Thursday, October 24, 2013

How to Retire Early With Tax-Advantaged Accounts

This is the third article on my series on how to retire early with tax-advantaged accounts. Be sure to check the first article and the second article, before reading this one, as it is a continuation of my ideas already presented there. Stay tuned for the fourth article later on this week.

With 401 (k) accounts, you can withdraw money penalty-free after the age of 55, penalty free. With IRA and Roth IRA accounts, you can withdraw money penalty-free after the age of 59.5 years. You can withdraw only contributions but not earnings from Roth IRA without penalty before the age of 59.50 years. Otherwise, a 10% penalty applies, unless Substantially Equal Periodic Payments (SEPP) are selected.

If you choose to retire early, but you have found an accidental income source that pays for your bills, you might decide that you can simply leave your tax-deferred accounts there to grow tax free for decades. This would be interrupted by age 70.5, when you would have to pay required minimum distributions for 401 (k) and IRA's, which increase as you age. As a result, it might make sense to roll-over some of that 401 (k) or IRA money into a Roth IRA. When you do that, you might have to pay ordinary income taxes on the amounts you convert to a Roth IRA. You can also, convert just a portion of your 401 (k) or IRA balance over to a Roth IRA, in order to minimize the tax hit.

For example, lets assume you needed $24,000 to live on annually, and you manage to somehow earn that in your retirement years from side-gigs. Let's assume that you have $50,000 in your 401 (k) plan. If all else is equal, you can essentially convert approximately $12,500 from your 401 (k) into a Roth IRA for four years in a row, and end up paying a 15% marginal tax rate on the conversion amount. The distributions from your Roth IRA will grow tax-free for as long as you live, and you would never have to withdraw them. Once you are eligible to withdraw them however after the age of 59.5 years old, the distributions would be tax free.

This means that if you contributed to a 401 (k) or a tax deductible IRA and you were paying more than a 25% tax at the Federal level, it would be very beneficial to convert to a Roth IRA, especially if you can pay a tax rate that is much lower than 25% on the conversion. Your money will grow tax free in the Roth, you would have the option to buy US securities traded on NYSE, Nasdaq or Amex, and your distributions would be essentially tax free when you are eligible to withdraw them.

There is also an exception related to Roth IRA accounts, when you made a conversion from a regular IRA or a 401 (k) and paid taxes on the converted amount. You can essentially withdraw the amount of the contribution you made to the Roth at the time of conversion after five years from the conversion. For example, if you converted a $1000 IRA into a Roth in 2000, you can withdraw that $1000 tax-free in 2006.

With a Roth IRA, you can essentially put up to $5,500 per year, if you are under the age of 50. This money grows tax-free for decades, and you never have to distribute it. When you are eligible to distribute all the money from the Roth ( typically after you are 59.5 years old), you won’t owe any taxes on it. There is also this nice little thing about Roth IRA’s, where you can withdraw your contributions, but not earnings, prior to age of 59.50 years old, without paying any penalties. The real issue with regular Roth IRA’s is that it would take at least 10 – 15 years, before you can accumulate $100,000 in your account. Therefore, the way to attain critical mass with this account is through a rollover of a 401 (k), regular IRA or through a long period of contributing.

Check my last article on the topic.

Full Disclosure: None

Relevant Articles:

Why I Considered Tax-Advantaged Accounts for My Dividend Investments
Is Dividend Mantra Wrong on Taxes?
Roth IRA’s for Dividend Investors
Six Dividend Paying Stocks I Purchased for my IRA


  1. Pretty good series on taxes. I'd like to make a few comments.
    I remember reading DM's article about investint in taxable accounts only. If you talk or give advice in general, that is fine but it all depends on provided choices in a 401k. I've heard that 401k of small businesses or even teachers are given load funds or insurance products that can be very expensive. Maybe it's OK to contribute to such bad 401k or 403k plans up to an employer's match, but not anymore. If there's no match, I don't I'd even advise to invest in such account. It could be a wash: when you save in taxes by contributing now, you might end up paying for the front loads and/or onerous expense ratios. Also, imagine if one gets laid off or has to retire in a year like 2008-2009 and want to convert his/her 401k to a Roth IRA. Not only did you incur losses in the 401k, but you must pay ordinary income taxes on the conversion whereas if you saved and invested in DG stocks in a taxable accounts the dividends would still be coming (hopefully with the right blue-chips). Anyway, you might be in a wash here.
    Now speaking of DM if you tried to criticize his choice of investing, I definitely agree with you that he could at least open a Roth IRA because he would choose what to invest in, but we don't know what kind of funds are offered in his 401k or if he can get any match. Hopefully DM will read your articles and will tell us. I'd be interested to know.
    Overall great info for newbies. Thanks

  2. I like the idea of converting 401k balances over to the Roth over a period of several years (adjusting the amount of the conversion each year to keep one's total taxable income in the lower brackets, preferably 15% or lower).

    After the 5-year aging, the converted amount is yours to withdraw and deposit/invest in a taxable account with no strings attached.

    I hope to use this strategy to complement a phased early retirement plan in the not too distant future.

  3. If only we could roll over 401(k) funds from existing employers! I don't see myself leaving my current employer anytime in the next decade or more (37 y/o).

    I had a ROTH 401(k) at a previous employer and the ability to move those funds over to my ROTH IRA has been extraordinary. I have 3x's as much money in my account than I would have had if I had been limited to the $5,000 (now $5,500) limit.

  4. My wife and I both opened Roth IRA brokerage accounts and contribute the max each year. Our plan is to never touch these funds (all dividend stocks) so that they can be inherited by our children (prayerfully many years from now). Although they will be required to take MRDs, our children's distributions will all be tax free and can be used to fund their Roth IRAs for future generations.

  5. You can do an IRA to Roth Conversion and not pay any taxes if you set up and make a charitable contribution to your own charity (managed by Fidelity, Schwab and others). To avoid the taxes, have your accountant or TurboTax calculate the amount you would have to make to lower or eliminate any tax obligation. The charitable offset can be managed by you in investment funds for future gains. You may have to make nominal annual contributions from your charity to legitimate 501c3 tax exempt organizations (i.e., Salvation Army, Red Cross or your church). I have converted over 1.5 million in the past 5 years with little or no tax obligation and built a 150k charitable fund at Schwab. I am doing what Warren Buffet does - but on a smaller scale!

  6. Anon,

    The point of the series is to get people thinking of whether optimizing their investments from a tax perspective makes sense. The decisions are up to the individual, depending on a variety of factors.

    One of my friends has a 401K, where all the funds have fees of 1%, which is disgusting.

    However, DM can easily do a SEP IRA, plus a ROTH. I would assume that he is likely going to push above the 25% bracket pretty soon ( if he hasn't already). Also, it might make sense for him to max out 401K, and get the maximum tax deductions at 25%, if he can pay no more than 10 -15% if he withdraws the money.


    Thanks for comment. If I can get the deduction today, and pay almost no taxes ( or less in taxes) in Roth Conversion, I would be ecstatic.


    Unfortunately, you can only do these rollovers when you leave employers. For Ex I have been "fortunate" to have switched jobs several times over the past decade. The 17.5K in ROTH 401k is nice, but unfortunately not available for everyone today.


    Thanks for your comment. Good luck and hope your children wont get to touch the money for many decades from now ;-)


    This sounds very complicated. I would have to research it, and see how it works.

    My question is, how can you withdraw the money to use in your daily life? And aren't foundations required to distribute something like 5% of assets each year in order to maintain their status as a charity?


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