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I'm an individual investor focused on dividend paying stocks, IPOs and index investing. My goal is to retire by age 55, one year before my Dad retired. Read more at
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Retire Before Dad
  • Utilize The Roth IRA As An Early Retirement Tool 0 comments
    Feb 13, 2014 10:57 AM

    Anyone seeking financial independence or early retirement must understand how to use the Roth IRA to their advantage in the context of their own retirement plan. Its usage will not be the same for everyone.

    Government incentives and laws consequently shape and complicate all of our retirement tactics. I am sure that when the retirement savings laws were written, the ages were chosen carefully and hotly debated. We have to contend with the IRA/401k withdrawal age (59 ½), the minimum Social Security age (62), full retirement age for Social Security (66), and the IRA/401k Minimum Required Distribution age (70 ½), all set by the regulators and subject to change. For the early retiree, these age milestones are planning factors rather than targets.

    Roth IRAs further complicate retirement planning when you encounter government limits on contributions based on income. For 2013, a single person with a Modified Adjusted Gross Income (MAGI) below $112,000 can contribute the full amount of $5,500 to a Roth. For incomes up to $127,000, partial contributions are allowed; after that, nothing. For 2014, add $2,000 to each number.

    For married people filing jointly those numbers are $178,000 and 188,000 in 2013 and add $3,000 for 2014. Most people won't know their MAGI until they do their taxes, so that can make contributing to a Roth confusing during the year if you are near the limits.

    For the official explanation of how this all works, check out IRS Publication 590, Individual Retirement Arrangements (IRAs).

    Note: Adjusted Gross Income (NYSE:AGI) is line 37 of your Federal 1040 tax return. MAGI adds back in certain deductions, but for most filers it is the same number. More on AGI vs. MAGI here.

    My Roth IRA Game Plan
    As I've written about before, my plan is to retire at age 55, one year before my Dad retired. Unless my target date changes, my full retirement will happen about four years before I can access my 401k or traditional IRA money. Once I turn 59 1/2, I'm not as worried.

    Any money contributed to a Roth account is after-tax money, as opposed to 401k and traditional IRA money which is pre-tax. Pre-tax detracts from your MAGI. After-tax money does not, even though the government uses the MAGI to set limits on your Roth contributions.

    Here is where the Roth IRA comes in handy for me. The money that I contribute can be withdrawn without penalty and without any tax at any time. However, the earnings made from contributions in the Roth are not eligible for early withdrawal.

    So If I put $10,000 into my Roth and it grows to $12,000 through appreciation and dividends, I can withdraw the original $10,000 without penalty at any time. The $2,000 however must stay until I turn 59 ½ or I must pay a 10% penalty and taxes on it.

    So here's my plan:

    1. Max out contributions on a yearly basis for the next 18 years.

    2. If needed, withdraw up to ¼ of the contributed money each year between ages 55 and 59 ½.

    3. After age 59 ½, evaluate the need to take additional withdrawals from the Roth or start traditional IRA withdrawals.

    A big risk with this plan is if mine and my wife's combined income, or more specifically our MAGI, would increase to surpass the income limit of $191,000 (2014). While this is an outlying possibility in the future, it would be a welcome problem.

    Building the Account
    My wife is now a stay at home Mom. But prior to the birth of our son, she had a pretty lucrative career in crisis communications. She had a nice income to supplement mine, and continued to work part-time for another year after her maternity leave. Before this past year, her income took us over the threshold for contributing to a Roth. So 2013 was the first year we were able to contribute to the Roth since before we were married. As a bachelor I was a little late to the Roth game, only opening an account a year or two before we got married. So the balance on my Roth is relatively low compared to my 401k and traditional IRA.

    This low balance needs to change. One of my goals for 2014 is to deposit $450 per month into this account to max it out for the year. I plan to extend the goal for the next 18 years.

    If I contribute $5,500 to my Roth IRA for the next 12 years, and $6,500 for the 6 years from age 50-55 (so-called catch up contributions), the total comes to $105,000, assuming the $5,500 level doesn't change over time, although It will likely rise with inflation.

    Add that to my previous contribution amount of $9,500 and it takes me to $114,500 of contributions between opening the account and when I am 55. If during the four years between ages 55 and 59 ½ I need additional income to live off of aside from my investment income, then I can tap all of it at once, or a quarter of this cash each year without penalty or tax consequences. That amount is $28,625. I don't want to need it, but it's a built in backup in case my dividends, rental and other income don't cover my living expenses. Whatever money is left in the account that was earned investing over the years would stay until I turn 59 ½ or longer, depending on my situation at the time.

    I could even use this $114,500 lump sum to put the final kibosh on our mortgage, or use it to supplement college education costs for my kids.

    For now, half of the money in this account is invested in a the Fidelity Mid-cap Value Fund (FDVLX) and has returned 24.76% over a the past 5 years with a .67% expense ratio. I picked this fund years ago because I was looking for mid-cap exposure. It has proved to be a good investment so I'll be sticking with it for now. Sorry to you managed fund haters out there*. Compare this to the Vanguard Total Stock Market Index (VTSMX) which has returned 20.03% and a .17% expense ratio, or better yet the Vanguard Mid Cap Index (VIMSX) which has returned 23.11% and a .24% expense ratio.

    I currently have another $6,000 of newly contributed cash in my Roth which I plan to put in a Vanguard income ETF like the VIG or VYM, once we get another dip. I missed the last dip for this account.

    Any money I contribute to my Roth is in addition to maxing out my 401k.

    During the research for this article, I learned that the law allows for us to open a Spousal IRA in the form of a Roth, even though my wife is not working. This would allow us to double our future Roth savings. Since this is news to me, I need to take a closer look into this and see if it fits into our monthly savings budget.

    * Note: Over time I am switching most of my investments to low-fee index funds and ETFs as a long-term strategy. I currently own a number of managed funds in my 401k, because that is all that is available, and in my traditional IRA because they were rolled over and are still performing very well. I mostly agree with all the Bogleheads out there, so cut me some slack for owning the funds. The transition to all index funds is a slow and careful one.

    Conversions of IRAs to Roths
    In the past, a taxpayer's income needed to be less than $100,000 to be able to convert from a traditional to a Roth IRA. The IRS rules have since changed and there is no longer an income cap in place. This is a new workaround so that wealthy people can take advantage of the Roth.

    My wife and I both have traditional IRAs, but we are not considering converting them to Roths in the foreseeable future. While converting is widely recommended, I don't want to give more of my money to the government today. We'd end up paying a 25-28% tax on our current balances. No thanks. In retirement, I don't plan on having income higher than I do today, so my tax rate should be lower.

    Other Viewpoints
    There's plenty of viewpoints on Roth IRA investing on the internet. I've recently come across two compelling articles that you might also enjoy. The Financial Samurai is not tickled at all by Roth IRAs and is flat out against conversations. Also check out the post by Jim Collins with the Mad Fientist discussing tax advantaged accounts. The Mad Fientist explains how to create a Roth conversion ladder, helpful for the extreme early retiree.

    As always, retirement planning is amoebic. But I think this strategy of beefing up my Roth is prudent base on my future needs. It will serve as backup income in case my taxable investment income isn't enough. The way you use the Roth IRA will likely be different not matter what age you plan to retire.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    Additional disclosure: I own the FDVLX mutual fund. I have no positions in the VIG and VYM ETFs but may initiate a long position over the next 72 hours.

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