In the past I’ve talked before about how a 72t is a key part of my early retirement strategy.
In case you’re not aware of what that is, a 72t is a special exception in the IRS rules that allows you to take money out from your 401k or IRA before age 59-1/2 and without facing that stiff 10% penalty (we’ve got a whole post about it here). For anyone looking to retire early, that’s a massive win!
While that’s all fine and good, one of the things I like to make sure of when it comes to my money strategy is to always be searching for something better.
Maybe an option with less rules or something that’s easier on your taxes?
Lately as I was poking around the Early Retirement forum, I came across one such strategy that I felt is definitely worth looking into further. In fact it might just be even better than the 72t!
It’s called a Backdoor Roth IRA. And even though it’s more commonly used by high income earners to move money from a traditional to a Roth IRA, it also has some not-so-obvious strategic advantages: Like the fact that it could be used to help fund your early retirement!
That’s right – conversions to a Roth IRA could be laddered in such a way that you could gain access to your nest egg without penalty and – if it’s done smart – taxes!
Here’s how this works:
What is a Backdoor Roth IRA Conversion?
Like I mentioned above, the conventional use of a backdoor Roth IRA conversion is for higher income earners to still be able contribute to a Roth IRA even though they exceed the IRS income limits. Right now the completely phased out limit in 2015 is $193,000 for a married couple filing jointly.
Suppose you fit that description. The way you would go about using a Backdoor Roth is simple.
- First you would contribute to a Traditional IRA (usually a non-deductible one).
- Then you would immediately convert the amount to a Roth IRA.
Pretty simple, right?
Great … How Does That Help Our Early Retirement Strategy?
Here’s where the magic happens …
To start, give yourself a quick Pop quiz: What’s the difference in withdrawal rules for a Traditional IRA vs a Roth IRA?
- You can’t touch any part of the Traditional IRA until age 59-1/2 without penalty.
- With a Roth IRA you can touch just your contributions (after 5 years) without penalty; not the earnings.
Therein lies the trick! That tiny bit of difference with the Roth is what will allow us to access our money earlier than age 59-1/2 without penalty. And here’s how:
Example – A Roth IRA Conversion Ladder:
Suppose you’re age 45 and have a traditional 401k at work worth $500,000. You decide to retire early and quit your job, so you’re going to want to have access to that money!
The first thing you’d do is convert the 401k into a traditional IRA. Since it’s a Traditional-to-Traditional rollover, there won’t be any taxes. Just whatever fees (which is usually nothing) for the conversion.
Next you do a backdoor Roth IRA conversion from the Traditional IRA with a reasonable amount of the nest egg. We’ll say $20,000 for this example. You’ll of course pay taxes this year on that $20K since this is a Traditional to Roth conversion.
Now repeat that last step every year for the next 5 years and beyond.
On year 6, guess what? The $20,000 you converted back in Year 1 is NOW eligible for withdrawal – penalty free! So now you are free to take out the $20K conversion to do with as you please. You just can’t take out any earnings you made from it.
Similarly in year 7 your second $20,000 conversion from year 2 now becomes eligible for withdrawal without penalty.
As you can guess, you can continue this on and on for as many years as you need. Hence the name “ladder” as you move from one rung to the next.
Once you reach age 59-1/2 you can then access whatever retirement accounts you want and take out whatever amount you need. That means you finally can touch all those earnings that grew upon your $20K contributions you made while they were sitting in the Roth IRA without penalty.
How is This Strategy Better Than a 72t?
Even though it’s good to have a few early retirement strategies up your sleeve, the more I looked into a Backdoor Roth Ladder, the more I realized that this technique really does have some pretty significant advantages over a 72t.
- With a 72t your withdrawals are fixed and based on a pre-calculated formula set by the IRS. There is very little room for flexibility based on what your actual needs are. By contrast the Backdoor Roth is based on whatever amount YOU choose to convert.
- You have to continue the 72t withdrawals for at least 5 years or until you reach age 59-1/2, whichever is longer. That means even if you don’t need them for some reason, it doesn’t matter! You still have to take them! And IF you were to stop taking the withdrawals or mess up in any way, you’ll owe taxes and penalties on all the amounts you’ve withdrawn. Ouch! In contrast with the Roth IRA ladder, you can stop anytime you like without penalty. Once you’ve met the five year wait, it’s up to you if you want to continue taking the money out.
What About the First Five Years?
Admittedly the one fatal flaw with a Backdoor Roth is the first five-year wait. Going back to our earlier example, it wasn’t until Year 6 that we were actually able to touch our money.
But not to worry! Here are a few ways around that issue:
- Use money from your taxable income bucket. This would be investments like your capital gains and dividends from stocks or mutual funds you own outside your retirement funds.
- If you’ve already got a Roth IRA, use the principal contributions you’ve already built up. Hopefully you’ve been investing in a Roth IRA already for 10 or 20 years and have a substantial amount of contributions already beyond the five year qualification.
Bonus Strategy! Pay No Taxes At All!
As if that strategy wasn’t cool enough, now here’s the cherry on top – How to pay zero taxes on your tax-deferred savings!
Go back to our example at Year 6. That year two things will happen:
- You’ll convert $20,000 from your Traditional IRA to your Roth IRA (to be used hypothetically for Year 11). You’ll owe ordinary income taxes on this amount.
- You’ll withdraw your converted $20,000 (originally from Year 1) for living expenses.
Now suppose you only need $30,000 to cover all your living expenses. That means you’ll have to get $10,000 from one of your other retirement buckets.
If you can make that extra $10,000 come from a taxable brokerage account in the form of capital gains and dividends, guess what? You won’t owe any Federal taxes on it because you’re under the first $74,900 of your taxable income.
Observe how this looks from a tax perspective in Year 6:
+ $20,000 withdrawal from the $20K Roth IRA conversion for Year 11
+ $10,000 withdrawal from the Capital Gains and Dividends
– $0 for the Roth IRA withdrawal (Since you paid taxes on this during Year 1, it’s tax free now)
-$20,500 tax credit = $12,600 for a standard deduction and 2 x $3,950 for personal exemptions (you and your spouse)
= $9,500 in taxable income
- Because your taxable income is below the total of standard deduction and two personal exemptions
- And the $9,500 came from capital gains and dividends that don’t get taxed until your taxable income exceeds $74,900
You won’t owe any Federal taxes on the whole balance in Year 6 at all!
So what does that mean? It means you just found a way to pay ABSOUTELY NO FEDERAL TAXES on your Year 11 income!
Check it out:
- You paid no taxes when you first saved the money in your 401k.
- You paid no taxes on the money while it grew in your 401k.
- You’re paying no taxes on the money when you converted it into a Roth IRA
- And now you’re paying no taxes when you finally withdraw the money!
SUCCESS! That is indeed a pretty incredible trick!
Plan with Caution …
As with all early retirement investment strategies, the one thing you have to keep in mind throughout all of this is that you’ve really got to put some thought into NOT taking out too much money too soon. Planning for early retirement is great and really exciting, but not at the expense of shooting yourself in the foot by the time you’re age 70 and too old or too unhealthy to work.
Always look at your plan from an overall view and be sure to do things in a way that will provide you with overwhelming confidence that your money will be safe and never run out prematurely.
Readers – Have you ever heard of a backdoor Roth IRA conversion or ladder? Has anyone actually used one?
Images courtesy of FreeDigitalPhotos.net
Jayson @ Monster Piggy Bank says
I left my job and have a simple IRA behind, they gave me an option to roll over the simple IRA balance to a traditional IRA, another Simple IRA plan or, depending on my new employer’s plan, which I may be eligible to roll the funds into the 401(k) plan with my new employer. However, my goal is to ultimately roll over your Simple IRA to a Roth IRA, and what I have to do is to process a Roth IRA conversion process, which is really easy and very doable.
The great thing about doing it that way is that you’ll be able to access the money from the Roth IRA whenever you want after five years from now (or whenever you convert all of your Simple IRA).
[email protected] says
We use a Roth IRA in addition to our SEP IRAs. No conversion or anything fancy- just straight up contributions!
I like the idea that we could take out contributions early if we need to. We are definitely retiring before 59 1/2. I hope not to touch that money but having access to it is part of our strategy.
It’s not a bad insurance policy or plan “B” to have early access to your money in case you really get in a squeeze during your early retirement efforts. But I agree – try not to touch the money if you don’t really have to. I’ve got a few retirement buckets I’m going to leave alone if I can help it.
John @ Frugal Rules says
Very nice breakdown MMD! I’ve been reading a bit on these lately and they’re definitely intriguing, though I don’t know if we’d ever been encountering doing these – all depends on the growth of our business I assume. We’re actually going to be moving from a SEP to Solo 401(k) this year as it’ll allow us to put away significantly more, but was interested to find out that in no instance are we allowed to touch those funds (the ones in the new Solo) until we hit 59 1/2 – regardless of the situation.
I’m curious John – as your own employer funding a Solo 401k, are you allowed to grant yourself the ability to rollover your Solo 401k into a traditional IRA someday if you choose to do so? If you could, that would not only allow you to save significantly more, but it would also give you the ability to use the Backdoor Roth strategy if you ever wanted to further down the road.
Fervent Finance says
Jeremy at GCC and Justin at ROG are big proponents of the Roth IRA conversion ladder. I personally like this method better than 72t due to the flexibility. I’m still years away from these strategies so hopefully the IRA conversion ladder is still a possibility.
As I was learning more and more about this strategy, I’ve got to admit I also like it a little bit better than the 72t strategy also. The main advantage I believe is flexibility. You can decide how much you’ll need for your early retirement income and plan accordingly rather than be confined by whatever the 72t income calculates out to be.
One thing I’m concerned about however is how long the government is going to allow this loophole to last. If enough people voice their dissatisfaction about it, some politician somewhere will get it closed.
This is ridiculously smart!
And simple too!
[email protected] says
We’ve done a back door Roth during the year I sold my practice and we had a really high income. Hopefully we can use that strategy down the road to pay less in taxes.
The less/no taxes part was like icing on the cake. Not only can you access your money well ahead of the 59-1/2 age requirement, structuring your income to pay next to nothing in taxes is truly very creative!
This is a brilliant idea! All I have is a 401k and a taxable brokerage account (I simply don’t make enough money to contribute to any IRAs and I’m planning for my brokerage account to be my early retirement workhorse). I thought that the money in my 401k would be stuck in there until I’m 59 1/2, but this seems to be a great workaround.
I just want to make sure I understand this because I am much better with banking and investing than I am with accounting/taxes. All I have to do (upon early retirement) is convert the 401k into a Traditional IRA, then open up a Roth IRA and start slowly moving the funds from the Traditional to the Roth (paying the taxes as I go), and after five years then I will be able to start withdrawing from the Roth (contributions only) without paying any sort of taxes, supplementing my dividend and (hopefully) blogging and niche website income the whole time. Did I pretty much get the gist of that right?
It looks like I’ve got to up my 401k contributions! If what I wrote is true, then my 401k CAN contribute to my dream of financial freedom after all!
MMD, I hope you are a CPA in your day job. You’re good at this.
ARB–Angry Retail Banker
Absolutely your 401k contributions can contribute to your early retirement / financial freedom dream! This is why I’m always encouraging everyone to push that contribution number up as far as you can get it!
Yes, you’ve got the process correct. Convert the money over year after year and then you get access to it five years later after you converted it. Just to be clear: In Year 6, you do NOT owe taxes on the principal amount you moved over in Year 1 because you paid taxes on that amount in Year 1. BUT if you simultaneously withdraw your Year 1 principal in Year 6 AND convert money that you plan to use in Year 11, then you’ll need to pay taxes on your Year 11 money in Year 6.
If you have any doubts at all or want to hear it straight from the horse’s mouth, I invite you to call whoever your brokerage account provider is. Before I wrote this article I called my IRA provider Vanguard and spoke with their retirement services department to make sure my understanding was correct.
Remember to check with your 401k provider to make sure there aren’t any special restrictions on your 401k account (usually imposed by your employer). For example some 401k plans make you wait a year before you can even withdraw the funds for a rollover. Though that is probably a pretty extreme case, it would be better to know now rather than be surprised later and put a wrench in your plans.
For legitimate Roth contributions (not conversion) doesn’t the five year rule not apply? Aka if you’ve been contributing to Roth for less than five years couldn’t you still withdraw contributions to supplement income in the beginning years? Thanks
With “normal” Roth IRA contributions, you have to be careful. Yes you can pull out your contribution any time. BUT if you do, the growth from those contribution will not count as a tax-free qualified distribution when you finally retire because it did not satisfy the 5-year rule. This article is very helpful in understanding how this works:
As long as you pull out contributions that have been in your “regular” Roth IRA for longer than 5 years, then there should be no issues.
WG @ Wealth Gospel says
Great tip. I plan to retire early and have a 401k that I may just do this exact thing with. Ideally, I’d like to leave the money in there long-term, but it is a good backup plan if I need it.
If nothing else its good to know that this strategy is an option.
Brian @ Luke1428 says
I think this is a great strategy for those who want to access their money early. We do two straightforward Roth IRAs and don’t plan to access the money early. Of course, you can never plan for what might be coming, so the sooner you can get to your money the better.
Kalen Bruce says
This is brilliant! I knew about the idea of converting to a Roth and pulling contributions, but this strategy for early retirement is pretty good. Thanks for sharing!
It’s amazing you don’t see more people highlighting the early retirement aspect as one of the great features of a backdoor Roth. I’m also surprised more people don’t make a big deal out of the possibility of paying no taxes on your money. That part is mind-blowing!
EL @ Moneywatch101 says
Good strategy and yes I’ve heard of this before. As of right now no need to do it, as IM not FI or retired. Still working hard for the money, but when the time comes I will convert traditional Roth money over and use this strategy. Thanks.
I definitely plan on integrating this into my eventual early retirement plan as well.
Jon @ Money Smart Guides says
Thanks for sharing this MMD. There are all kinds of loopholes and tricks in the tax code that many people are unaware of, especially if you do you taxes yourself. But even for those with a CPA< you need to ask them questions about how you can save more money on your taxes. A good CPA will help you without asking, but sadly too many are so busy, they just crunch your numbers and move on to the next client.
Good point. Often times unfortunately unless you ask, no one is ever going to come out and tell you.
Wow. I’m new to this blog and I love this post! I need to read the Roth rules again. When the Roth IRA first came out, my parents preached it like the gospel ! They were so convinced that this was the thing to do , they gifted us the cash to pay the tax to convert.. Was that great, or what ?
I’m divorced now, but I still have my Roth! I didn’t realize that I could access the contributions … maybe I can get a house sooner then I thought! I knew I could get $10k penalty free as I qualify ( again) as a first time home buyer … I wonder if I can do both ?
Doing both … that is the kind of thing you need a real accountant for. You can’t figure out this out with the help of your friendly tax preparer, bank teller etc. They never know. It’s like you need a special radar to find the folks with a radar for this stuff.
Welcome to the site Christie! I think poking around the personal finance blogshpere, your radar is right on course. Yes, definitely ask a real financial professional about how the home exception and contribution rules work together. Usually I get all my “tough” questions answered for free by simply calling my IRA provider (Vanguard) and asking to speak to a retirement specialist.
I just came across this article and loved the beautiful explanation.
I currently cannot contribute to a ROTH IRA due to my income being too high. I know I can do a backdoor Roth IRA but it sounded like if I did that I would have to pay taxes on the entire value of the IRA and couldn’t just pay a portion that I wanted to do backdoor with (i.e. it sounded like it was all or none). Researching this, some people say that if I rollover the part I don’t want to be converted b/c of taxes, I should roll it into my employee 401k plan.
My question is how does your method work by essentially paying taxes only on the conversion amount you want each year? Wouldn’t the entire traditional IRA balance be subject to tax similar to the above backdoor Roth scenario?
Thanks! I’m glad you enjoyed the article.
With backdoor Roth’s, there are really two main uses:
1. During your working years
2. During your early retirement / normal retirement years
This article is mainly geared towards #2 – how to get your savings out of a 401k / IRA without penalty. In this scenario, yes, you only pay taxes on the amount you convert each year. The idea here is that you are likely in a lower tax bracket (because you are now retired and not earning so much money), and therefore you should pay a lower tax on this converted amount than you normally would.
It sounds like your situation better describes #1. For that, you might find this article more helpful:
In this case, you use the Roth Backdoor by making a taxable contribution either to a non-deductible IRA or 401k. Yes, the fact that you have to pay taxes now on the full amount you contribute seems to defeat the benefit. But by doing so, you have the opportunity to then convert that amount over to a Roth. Once you do this, the savings grows and compounds for the rest of your life, and you never have to pay taxes on any of it ever again.