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I am a software engineer for hire. It has been my trade since my first gig ca. 1985, and as a full-time employee and as a consultant during and since my C.S. degree. This profession requires continuous and independent learning to keep up with the fresh college graduates. I am a financial... More
  • Too Much Money In A 401(K) Or Traditional IRA To Retire Early? 7 comments
    Feb 13, 2013 1:57 AM

    If you want to retire early, but your taxable accounts are not sufficient to fund your retirement until 59-1/2 when you can tap your Traditional IRA without penalty, what do you do?

    First remember that Roth contributions can be withdrawn tax and penalty free.

    Still not enough to live on? Or you don't want to deplete your Roth so early?

    One strategy for IRA withdrawals for an early retirement (and avoiding the penalty) might be to start doing a conversion every year of funds from Traditional IRA to Roth.

    Each year you will need to live off of and pay the taxes from non-Traditional-IRA funds, otherwise you'll pay an additional 10% penalty. But after 5 years, converted funds are considered to be Roth contributions.

    So if you have taxable funds to live on (or existing Roth contributions which can be withdrawn tax free), then the strategy would be to convert up to your tax bracket is full or a year's worth of expenses from Traditional to Roth. Pay the taxes and live on your taxable or pre-existing Roth contributions.

    Then 5 years later, that converted amount will be considered as "principal" (or contribution) and can be withdrawn tax free.

    If you repeat this conversion every year (into a different Roth every year), then in the 6th year you'll be able to start using the 1st year's converted funds. The 7th year you could use the 2nd year's conversion, the 11th year the 6th year's, etc.

    This way you deplete your traditional IRA starting early, but at the rate you decide and sheltering the money into a Roth. But at the same time, creating a source of funds to live on outside of the Traditional IRA, without paying the penalty for early withdrawal.

    It seems like it could work and comply with all the IRS rules...

    If you don't have enough outside the Traditional-IRA to survive that first 5 years, this approach could also be used to minimize the penalties incurred withdrawing from your Traditional IRA. Whatever you live on in the first 5 years, still do at least some conversion so that in year 6 you'll have the 5yr old Roth conversion contribution available. At that point then you won't need to spend as much if any T-IRA money until the penalty expires at 59-1/2.


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Comments (7)
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  • davebutler
    , contributor
    Comment (1) | Send Message
    Very interesting strategy! I'd been looking for an article just like this and found very little on the topic. Plenty about "retire early" and "save" but very little practical info on how to access the funds in tax advantages savings beyond the basic substantially equal withdrawals. Thanks for sharing.
    14 Feb 2013, 05:21 AM Reply Like
  • Robert Allan Schwartz
    , contributor
    Comments (21166) | Send Message
    AAM, is it necessary to have "earned income" in order to contribute to a Roth?


    I'm thinking about what happens between age 59.5 (when I can withdraw from an IRA without a penalty) and age 70.5 (when the RMD's begin), and how to reduce the size of the IRA by taking money out of it during those 11 years, paying tax on it, then contributing it into a Roth.


    What do you think?




    7 Apr 2013, 07:18 PM Reply Like
  • AgAuMoney
    , contributor
    Comments (4635) | Send Message
    Author’s reply » Short answer, yes. But I think that wasn't the right question. :)


    Critical terms: contribute, withdraw, convert, rollover


    A contribution is done with money outside of an IRA to put it into an IRA (Roth or Traditional). It must be "taxable compensation" in the IRS lingo. However, if you have $10,000 in "taxable compensation" but you spend it all, you are still qualified to contribute to an IRA. The funds you contribute could be withdrawn and contributed as you describe. But probably that is not the best approach.


    It sounds like you are talking about a conversion from a traditional IRA to a Roth IRA. This conversion needs to be done as a direct rollover, or it will be treated as a withdraw and contribution. From the tax perspective they are the same. But the amount allowed is different.


    For a rollover there is no limit on the amount that can be converted. The IRS will let you pay taxes on as much as you like. A rollover means the money is never in your control (or it gets more complex).


    A contribution is limited by the IRS to the lesser of the age-adjusted limit, or your "taxable compensation," whichever is less. From the IRS, :


    "To contribute to a traditional IRA, you must be under age 70½ at the end of the tax year. You, and/or your spouse if you file a joint return, must have taxable compensation, such as wages, salaries, commissions, tips, bonuses, or net income from self-employment. Taxable alimony and separate maintenance payments received by an individual are treated as compensation for IRA purposes.


    "Compensation does not include earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation."
    8 Apr 2013, 12:35 AM Reply Like
  • AgAuMoney
    , contributor
    Comments (4635) | Send Message
    Author’s reply » Addendum:


    You could combine conversion and withdraw. For example, you might convert $20,000 with a direct rollover (which is more than you could contribute). But now you need to pay an additional $2,000 in taxes. If over age 59½ then you could withdraw $2,300 from your IRA to cover those taxes ($2,000 needed plus another $230 for taxes on the $2,300, all assuming a 10% effective tax rate).


    Personally I would prefer to pay the taxes from taxable funds, since the entire purpose of this exercise was to get into in a tax free (Roth) account!
    8 Apr 2013, 12:41 AM Reply Like
  • Robert Allan Schwartz
    , contributor
    Comments (21166) | Send Message
    AAM, let me try another question.


    Suppose I have no "earned" income (I abhor that term, but it is what the IRS uses).


    Suppose I withdraw from my SEP, more than I need to live on.


    Can I take the remainder of the withdrawal and contribute it into a Roth?
    8 Apr 2013, 04:56 AM Reply Like
  • AgAuMoney
    , contributor
    Comments (4635) | Send Message
    Author’s reply » For IRA's, the IRS uses "taxable compensation." The way I read the IRS page linked above, I don't think a SEP withdrawal qualifies.


    I did not find a good IRS page with SEP specific instructions. They just say a SEP mostly follows traditional deductible IRA rules and list some exceptions. Here is the best summary page I saw:


    Short answer: you can rollover to do a direct conversion from a SEP to a Roth just as I originally described.
    8 Apr 2013, 09:47 AM Reply Like
  • Robert Allan Schwartz
    , contributor
    Comments (21166) | Send Message
    Thanks, AAM!


    8 Apr 2013, 11:13 AM Reply Like
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