It’s most likely that you would have browsed through many articles debating on IRA v/s Roth IRA, but would have found no concrete answers. That’s because the decision is subjective, and both IRA and Roth IRA have their pros and cons. However, we might have the perfect advice if you plan to retire early.
What’s an IRA?
Individual Retirement Accounts (IRA) are investing tools that help an individual save for retirement in a tax efficient manner. There are many variants of IRAs such as Traditional IRAs, Roth IRAs, SIMPLE IRAs, 401(k) IRAs etc., but they are primarily grouped into Traditional IRAs and Roth IRAs. The form of IRA holds importance depending on the expected age of retirement, financial goals and tax bracket of the individual.
You get the advantage of tax-free contributions when you invest through Traditional IRAs. The most significant advantage of a Traditional IRA is that any taxes on your investment are deferred up to the time when you pull out money from the account. This is a powerful compounding factor.
Roth IRAs do not provide tax relaxations for contributions, but earnings and withdrawal are generally tax-free (withdrawals of earning is penalized before the age of 59.5). Moreover, Roth IRAs can be invested in index funds, lifecycle funds, individual stocks and what not.
Investing in Traditional & Roth IRAs
Every form of investment has its inherent strengths and weaknesses. It is essential to look at the fine print and create a structure which is powered to maximize your portfolio size and minimize the tax bill. As an early retiree, it is critical that you have your retirement planning figured out.
Pros of Traditional IRAs
- Funded prior to/without tax deductions.
- No income limits to get started (higher or lower both).
Cons of Traditional IRAs
- Withdrawal before 59.5 has a 10 percent penalty.
- Withdrawals are eligible to be taxed as per the income bracket.
- After 70.5 you can no longer make contributions.
Pros of Roth IRAs
- Tax-free withdrawals.
- You can continue your investments after the age of 70.5.
Cons of Roth IRAs
- No initial tax benefit of investing in a Roth IRA.
- Have various restrictions on how much you can contribute.
Picking Between a Roth IRA and a Traditional IRA
While picking between a Traditional IRA and a Roth IRA, you are basically picking when you need to pay tax on your money. Traditional IRA is the tax-deferred account that is, in the event that you choose to go with a Traditional IRA, you pay tax when you pull back the cash (i.e. tax on the amount you withdraw), and on the off chance that you go with a Roth IRA, you pay the tax in advance.
Connection Between Roth IRA and Early Retirements
Retirement age matters with a Traditional IRA, but it is not a matter of concern when we go with Roth IRA. That is when Roth IRA conversions come into the picture. Each conversion requires a five-year waiting period to avoid the 10 percent penalty. So, if you delay withdrawal on each conversion for at least five years, the early penalty does not apply.
Roth IRA Conversion Ladder
If you wish to plan early, Roth IRA Conversion Ladder can put you in a win-win situation and minimize the taxes in both the post and pre-retirement phase. There is a catch to it though. You will need to switch or transfer to Roth IRA from Traditional IRA.
Here’s how it’s done:
Stage 1: Contribute to IRA During Your Working Years
While you are working, you will fall in the higher tax slab than post-retirement. So, shield however much of your income from the tax authorities as you can by contributing to IRA.
Stage 2: Gradually Convert Traditional IRA to Roth IRA
When you start your retirement, you’ll have less taxable income than you did before, so utilize this period to change over your Traditional IRA to a Roth IRA.
You evade tax on your money when you add to your Traditional IRA, so you need to pay taxes when you change over to a Roth. Your income will be brought down after you resign, however, so you’ll likely pay next to no tax on the conversion. Indeed, on the off chance that you change over a sum equivalent to your deductions, exemptions, and credits each year (provided that you have no other income), you could execute these conversions paying next to zero tax.
Stage 3: Get Access to Completely Tax-Free Retirement Money
In the wake of changing over your whole Traditional IRA to a Roth IRA amid your initial retirement years, you can pull back that money from the Roth tax-free!
Note: to abstain from paying a 10 percent early-withdrawal fee, you need to hold up five years after the conversion (or until the point that you turn 59.5, whichever is sooner) to pull back the changed over assets from the Roth.
Roth IRA Conversion Ladder Table
This case study will provide you with a detailed insight regarding conversion details.
|Year||Age||Conversion amount*||Amount withdrawn*||Sources of funds withdrawn|
*These amounts refer to Roth IRA
This table makes it clear that one cannot withdraw before five years (and if you do, that 10 percent penalty on each withdrawal awaits you).
This is a critical table and should be used as a template for your investment planning. You need to consider the following elements before you take action.
First is your expected retirement age. The model will only work if you start at least five years before your retirement. So, you need to fix a tentative date otherwise you might be shooting in the dark. You don’t want to be too early, and being too late is a strict no-no.
It would help if you evaluated how much you are looking to spend in your early retiree years. The amount of conversion needs to be planned accordingly
Diversification of retirement assets is also a good idea. Converting the entire IRA into a Roth and withdrawing the funds so early in your retiree phase is a recipe for disaster.
You Can’t Throw Caution to the Wind
You have to ask yourself some basic questions – which federal tax slab would you say you are in today? Do you hope to be in a higher or lower one after you resign? Will your yearly income increase or lessen? Answering these questions will help you to minimize taxes during your retirement.
Albeit, a tried and true way of thinking proposes that gross income decreases in retirement, and taxable income in some cases does not. Consider it. You’ll be gathering (and owing taxes on) Social Security installments. You may choose to do some counseling or freelance work, on which you’ll need to pay self-employment tax. Furthermore, once the children grow up, you quit adding to the retirement savings, you lose some significant tax deductions and tax credits. This could leave you with higher taxable income, even after you quit your job.
Cons of Roth IRA Conversion
Roth IRA Conversion Ladder is a tool for financial independence. Your planning needs to be according to your income in a particular tax year. It is not a one-size fit model, and every unique circumstance of your financial journey needs to be considered before you start building out the IRA conversion structure.
Here are some of the cons of the Roth IRA Conversion Ladder:
- You might need to pay taxes on the balance you convert from Traditional to Roth IRA.
- The conversion could lead to you falling in a higher tax bracket which could lead to further cash outflows to the tax man.
- The five-year waiting period could be frustrating if you were late in your planning.
- You still need to have separate retirement funds. If you are shifting your entire Traditional IRA to Roth IRA, there is a probability that you might blow your retirement capital in the first five years.
- The financial discipline needed for adhering to your financial and retirement goals is critical for a Roth IRA Conversion Ladder to succeed.
Who the Roth IRA Conversion Ladder Works Best For
- Early retirees with low income: People who live on modest income from long-term capital gains which are taxed at zero percent under the tax bracket of 15 percent or below.
- Retirees who are willing to stretch transition from IRA to Roth IRA: Transitions from a Traditional IRA to a Roth IRA are taxed as regular income, so it’s useful to spread the change over a vast time span. That way, one doesn’t overextend your taxable income in any given year.
A Roth IRA Conversion Ladder is a godsend for early retirees. It helps to get your savings in your hands in an accelerated manner without the hefty tax bill associated with a Roth IRA conversion. However, how you manage your overall retirement portfolio is equally important. This structure is one part (though an essential one) of your overall retirement planning, and you need to make sure that it fits the overall retirement strategy.
Now that I have elaborated the Roth IRA Conversion Ladder alongside sharing conventional wisdom (for whom it works), and scrutinizing the strategy, it is you who needs to take the final call, assess, and go on to choose whatever best fits your needs.