Hey guys, Mike Frontera here, back with another Retirement Theory video! So, you’ve been diligently saving in your 401(k) with thoughts of retiring early. Maybe not fully retiring, but seriously cutting down on your workload. Maybe go on cruise control starting at age 50. That’s cool. But you’re afraid, because you’ve heard that you’ll get hammered with taxes and early withdrawal penalties if you pull from those retirement accounts before you turn 59 ½ years old.
So how do you bridge the gap until you actually reach 59 ½ years old? Well, I’m going to show you a strategy that you can use to get around that pesky 10% early withdrawal penalty. But like most good things in the financial world, planning ahead is key!
So this strategy will invoke my old friend, Senator William Roth, and his amazing wonderful Roth IRA! The Roth IRA is one of the most versatile, retirement friendly accounts we have available to us.
The most basic description of a Roth IRA is that it is an account in which you invest after-tax money, in other words no deduction, and in turn it can provide you with tax-free growth and withdrawals in retirement. Kind of like a Traditional IRA or 401(k)in reverse. In those accounts, generally you contribute pre-tax money, but your withdrawals in retirement are considered taxable income.
Now, most all retirement accounts stipulate that, barring some small exceptions, withdrawals prior to 59 ½ years old are not subject just to taxes but also a 10% early withdrawal penalty. This rule is slightly different for 401(k) plans, but that’s beyond the scope and point of this strategy. So then, how do we get around this early withdrawal penalty when we’re ready to retire before we’re 59 ½?. There are actually a few ways to do it, but I’m going to go over perhaps the easiest way. And that is by taking advantage of two very special properties of Roth IRAs.
Special property 1, is that contributions that you make to a Roth IRA can be withdrawn at any age, tax-free and with no penalty. Now, I said “contributions”, not the growth on the Roth IRA account. So, the reason behind this is that your contributions went into the Roth IRA without a deduction, and so withdrawing them just represents a return of your principal. For example, if you contributed $5000 to a Roth IRA every year for 20 years, your contributions would total $100,000. That means you would be able to draw $100,000 out of your Roth IRA account at any time for any purpose without paying any taxes and penalties. Good.
The next special property deals with conversions from IRAs to Roth IRAs. When you convert money from a pre-tax retirement or IRA to a Roth IRA, you’re basically saying that you are going to pay tax today on the principal amount that you’re converting. In exchange, all of the future growth on that money is tax-free for qualified withdrawals after age 59 1/2. But here’s where it gets interesting.
While the growth of the Roth IRA conversion money must wait until you’re 59 ½, the principal amount of your conversion does not. Instead, it is subject to a 5-year waiting period, which starts January 1st of the year of your conversion.
So let’s break this down. Let’s say you’re 45 years old and want to start drawing $25,000 from your IRA account at age 50. Well, if you just waited until you were 50, and took a $25,000 IRA withdrawal, you would generally be subject, not just to taxation but also that darn 10% early withdrawal penalty. Bad deal. If, however, you had some foresight and you converted $25,000 of your IRA to a Roth IRA today, you would still pay taxes on that $25,000, but you could withdraw that $25,000 five years from now without any additional taxes! No early withdrawal penalty!
Now, let’s take this one step further. Same situation except that you want to be able to draw $25,000 EVERY year starting at age 50. Well, that would require a pretty darn big conversion, wouldn’t it? And big conversions mean a high income in the year of the conversion, which also means likely paying a much higher rate of taxation.
So instead, we convert smaller amounts each year. That is, we convert $25,000 at age 45, another $25,000 at age 46, another $25,000 at age 47, and so on. This strategy is known as laddering Roth Conversions and it is one way to plan ahead for early IRA withdrawals. One critical thing to remember is that each conversion must satisfy its own 5-year waiting period to be able to draw that conversion back out without penalty.
“Mike, you’re talking my language. But here’s the deal. I’m already 50, and I want out right now. I don’t want to wait 5 years for this conversion money to cook. What do you got for me?”
Well, lucky for you Mr. Perfect Hypothetical-Example, you’ve been steadily contributing $5000 per year to your Roth IRA since you were just 25 years old. That’s 25 years times $5000 equals $125,000. That means you have a pool of contributions of $125,000 that you can use to draw $25,000 each year for the next five years during your 5-year conversion waiting period! But if you didn’t use that, perhaps you had a pool of non-IRA investment money or cash savings that you could also use to bridge the gap during that 5-year gap period.
So, do you have questions for me? Come visit me at www.retirementtheory.com or send me an email at email@example.com. Did you click subscribe on this video or follow me on Facebook? I think that you should. You’ll continue to see videos like these on everything retirement planning. Once again, thank you for joining me, we’ll see you next time.