfolio and that should be plenty to cover the first 5 years of early retirement. We also have some previous contribution in our Roth IRA that we could draw on. Nick probably should build up his taxable accounts before he retires or find some other ways to generate a little income.
- Invest in rental real estate.
- Part time work, freelancing, or other enjoyable jobs.
- P2P lending, P2P investing, and other ways to generate passive income.
- Negotiate a separation package. (Don’t quite your job until you read this book.)
- Build a dividend portfolio. I particularly like this option because of the tax synergy. You can’t beat the 0% tax on dividend. I just hope the tax law stays the same.
The other problem is inflation. We don’t really notice inflation much from year to year, but it is a pretty 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. At 3% annual inflation rate, we’d need 16% more in 5 years. That means we will have to convert about $58,000 assuming we keep our spending at about the same level. We need to fix the table and take inflation into account.
Wow, inflation looks pretty scary. As long as your investment outperforms inflation, you probably 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.
- Keep funding the new 401k and 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 year long test drive.
- Rollover the latest 401k to his Traditional IRA.
- Set up the conversion. I’m sure Vanguard can help with the partial conversion. They were always very helpful when I called.
- Don’t forget about inflation.
- You might want to talk this through with a good tax adviser.
- 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 have to revisit this topic in a few years. 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 bin.
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?
If you need help keeping track of your finances, try using Personal Capital to manage your portfolio. Also check out their fantastic retirement calculator. You can read my review here –The Best Free Retirement Calculator.
- Why You Need a Roth IRA Folder – Early retirees need to track their contributions. Don’t leave it a mess like I did.
- How to Start Contributing to a Roth IRA – If you don’t have a Roth IRA, you really need to open one. Don’t wait. Do it today!
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.
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