*** Disclaimer – I am not an investment advisor, CPA, or tax consultant, so the things I write about below are from a lay person’s perspective. Please consult with a tax advisor should you decide to proceed with anything I reference in regards to a Roth Conversion Ladder, or SEPP.
Now that we’ve gotten that out of the way, we can get to the article.
When people talk about FIRE and the 4% withdrawal rate, are they including retirement savings?
How is the fact that those savings aren’t accessible until you’re ~60 years old taken into account, and what does that mean for your non-retirement account savings?
For instance, if you spend $24,000 a year, your target savings is $600,000 – what should be the breakdown of that with regards to retirement vs. non-retirement funds if you are 29 years old and have to live off something for many years before you have access to retirement funds?
There is quite a bit to unpack here and I will do my best to deconstruct my take on this.
Do folks in the FIRE community include retirement savings when discussing the 4% rule? Yes.
The main source of the FIRE community’s assets are in retirement vehicles: 401(k)s, Roth or Traditional IRAs, and you could lump a taxable/brokerage account into this group as well. The last investment/retirement vehicle I mentioned, the taxable account, is vital to the success of people aiming to achieve FIRE. I’ll get more into the taxable account later in this post.
One of the main reasons the FIRE folks use retirement vehicles is due to their tax advantages. For a traditional 401(k), a person can deduct $19,000 per year. Tack on a Traditional IRA and a Health Savings Account (HSA), a person could deduct $31,250. Some jobs that offer a 401(k) and 403(b) enable a person to tack an additional $19,000 on top of that.
401(k) Contribution Limits by Year
- 2019 Regular Contribution Limit = $19,000
- 2018 Regular Contribution Limit = $18,500
- 2017 Regular Contribution Limit = $18,000
** NOTE: The contribution limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $18,500 to $19,000.
The more that you can save into tax-advantaged accounts, the less Uncle Sam will take out of your pocket.
How much?
Let’s look at a quick example of a person making $100,000 and compare how much they pay in taxes if they don’t save anything versus if they maxed out their 401(k), IRA, and HSA.
- Federal tax liability for not saving into tax-advantaged accounts: $25,697
- Federal tax liability if tax-advantaged accounts are maxed out: $15,821
Not only would you save over $30k for retirement, but you would also save almost $10k that goes directly into your pocket!
Strategies for Paying Minimal Taxes and Avoiding Penalties: The Roth Conversion Ladder
The Roth Conversion Ladder is a well-known strategy implemented in the early retirement community.
Here is How the Roth Conversion Ladder Works
When you retire, you roll your 401(k) into a Traditional IRA. This is a non-taxable and penalty-free event.
Next, you convert the money in your Traditional IRA to your Roth IRA. You do pay taxes on the amount you convert, but not always as I will discuss later.
The contributions you make to your Roth IRA is able to be pulled out tax-free 5 years after your first contribution.
Here is a nice flow chart the Mad Fientist put together to summarize the Roth Conversion Ladder process:
Mad Fientist Roth Conversion Ladder
Coming back to the taxes you pay on the conversion from a Traditional IRA to a Roth IRA…
Disclaimer: I am not a tax expert so please don’t take this advice to the bank. My motto with any new information I receive is: trust, but verify. I recommend you do the same.
The lower your income is, the less you will pay in taxes when you convert your money. Additionally, there are tax deductions that you can take advantage of. In 2019, single and married taxpayers who file separately have a $12,200 standard deduction, yet, a married couple who files jointly can take advantage of twice that amount at $24,400. And if you are a taxpayer filing as “head of household“, then you can claim a standard deduction of $18,350.
So, if your income for one year is $0, you can essentially convert $21,000 from your Traditional IRA to your Roth IRA COMPLETELY TAX-FREE.
Now, if you are like me when I first heard this you are probably scratching your head saying, “this sounds great, but how am I going to live on $0 for an entire year?”
Bring on the TAXABLE ACCOUNT.
The Advantage of the Taxable Account
The taxable account is key to the Roth Conversion Ladder because it provides income during the years you are converting money from your Traditional IRA to your Roth IRA.
There are a few tax implications with a taxable account, but first, let’s take one step backward.
Before investing in a taxable account, I recommend maxing out your 401(k), HSA, and Traditional or Roth IRA before starting a taxable account. Understandably, not everyone is able to do this. However, if you are determined to retire early, I stress that you find efficiencies in your budget to make saving this way possible.
If you are able to contribute to a taxable account, here are a few things you should know about it.
Money used to contribute into a taxable account is post-tax.
Growth on your investments is taxed at long-term capital gains – which is 15% or less if you make under $434,550.
The money is easily accessible and can be withdrawn penalty-free after one year of investing.
I recommend investing in Vanguard or Fidelity’s low-cost index funds.
So taking the example from a recently asked question:
A married person who had annual expenses of $24,000 per year needs a portfolio of $600,000 (25x annual expenses.) Let’s say by age 25 this person graduated from college and eliminated all of their debt. They are maxing out their 401(k), HSA, and Roth IRA (total of $31,250/year) AND they are contributing $5,000/year to their taxable account.
By the time this person is 40, they will have just over $950,000 (assuming 8% return), with $135,000 of that in their taxable account. Implementing the Roth Conversion Ladder, this person can pull just over $24,000 per year from their taxable account to live on AND rollover roughly $21,000 a year from their Traditional IRA to their Roth IRA TAX-FREE.
AND, they are paying $0 income tax because unless you make over $75,000 as a married couple, you pay $0 in long term capital gains.
Once their taxable account is consumed, they can start to pull $21,000 per year from their Roth IRA tax-free. Any amount they withdrawal over the $21,000 they would have to pay income taxes and a 10% early withdrawal penalty.
There’s more…
The Roth Conversion ladder is one of two ways to access your funds early.
I will now cover something that I recently discovered.
Substantially Equal Periodic Payment (SEPP).
I will now tackle a second method that enables you to pull money from your retirement funds early without paying the 10% penalty. The second method is called Rule 72(t) – Substantially Equal Period Payments (SEPP.)
This method is calculation-intensive and I recommend checking with a tax professional if this is a method you plan to implement. In this post, I will highlight the following:
- How Rule 72(t), also known as SEPP, works from a high level
- The rules for how many years you need to withdraw from your IRA
- The three methods for calculating the amount you can withdraw each year
- An example from the Mad Fientist comparing SEPP versus other withdrawal methods
- Cautions to be aware of regarding SEPP
- My take on SEPP and if I plan to implement it
How Does Rule 72(t) Work?
The SEPP rule enables you to withdraw funds from your IRA before you turn 59 1/2 without paying the 10% early withdrawal penalty. Before I dig into this in detail, I recommend checking with a tax professional if this is something you want to do.
If you make a mistake in calculating how much you can withdraw each year, you will have to pay taxes and potentially penalties on each distribution you’ve taken.
Another caution with SEPP is the length of how long you have to withdraw money. The SEPP plan requires you to withdraw money each year until you turn 59 1/2 or for at least five years, whichever is longer. You can keep withdrawing indefinitely if you choose to.
For example, if Joe implements SEPP at age 44, he must make a withdrawal each year from age 44 through age 59 1/2. However, if Joe was 57, he would only have to make withdrawals until he reached age 62 (5 years).
If you deplete your account, you no longer have to make withdrawals. Or, if you become disabled or die you no longer are required to make withdrawals.
How is the Annual Withdrawal Amount Calculated?
There are three methods for calculating the amount you will withdraw each year.
- Required minimum distribution method
- The amortization method
- The annuitization method
The required minimum distribution method is calculated by taking the account balance and dividing by the expectancy factor of the taxpayer and the beneficiary (if applicable.) Each year, the annual amount needs to be recalculated.
The annuitization method, similar to the amortization method, provides the same amount each year. The amount you receive each year is determined by an annuity based on the age of the taxpayer and a chosen interest rate.
The amortization method calculates a payment based on life expectancy of the taxpayer and his or her beneficiary and a chosen interest rate. This payment will be the same payment each year the SEPP is in effect. The interest rate is calculated by using the federal mid-term rate. The federal mid-term rate is provided each year by the government and the interest rate in the SEPP calculation can be up to 120% of the federal mid-term rate.
Here is a quick explanation:
A single lady contributes $18,000 pre-tax/year from age 30 to age 40. This analysis compares saving into a taxable account, different traditional accounts, and a Roth. At age 40, this lady retires and lives off her investments. Long-term, the SEPP performs the best – this lady is able to live until age 90 before her money runs out.
Vanguard also has a nice write up here. Vanguard summarizes much of what I covered in this post. If you invest with Vanguard, you should be eligible to get free advice on how to best execute SEPP.
Finally, I recommend checking out the IRS website. They have a frequently asked questions page that is quite helpful.
Cautions When Considering SEPP
If you pull from a Roth IRA, you have to pay taxes. This is not recommended because the crux of a Roth IRA is to let your money grow tax-free. Also, with a Roth IRA you can pull the money out tax-free. If you set up your withdrawals to come out of your Roth with SEPP, you are effectively paying taxes twice on your money.
You cannot pull money from a current 401(k) plan. First, you must roll your 401(k) into a traditional IRA. A traditional IRA is the best account to withdraw money from for SEPP.
If you make a mistake calculating your yearly withdrawal amount, you have to pay a penalty. The penalty can be applied to each year’s withdrawal amount, which could be quite costly.
You will still be taxed at ordinary income taxes on the withdrawals.
Do I plan to implement SEPP?
I honestly don’t know. If I was able to go through Vanguard to run the analysis and ensure that I wouldn’t face a penalty, I might be more inclined to consider this approach. However, I am pretty far away from retiring so it is hard to consider implementing this concept.
It appears that you can execute a SEPP almost like a Roth Conversion Latter.
Implementing this method, SEPP, would have the benefit over the Roth Conversion Latter of not having to wait five years to access your money.
For example, if you had enough in your Traditional IRA to cover roughly $30k in expenses each year after implementing SEPP, you could essentially withdraw most of that tax-free. That assumes you are married and maybe have a kid or two so that you have enough in deductions to cover the income tax liability you would face.
The caution is – if you are young, you will have to withdraw money until you turn age 59 1/2.
If you enjoyed this post, you might also enjoy this post: How to Become a Decamillionaire, Grow your Net Worth to $10 Million, and Join the 1% Club
And this one: How Do You Prioritize Spending Your Money? I Share My Secrets
And this one: How Much Money Do You Need To Never Have To Work Again? Let’s Do The Math.
You should also consider subscribing to my blog. I publish one article a week on small business and wealth creation. You can subscribe here.
Also, I published a book during the summer of 2018, “The Kickass Entrepreneur’s Guide to Investing, Three Simple Steps to Create Massive Wealth with Your Business’s Profits.” It was number 1 on Amazon in both the business and non-fiction sections. You can get a free copy here.
This post was written by Ashley Jenkins, a guest blogger on The Kickass Entrepreneur.
*** Disclaimer – The information provided on this site is based on my own personal experience and is not to be construed as professional advice. I am not a financial advisor or planner, nor am I a CPA. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.
