In a previous article we talked about using IRS code 72(t), section 2 to access our tax sheltered accounts prior to reaching age 59 1/2. Unlike the Rule of 55 approach, 72(t) appears fairly complicated with penalties for non-conformance. Also, the amount of funds that we could pull is strictly limited based on the IRS calculation methods.
Education is not only a ladder of opportunity, but it is also an investment in our future
Ed Markey
In this article we will look at the concept of a Roth Conversion ladder. In general, a conversion ladder involves taking our 401k or 403b funds, and gradually migrating them into a Roth IRA so we can use it to pay expenses prior to reaching age 59 1/2. We need to consider the tax implications and spread it out over a number of years, to avoid a big hit.
The first key is saving enough in your pretax accounts to minimize your taxes during the working years. We have been trying to save aggressively in both pretax and taxable accounts as part of our retirement budget. At (early) retirement, we would convert our 401k accounts to Traditional IRAs. Since both are tax sheltered, there would be no taxable event at this point.
The magic to make the money accessible is to convert a chunk into a Roth IRA. Unlike our back door Roth IRA contributions, this conversion would be taxable, because the source funds have never been taxed and have a cost basis. The next factor to consider is that we need to “age” the Roth IRA funds for five years, otherwise we would need to pay a penalty to actually withdraw.
To summarize, Mad Fientist has a great graphical representation of the process:
Unlike the 72(t) method, the Roth Conversion Ladder has a lot of flexibility, which is something we prize as part of our Financial Independence planning. We can decide how much of a conversion we need to take each year, if anything. On the downside, this planning is a little muddled because we have to look five years out to gauge how much money we will need. If we wanted to retire in the next 2 years or so, we should do a conversion NOW, so the funds would be accessible in 5 years…
We haven’t started any typical Roth Conversions yet, since the tax hit would be painful and at our highest bracket. I think we can incorporate when one or both of us stops working and our taxable income is much lower. I do like the concept, and this was part of my thinking in taking a Cares Act withdrawal in 2020. We took the maximum $200k withdrawal ($100k each), and we have 3 years to spread out the tax and/or pay back the withdrawal amounts. These funds were not rolled over into our Roth IRAs, and we have lots of options. So far, we already paid back $60K of the $200K to eliminate any tax hit for 2020, but we will see what we do for 2021 and 2022.
No definite plans yet, but I think our actual approach will be a hybrid of a couple methods, including 72(t) and a Roth Conversion ladder. Still trying to build up the passive income as well to help fill the gap. If anyone has some actual results to share in the comments, that would be appreciated!
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| Disclaimer: I am not a financial planner and content on this site is meant to provide food for thought, not professional advice. I share my experiences to show what worked so far and what didn’t, YMMV. Please consult your financial advisor or tax professional as needed. |
