It’s likely that you have browsed through articles debating the Traditional IRA vs a Roth IRA. Making a decision about which one is best is subjective because both the Traditional IRA and Roth IRA have their pros and cons. However, if you plan to retire early, you may have the opportunity to access your retirement funds prior to age 59 ½ without be penalized by utilizing a conversion ladder technique to move retirement funds from a Traditional IRA to a Roth IRA.
What is 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, and others. Each type of IRA has eligibility requirements. The most commonly used IRAs are Traditional IRAs and Roth IRAs.
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 earnings are deferred up to the time that you withdraw funds from the IRA. This is a powerful compounding factor.
Unlike Traditional IRAs, Roth IRAs contributions are made with after-tax dollars. However, as long as you are making qualified distributions by following the five-year rule and meeting the other required criteria, those withdrawals are not taxed. In simple terms, that means your earnings are tax-free.
Investing in Traditional & Roth IRAs
Every form of IRA has strengths and weaknesses. It is essential to fully understand your investments, tax sheltering vehicles, and to create a structure that will 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 with pre-tax monies (or tax-deductible funds)
- No income limits to get started (higher or lower both)
Cons of Traditional IRAs
- Withdrawal before 59 ½ has a 10 percent penalty
- Withdrawals are taxed based on your income tax bracket at the time of the withdrawal
- Restrictions on how much you can contribute
- After 70 ½ you can no longer make contributions
- Withdrawals are required – based on a formula using current account balance and life expectancy – the year you turn 70 ½
Pros of Roth IRAs
- Tax-free withdrawals
- Earnings are tax-free
- You can continue your investments after the age of 70 ½
Cons of Roth IRAs
- Contributions into your Roth IRA are not tax-deductible
- Have restrictions on how much you can contribute
Choosing a Roth IRA or a Traditional IRA
When choosing between a Traditional IRA and a Roth IRA, you are basically picking when you need to pay tax on your money. With a Traditional IRA, you pay taxes on your withdrawals. With a Roth IRA, you pay the tax on your money before investing.
Connection Between Roth IRA and Early Retirements
If you are planning to retire early, there are some strategies you can use that will help you access your retirement funds before age 59 ½ without being penalized.
With a Roth IRA, once your funds have been invested for five years, you can withdraw them without paying the 10% tax penalty. The five-year mark is calculated beginning the first tax year after the investment into the IRA. It’s also important to note the difference between Roth IRA contributions and Roth IRA earnings. Roth IRA contributions have already been taxed, the earnings, however, have not. In order to withdraw the earnings from your Roth IRA, and not be penalized, you must wait a minimum of five years and be aged 59 ½, be disabled, or be using the withdrawal for a qualified purchase of your first home (see IRS Publication 590B for additional information).
If you are retiring early, you can withdraw your contributions from your Roth IRA. For individuals with Traditional IRAs, who are planning to retire early, it may make sense to convert some of your Traditional IRA funds to a Roth IRA using a laddering technique.
Roth IRA Conversion Ladder
We are going to look at the conversion ladder in three stages.
Stage 1: Contribute to a Traditional IRA During the FIrst Stage of Your Working Years
A Traditional IRA uses pre-taxed funds to invest for retirement. In your Traditional IRA, your funds are tax-deductible.
Stage 2: Gradually Convert to a Roth IRA at Least 5 Years Before You Plan to Retire
When you withdraw funds from your Traditional IRA, you will create a taxable event. That means that the funds you withdraw will be subject to taxes at your current income tax rate. As long as you move the money into your Roth IRA within 60 days you’ll avoid paying a penalty on early withdrawal. It is likely that your broker or account holder will be able to reassign a portion of the traditional IRA to the Roth IRA without ever sending you a check; this is the simplest option and the one we recommend.
Stage 3: Utilize Your Contributions to Your Roth IRA for Early Retirement Years
Any funds you have moved from your Traditional IRA to a Roth IRA can be withdrawn after the five-year waiting period. Because these funds have already been taxed, you will not pay taxes on these withdrawals. It is important that you time your withdrawals, and plan for the correct amounts so that you are not using any of the investment earnings. If you use investment earnings before age 59 ½, even after the five years has passed, you will pay a 10% penalty on the whole amount of that distribution, even if only a small portion of it was funded from investment earnings.
Roth IRA Conversion Ladder Table
This case study will provide you with detailed insight regarding a conversion. This conversion could be for the entire amount of a Traditional IRA valued at $400,000 with the conversion spanning 10 years. It could also be a conversion of the amount of $400,000 based on the amount someone has determined that they will need between the time he/she retires until the time he/she turns 59 ½. Keep in mind, that with this example, there will be $40,000 per year of taxable income that is above and beyond the amount that would have been due otherwise. In some cases, a taxable income increase of $40,000 may increase the income tax bracket and cause undue hardship for an individual or family.
|Year||Age||Conversion amount*||Potential Amount withdrawn*||Sources of funds withdrawn|
*These amounts refer to Roth IRA
This table makes it clear that you cannot withdraw before five years. If you do, you will pay a 10% penalty on each withdrawal.
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.
The first thing to consider is your planned retirement age. The model will only work if you are able to start the conversion at least five years before your retirement. You should also evaluate and project your expenses during early retirement years. The amount of the conversion needs to be planned accordingly.
If you can’t trust yourself to stick to a plan or you worry that you will be tempted to withdraw more money than you planned because you don’t have to pay taxes on it, you might be better served leaving the majority of your funds in your Traditional IRA and only converting the amount necessary for the early retirement.
You Can’t Throw Caution to the Wind
You have to ask yourself some basic questions – which federal tax bracket would you say you are in today? Do you expect to be in a higher or lower tax bracket after you retire? Will your yearly income increase or decrease? Answering these questions will help you minimize taxes during your retirement.
Many people have made their retirement plans expecting that they will be in a lower tax bracket after they retire. That may not be true. You’ll be collecting (and owing taxes on) Social Security payments. You may choose to do some consulting or freelance work, on which you’ll need to pay self-employment tax. Furthermore, once the children move out, you stop contributing to your retirement savings, you lose some significant tax deductions and tax credits. This could leave you with higher taxable income, even after you retire.
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Cons of Roth IRA Conversion
Roth IRA Conversion Ladder is a tool for financial planning. You need to make decisions based on what you know and what you expect will be best for you in the future. Each part of your financial journey needs to be considered before you start implementing an IRA conversion plan.
Here are some of the cons of the Roth IRA Conversion Ladder:
- There will likely be a tax liability on the amount you convert each year.
- The conversion could lead to you being in a higher tax bracket which could increase your overall tax liability, not just the tax on the converted amount.
- There is a five-year waiting period even if you convert your funds after you are 59 ½ years old.
- 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, or are paying taxes of less than 15%.
- Retirees who are willing to stretch the 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 as a time frame as possible. That way, you won’t increase your taxable income too much in any given year.
A Roth IRA Conversion Ladder is helpful for early retirees. It can help you make some of your retirement funds available to you prior to age 59 ½. Mapping it out prior to actually making the first conversion can also help plan for changes in your tax liability due to the conversion. In addition to discussing your plans with your broker or account holder, you should also consult your tax preparer. This conversion is likely only one part of your overall retirement planning, and you need to make sure that it fits your overall retirement strategy.