How to withdraw funds from your IRA and 401k without penalty before age 59.5

[dandarc]

Generally, converted assets in the Roth IRA must remain there for at least 5 years....

Another exception to "Generally" is the amount of non-deductible traditional contributions converted to Roth.  See Backdoor Roth IRA.  Those amounts (subject to withdrawal ordering rules - these are #3 in http://retirementlc.com/wp-content/uploads/2017/07/2017-07-06-Roth-IRA-Distribution-Ordering-Rules.pdf) may be withdrawn at any time without tax or penalty.

Huh. I thought those were subject to the 5 year wait as well. TIL.

The ordering rules when making a non-qualified withdrawal from your Roth IRA are thus:

1. Regular contributions
2. Conversions on a first-in, first-out basis
    a. Taxable portion (the amount required to be included in gross income because of the conversion or rollover)
    b. Non-taxable portion
3. Earnings

In a Roth IRA, the penalty only would apply to taxable items - it is a 10% additional tax on the taxable portion. If you've done your backdoor Roth IRA well, item 2.a will be minimal - typically you're aiming to convert more or less immediately after the deposit is made so that there are no earnings when you convert, so if you've done it perfectly, 100% of the backdoor Roth conversion is the "non-taxable" portion.

That being said, if it has been 5 years or more since the conversion, the "taxable portion" essentially shifts into the "non-taxable portion".

[frugalnacho]

Is it really 5 years? It was my understanding that it's the 5th year after the conversion is made and only the tax year counts.  So if you convert on December 31, 2018 you would satisfy the 5 year "seasoning" on January 1, 2023 which is really only 4 years and 1 day later.

Is that correct?

[Nords]

Is it really 5 years? It was my understanding that it's the 5th year after the conversion is made and only the tax year counts.  So if you convert on December 31, 2018 you would satisfy the 5 year "seasoning" on January 1, 2023 which is really only 4 years and 1 day later.

Is that correct?

That's correct-- five tax years, not five calendar years.

https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/

[GUNDERSON]

Is there anything that changes about this process if one is using a solo 401k?
Thanks!

[secondcor521]

^ Your research is wrong.

First, anyone can withdraw Roth contributions at any point without penalty or taxes.  There is no need to wait 5 years or to attain any particular age.

Second, the age is 59.5, not 59.

Third, while your statement about taxes on earnings before 59.5 is accurate, it is incomplete.  In addition to paying taxes, generally a 10% early withdrawal penalty will apply (unless the withdrawal qualifies for one of the exceptions).

Fourth, plug your blog elsewhere.

[rush20]

I'm new to the website and am interested in learning more about investing and retirement planning. Why are people converting to ROTH IRA for retirement instead of leaving it in the tIRA? Why would your tax bracket be higher when you retire at age 59.5? If you're income when you retire are your withdrawals from LTCG and dividends, how would that be higher than your current salary? Shouldn't a tIRA be more beneficial?

[MDM]

I'm new to the website and am interested in learning more about investing and retirement planning. Why are people converting to ROTH IRA for retirement instead of leaving it in the tIRA?

Some (incorrectly) think that tax free earnings in a Roth make it inherently superior to traditional.  Some (who may or may not be correct) think their marginal tax rate on withdrawal now will favorable in comparison with that rate later.

Why would your tax bracket be higher when you retire at age 59.5?

Many possible reasons, including
- having "too much" in traditional (perhaps including an inherited IRA)
- having a very good pension
- expecting a higher marginal rate in just a few years, including IRMAA tiers and/or Soc. Sec. benefits.
- etc.

If you're income when you retire are your withdrawals from LTCG and dividends, how would that be higher than your current salary? Shouldn't a tIRA be more beneficial?

If LTCG and dividends are your only income later, then a tIRA is likely more beneficial now.

See Investment Order and Traditional versus Roth - Bogleheads for more.

[rmorris50]

Anyone just pay the penalty, especially when filing married and jointly and your other spouse isn't subject to the tax penalty. My calculations show it's only a 5% effective penalty in my case. My spouse has no interest in retiring and I am screaming to leave the corporate world. Our effective tax rate would be 24% instead of 19%, including state (NC at 5.25%). Any penalty sucks, but given the fact both our incomes right now put us in the top marginal tax bracket, this is still a decrease for us (yes, I am the breadwinner but have been socking most of it away)! I've looked into Roth conversions, SEPPs, and all that sort, but the penalty isn't that bad and leaves me plenty of flexibility still. And with my deferred comp, pension and SS I am not so scared to spend down my pre-tax IRA first in my early retirement years, at least low enough to a level where it doesn't grow out of control and I have massive force outs at 70.

[Cheddar Stacker]

Anyone just pay the penalty, especially when filing married and jointly and your other spouse isn't subject to the tax penalty. My calculations show it's only a 5% effective penalty in my case. My spouse has no interest in retiring and I am screaming to leave the corporate world. Our effective tax rate would be 24% instead of 19%, including state (NC at 5.25%). Any penalty sucks, but given the fact both our incomes right now put us in the top marginal tax bracket, this is still a decrease for us (yes, I am the breadwinner but have been socking most of it away)! I've looked into Roth conversions, SEPPs, and all that sort, but the penalty isn't that bad and leaves me plenty of flexibility still. And with my deferred comp, pension and SS I am not so scared to spend down my pre-tax IRA first in my early retirement years, at least low enough to a level where it doesn't grow out of control and I have massive force outs at 70.

Why would you want to pay the penalty when you can just do a SEPP instead? How long until you are 60?

Why is your spouse not subject to the penalty? If spouse is over 60, or disabled or something and can avoid a penalty, draw down spouses assets first to avoid the penalty.

A 10% penalty is not the end of the world, but if you can avoid it, why elect to pay it?

[rmorris50]

Anyone just pay the penalty, especially when filing married and jointly and your other spouse isn't subject to the tax penalty. My calculations show it's only a 5% effective penalty in my case. My spouse has no interest in retiring and I am screaming to leave the corporate world. Our effective tax rate would be 24% instead of 19%, including state (NC at 5.25%). Any penalty sucks, but given the fact both our incomes right now put us in the top marginal tax bracket, this is still a decrease for us (yes, I am the breadwinner but have been socking most of it away)! I've looked into Roth conversions, SEPPs, and all that sort, but the penalty isn't that bad and leaves me plenty of flexibility still. And with my deferred comp, pension and SS I am not so scared to spend down my pre-tax IRA first in my early retirement years, at least low enough to a level where it doesn't grow out of control and I have massive force outs at 70.

Why would you want to pay the penalty when you can just do a SEPP instead? How long until you are 60?

Why is your spouse not subject to the penalty? If spouse is over 60, or disabled or something and can avoid a penalty, draw down spouses assets first to avoid the penalty.

A 10% penalty is not the end of the world, but if you can avoid it, why elect to pay it?

I turn 46 this summer and my spouse turns 51. He plans to keep working and won't draw on retirement accounts until 60 at the earliest, so his income is subject to just normal tax is what I meant. I would love to retire now,  but by 50 at the latest (save a little more, let investments recover, etc). My spouse makes ok money, but he has never been the breadwinner and our lifestyle would be drastically reduced and he may divorce me (half joke, half serious). And SEPP doesn't provide enough for me to contribute to the household and keep us in a middle-class lifestyle. Starting at 55, I also have deferred comp from ages 55-70, and then if I defer pension and SS until 70 that is more than enough for me to live off of. So I don't need to make sure my IRA supports me to very old age. And if I keep working and just let the IRA grow I will just have massive forceouts from the IRA starting at 70. Just seems to make more sense to retire very soon and use my IRA to bridge the gap to age 55. Thus the reason i am willing to pay the penalty.

[rmorris50]

I should also add my IRA is currently $1 million and we have no children and won't. I don't plan on making any extended family rich off my hard work either :-)

[nickelwise]

Does anyone know if HSA can be converted to Roth the same way a Traditional IRA can? A lot of conversion ladder guides recommend doing the maximum HSA contribution every year in order to squeeze out more tax-free Traditional --> Roth IRA conversions. I'm worried I could drain my Traditional too quickly and then be left with a giant HSA that I can't use for Roth conversions, and then have some years before age 65 where my standard deduction is wasted due to no money left in the Trad IRA to convert.

HSA is often touted as the "ultimate retirement account", having all the advantages of the other types of retirement accounts plus more. But if it lacks the Roth conversion option, that's actually a major drawback it could have in some situations compared to Traditional IRA.

Obviously, a certain amount in HSA will be desirable because you'll get it out tax-free due to claimable medical expense. We don't know where the threshold will be for our own future medical needs, but at a certain point there could be a threshold of "too much" in the HSA if your Traditional account runs out before you can take advantage of all your tax-free conversion potential.

This concern won't apply to everyone, such as those who retire with most of their money in a Traditional IRA, since they have little chance of it running out early. Sequence of returns will also have a big impact on exactly when the account could potentially run dry.

Of course, if there is a major healthcare overhaul in the US at some point, who knows what will happen to HSA accounts. If one day we do single-payer or something like that, maybe HSAs will get discontinued and just turned into Trad IRAs.

[MDM]

I'm worried I could drain my Traditional too quickly and then be left with a giant HSA that I can't use for Roth conversions, and then have some years before age 65 where my standard deduction is wasted due to no money left in the Trad IRA to convert.

HSA is often touted as the "ultimate retirement account", having all the advantages of the other types of retirement accounts plus more. But if it lacks the Roth conversion option, that's actually a major drawback it could have in some situations compared to Traditional IRA.

If one contributes only to HSAs and not to IRAs and 401ks, that problem could arise.  In general, it might take a very specific set of circumstances for one to "drain my Traditional too quickly and then be left with a giant HSA."

Do you have an example (with numbers) in mind?

[nickelwise]

Well, say you retire at 40 with 400k in Trad IRA, 40k in HSA, and the rest of your money in taxable.

Then, every year of retirement, you max your HSA contribution, and then convert an amount from your Trad IRA to Roth equal to that year's standard deduction plus your HSA contribution. Then say you get an unfavorable sequence of returns that sees your balances drop drastically at the start of your retirement and stay low for several years. With the market low, your conversions drain your Trad IRA low enough that even during the market recovery, you're converting money out of it faster than it can recoup its losses. Many years later, you finally end up draining it down to zero, and all along you've been doing a max HSA contribution every year in order to speed up your IRA conversions. Now you've got a fat 6-figure HSA that keeps growing with market returns, and until 65 your standard deductible is "wasted" with no conversions to "spend" it on.

I didn't run hard numbers, but it seems like a plausible scenario.

[secondcor521]

Does anyone know if HSA can be converted to Roth the same way a Traditional IRA can? A lot of conversion ladder guides recommend doing the maximum HSA contribution every year in order to squeeze out more tax-free Traditional --> Roth IRA conversions. I'm worried I could drain my Traditional too quickly and then be left with a giant HSA that I can't use for Roth conversions, and then have some years before age 65 where my standard deduction is wasted due to no money left in the Trad IRA to convert.

HSA is often touted as the "ultimate retirement account", having all the advantages of the other types of retirement accounts plus more. But if it lacks the Roth conversion option, that's actually a major drawback it could have in some situations compared to Traditional IRA.

Obviously, a certain amount in HSA will be desirable because you'll get it out tax-free due to claimable medical expense. We don't know where the threshold will be for our own future medical needs, but at a certain point there could be a threshold of "too much" in the HSA if your Traditional account runs out before you can take advantage of all your tax-free conversion potential.

This concern won't apply to everyone, such as those who retire with most of their money in a Traditional IRA, since they have little chance of it running out early. Sequence of returns will also have a big impact on exactly when the account could potentially run dry.

Of course, if there is a major healthcare overhaul in the US at some point, who knows what will happen to HSA accounts. If one day we do single-payer or something like that, maybe HSAs will get discontinued and just turned into Trad IRAs.

As far as I know, they cannot.  While HSAs do have certain tax characteristics that help with retirement, they are intended to save you money on taxes for health related expenses and are not a retirement vehicle per se.

If you're concerned, then do the math and either drain your traditional IRA more slowly, or work longer and thus have a larger traditional IRA to start with.

[MDM]

Well, say you retire at 40 with 400k in Trad IRA, 40k in HSA, and the rest of your money in taxable.

How much in taxable, and what safe withdrawal rate is being used?

[nickelwise]

Just to make it up, let's say it's a 3.25% SWR and a $25k/year withdrawal. Overall stash is $770k, consisting of $400k IRA, $40k HSA, $330k taxable.

For my example, I intentionally invented these numbers such that $25k out of $770k is within the safe withdrawal rate assumption, but the current standard deduction plus the current HSA contribution limit exceeds the same safe withdrawal rate coming out of the $400k IRA. I did this just so that the assumption of the safe withdrawal rate could hold true for the overall drawdown, while still allowing for the possibility that the drawdown out of the IRA in the amount of standard deduction plus HSA contribution could cause it to run out of money.

Of course, my constructing it that way would become useless if we say that our SWR assumption is contingent on a certain allocation of stocks/bonds, but we keep all of our bonds in tax-advantaged accounts, which throws off the assumption of each account being individually expected to conform to the overall portfolio's SWR.

[seattlecyclone]

Nope, no Roth conversion option for the HSA. I would avoid contributing so much to one of these that you're worried about the annual growth outpacing your typical medical bills.

[MDM]

Just to make it up, let's say it's a 3.25% SWR and a $25k/year withdrawal. Overall stash is $770k, consisting of $400k IRA, $40k HSA, $330k taxable.

Well, say you retire at 40 with 400k in Trad IRA, 40k in HSA, and the rest of your money in taxable.
Then, every year of retirement, you max your HSA contribution, and then convert an amount from your Trad IRA to Roth equal to that year's standard deduction plus your HSA contribution.

If 3.25% is indeed safe for 50 years (assuming an age 90 life expectancy), then you should be able to make 25 years at which point the HSA turns into a traditional IRA at worst.

[secondcor521]

Nope, no Roth conversion option for the HSA. I would avoid contributing so much to one of these that you're worried about the annual growth outpacing your typical medical bills.

@seattlecyclone, it seemed to me in my HSA research that dying with an HSA is penalized by the tax code.  So my current HSA strategy is to have my HSA balance stay small enough so that I can drain it completely in a reasonable time frame starting in my late 60s.

Can you explain why it would be OK for it to grow so large as you imply above?

[seattlecyclone]

Nope, no Roth conversion option for the HSA. I would avoid contributing so much to one of these that you're worried about the annual growth outpacing your typical medical bills.

@seattlecyclone, it seemed to me in my HSA research that dying with an HSA is penalized by the tax code.  So my current HSA strategy is to have my HSA balance stay small enough so that I can drain it completely in a reasonable time frame starting in my late 60s.

Can you explain why it would be OK for it to grow so large as you imply above?

Huh? I suggested not contributing so much that you expect it to grow out of control. You're absolutely right about dying with a large HSA being a bad thing: your heirs will be required to take it all out (and be taxed on it) in the year of your death. Compare this to IRAs where they can spread withdrawals out over ten years. Not great!

[secondcor521]

Nope, no Roth conversion option for the HSA. I would avoid contributing so much to one of these that you're worried about the annual growth outpacing your typical medical bills.

@seattlecyclone, it seemed to me in my HSA research that dying with an HSA is penalized by the tax code.  So my current HSA strategy is to have my HSA balance stay small enough so that I can drain it completely in a reasonable time frame starting in my late 60s.

Can you explain why it would be OK for it to grow so large as you imply above?

Huh? I suggested not contributing so much that you expect it to grow out of control. You're absolutely right about dying with a large HSA being a bad thing: your heirs will be required to take it all out (and be taxed on it) in the year of your death. Compare this to IRAs where they can spread withdrawals out over ten years. Not great!

OK, thanks for confirming what I thought.  Your phrasing just confused me a bit - I would hit the point where I was worried about draining my HSA in a reasonable time frame long before I would hit the point where I was concerned about the annual growth outpacing my typical medical bills.  I thought you were suggesting that it was OK for an HSA to get to endowment levels, but evidently you weren't.

[asauer]

Question about Roth conversation and taxation.  I will retire in 18 months at age 43.  My husband will continue working for another 7 years and retire at age 50.  Can I begin my Roth conversion after I retire with the same income tax advantages or will we need to wait until he retires?  We are married filing jointly so I would imagine we would have to wait.

[dandarc]

@asauer - you'll pay whatever your marginal tax rate is whenever you decide to convert any amount from Traditional to Roth. May or may not make sense for you to convert while your husband is still working. You certainly can do Roth conversions while your husband is still working if you think it makes sense to do so, all things considered.

Many folks pick a tax bracket they are comfortable paying & locking in and convert to take taxable income up to the top of that tax bracket in any given year.

[Blue Gem]

Hi folks, quick question. Are the investment gains that the roth conversion makes in the 5 years of "maturing" also withdrawable penalty-free before age 59.5? I assume not, but just wanted to check.

[Nords]

Hi folks, quick question. Are the investment gains that the roth conversion makes in the 5 years of "maturing" also withdrawable penalty-free before age 59.5? I assume not, but just wanted to check.

Nope, just the amount from the traditional account that was transferred to the Roth IRA for the conversion.

You could withdraw the gains, but you'd have to pay the 10% penalty. 

[secondcor521]

Hi folks, quick question. Are the investment gains that the roth conversion makes in the 5 years of "maturing" also withdrawable penalty-free before age 59.5? I assume not, but just wanted to check.

Nope, just the amount from the traditional account that was transferred to the Roth IRA for the conversion.

You could withdraw the gains, but you'd have to pay the 10% penalty.

Nords is correct.

Further, the IRS doesn't let you pick and choose what you're withdrawing.  When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last.  Fortunately, this generally matches what you'd want to do anyway.

[Wolfpack Mustachian]

Hi folks, quick question. Are the investment gains that the roth conversion makes in the 5 years of "maturing" also withdrawable penalty-free before age 59.5? I assume not, but just wanted to check.

Nope, just the amount from the traditional account that was transferred to the Roth IRA for the conversion.

You could withdraw the gains, but you'd have to pay the 10% penalty.

Nords is correct.

Further, the IRS doesn't let you pick and choose what you're withdrawing.  When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last.  Fortunately, this generally matches what you'd want to do anyway.

This is probably a very dumb question, but when you say "When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last," what does that mean in terms of the nuts and bolts of you withdraw it. By this, I mean, I have a Roth IRA with Vanguard. I sell some VTSAX, for example, from it for cash and move to pull it out. Does this mean that whatever I sell will be calculated as my contributions until the dollar amount goes above what I actually contributed into the account and then it counts as conversions until my conversion amounts are gone and then gains until it was empty? By this, I mean, is it all "theoretical" and unrelated to me actually selling and how the VTSAX I bought has actually gone up in value and totally related to how much money I actually put in?

[Nords]

Nords is correct.

Further, the IRS doesn't let you pick and choose what you're withdrawing.  When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last.  Fortunately, this generally matches what you'd want to do anyway.

This is probably a very dumb question, but when you say "When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last," what does that mean in terms of the nuts and bolts of you withdraw it. By this, I mean, I have a Roth IRA with Vanguard. I sell some VTSAX, for example, from it for cash and move to pull it out. Does this mean that whatever I sell will be calculated as my contributions until the dollar amount goes above what I actually contributed into the account and then it counts as conversions until my conversion amounts are gone and then gains until it was empty? By this, I mean, is it all "theoretical" and unrelated to me actually selling and how the VTSAX I bought has actually gone up in value and totally related to how much money I actually put in?

Yes.  You can read about it on page 31 of IRS Pub 590-B "Ordering Rules for Distributions", including the example at the end of the section:
https://www.irs.gov/pub/irs-pdf/p590b.pdf

Your cost basis of your shares of VTSAX and their gains have nothing to do with the order in which you're assumed to make the IRA withdrawals.  That's how the realized gains of taxable accounts are handled.

[secondcor521]

Nords is correct.

Further, the IRS doesn't let you pick and choose what you're withdrawing.  When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last.  Fortunately, this generally matches what you'd want to do anyway.

This is probably a very dumb question, but when you say "When you withdraw from a Roth, it's always contributions first, then conversions oldest to newest, then gains last," what does that mean in terms of the nuts and bolts of you withdraw it. By this, I mean, I have a Roth IRA with Vanguard. I sell some VTSAX, for example, from it for cash and move to pull it out. Does this mean that whatever I sell will be calculated as my contributions until the dollar amount goes above what I actually contributed into the account and then it counts as conversions until my conversion amounts are gone and then gains until it was empty? By this, I mean, is it all "theoretical" and unrelated to me actually selling and how the VTSAX I bought has actually gone up in value and totally related to how much money I actually put in?

Yes.  You can read about it on page 31 of IRS Pub 590-B "Ordering Rules for Distributions", including the example at the end of the section:
https://www.irs.gov/pub/irs-pdf/p590b.pdf

Your cost basis of your shares of VTSAX and their gains have nothing to do with the order in which you're assumed to make the IRA withdrawals.  That's how the realized gains of taxable accounts are handled.

Nords is correct again. :)

To say it a different way, the IRS doesn't care one whit about what happens inside a Roth IRA - it's one big black box.  They only look at dollar amounts going in and coming out.  You contributed $X dollars.  You converted $Y dollars.  The balance in the Roth is $Z dollars.  When you withdraw, you withdraw $W dollars.  Whether it was in Zimbabwean banana futures contracts or VTSAX inside your Roth they don't care.

[thrifted]

I have 2 questions, as I am now looking into investing in property and buying a car. I just moved back to Southern California after 8 years as a renter in NYC.

Here's my portfolio:
$236k in retirement funds with TIAA CREF
(note: 8% employer contribution, matching not necessary to reap the benefits)
$34k in regular savings in a credit union
a $3k IRA in another credit union

Is it worthwhile to convert retirement to IRA so you can withdraw and have a larger down payment to buy property?

My friends have owned property for quite a while but all saved in cash and no one pulled from other investments. I just want to make sure I do everything I can to get the most conservative loan. I was far from MMM exposure when I faced a foreclosure during the 2008 bubble and I am so weary of making another obvious mistake. I'm willing to wait to buy if I can rent a modest room from my cousins who have a spare room available for rent. But of course prices will more than likely rise.

I also feel like I need to buy a car. It will be used but my other question if there are any other tips related to deciding how much down payment to put. I like to leave my savings alone and just contribute $1k/month. Now $200 a month or so of that will be going to a car.



I turned 40.5 this month and am aiming to be FIRE by 50. I now live in Southern California, where home prices are astronomical. I used to like in NYC, where I felt fine renting. 

[ixtap]

Do you have a pension lined up? Your savings seem rather low for your time to retirement. As such, pulling from retirement funds seems like a poor choice.

The good news is, SoCal generally favors renting when you run the rent buy calculations. I pay less in rent than I would be paying in interest + taxes, even if I had put 20% down when I first rented this unit 3+ years ago. And the HOA went up shortly after we moved in, but the landlord only raised the rent by that amount when we renewed two years later.

Do you need a car right away? Some areas you do, but it is worth asking yourself.

[thrifted]

Hi ixtap!

Good question. I do not have a pension and actually never worked for a company who offers one. I been toying with the idea of moving into a government job exactly for the pension. County is hiring but there's a longer wait on federal for now during the pandemic I believe.

I manage to not need a car on a daily basis and borrow one from a relative if there is something urgent and the errand cannot be run in a carpool. I'm going to test drive cars when I return to SD (I'm in the midst of moving back) but I'm really weary about buying one.  I've always lived in walkable areas in SD but needed a car for weekly errands or commuting to work. I could go for a carpool option again.

I don't want to waste a penny ever again!

Your insight is super appreciated!

[TomTX]

I manage to not need a car on a daily basis and borrow one from a relative if there is something urgent and the errand cannot be run in a carpool. I'm going to test drive cars when I return to SD (I'm in the midst of moving back) but I'm really weary about buying one.  I've always lived in walkable areas in SD but needed a car for weekly errands or commuting to work. I could go for a carpool option again.

I don't drive many miles, so a state surplus Crown Vic was an amazing deal. Bought 4 years ago for $2,300, only thing I've put into it is routine maintenance.