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

Popular Posts