Author Topic: 72t vs. Roth IRA conversion  (Read 6817 times)

NoMoarWork

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72t vs. Roth IRA conversion
« on: August 05, 2015, 11:15:29 AM »
I've seen these compared in previous posts (e.g., http://forum.mrmoneymustache.com/welcome-to-the-forum/72t-vs-roth/?action=post;last_msg=610247), but I am having some trouble understanding the comparison.

The 72(t) is pretty clear - you elect to withdraw a certain percentage of your IRA holdings early (before 59 1/2), and have to continue taking that withdrawal rate for the next X years until you turn 59 1/2. This is taxed as income. The downside is obviously the lack of flexibility on a year to year basis.

The Roth IRA conversion (and "ladder") is more confusing to me. I understand one can convert IRA funds to Roth IRA funds any year (and pay taxes on the converted amount). And that to avoid taxes/penalties, a Roth IRA needs to be held for 5 years before withdrawals. However, I do not understand how the Roth IRA can be a viable substitute for the 72(t) if I want to withdraw before turning 59 1/2. I have not seen it written that I can withdraw from a Roth IRA before 59 1/2 for any reason without penalty/tax (aside from the usual reasons like first-time home purchase, etc.).

Can anyone shed some light? Thanks.


Cathy

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Re: 72t vs. Roth IRA conversion
« Reply #1 on: August 05, 2015, 11:31:36 AM »
There's one terminological issue that I would like to nip in the bud here.

26 USC 72(t) is the section of the tax code that both establishes the 10% additional tax on certain distributions from a qualified retirement plan and also creates various exceptions to the same additional tax. The subparagraph that deals specifically with substantially equal periodic payments is 72(t)(2)(A)(iv). It doesn't make sense to equate "72(t)" itself with the substantially equal periodic payment regime, since the provision deals with many other things as well.
« Last Edit: August 05, 2015, 01:06:40 PM by Cathy »

NoMoarWork

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Re: 72t vs. Roth IRA conversion
« Reply #2 on: August 05, 2015, 11:35:06 AM »
Thanks for the clarification, let's use SEPP instead of 72(t) in the original post.

But the main question still remains: Is it possible to withdraw Roth IRA funds before 59 1/2 without penalty for any expense (not just qualified expenses such as healthcare and homeownership)? If so, how? Google is full of conflicting info.

forummm

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Re: 72t vs. Roth IRA conversion
« Reply #3 on: August 05, 2015, 11:36:36 AM »
I've seen these compared in previous posts (e.g., http://forum.mrmoneymustache.com/welcome-to-the-forum/72t-vs-roth/?action=post;last_msg=610247), but I am having some trouble understanding the comparison.

The 72(t) is pretty clear - you elect to withdraw a certain percentage of your IRA holdings early (before 59 1/2), and have to continue taking that withdrawal rate for the next X years until you turn 59 1/2. This is taxed as income. The downside is obviously the lack of flexibility on a year to year basis.

The Roth IRA conversion (and "ladder") is more confusing to me. I understand one can convert IRA funds to Roth IRA funds any year (and pay taxes on the converted amount). And that to avoid taxes/penalties, a Roth IRA needs to be held for 5 years before withdrawals. However, I do not understand how the Roth IRA can be a viable substitute for the 72(t) if I want to withdraw before turning 59 1/2. I have not seen it written that I can withdraw from a Roth IRA before 59 1/2 for any reason without penalty/tax (aside from the usual reasons like first-time home purchase, etc.).

Can anyone shed some light? Thanks.

You would do the Pipeline to drain your 401k and TIRA. You can take out your Roth contributions at any time. And then you would do SEPP to drain your Roth earnings before 59.5.

NoMoarWork

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Re: 72t vs. Roth IRA conversion
« Reply #4 on: August 05, 2015, 11:40:39 AM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

Also, are employer-match contributions eligible for penalty-free withdrawal?
« Last Edit: August 05, 2015, 11:43:38 AM by NoMoarWork »

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #5 on: August 05, 2015, 11:46:23 AM »
But the main question still remains: Is it possible to withdraw Roth IRA funds before 59 1/2 without penalty for any expense (not just qualified expenses such as healthcare and homeownership)? If so, how? Google is full of conflicting info.

Yes, it is possible. You need to be 59 (or disabled, buying a first home, etc.) to make qualified distributions. The Roth pipeline relies on you taking non-qualified distributions. The law specifies a set of ordering rules for these distributions: contributions come out first, then conversions (oldest first), then earnings. Of these, only conversions newer than five years and earnings are subject to the 10% early withdrawal penalty. Contributions of any age and conversions older than five years are not.

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #6 on: August 05, 2015, 11:48:28 AM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

You have to wait five years, but yes. Any amount that this money grows after being placed in the Roth account should be left there until you turn 59.

Quote
Also, are employer-match contributions eligible for penalty-free withdrawal?

Yes. When you convert your 401(k) to a Roth IRA, the law doesn't distinguish between funds that came out of your paycheck and funds that your employer contributed to the account on your behalf.

NoMoarWork

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Re: 72t vs. Roth IRA conversion
« Reply #7 on: August 05, 2015, 11:49:38 AM »
Thanks. More clarifying questions:

Let's say I contributed 100K to my 401K and earned 100K in capital gains etc for a total balance of 200K.

I convert 401 K > TIRA > Roth IRA.

Now, I have 200K in my Roth IRA.

Assume my portfolio stays flat for the 5-year waiting period just to make the math simple.

5 years later, I have 200K in my Roth IRA.

Question: Is only 100K eligible as a contribution for penalty-free/tax-free withdrawal, since that is all I actually contributed. Or is the entire 200K eligible since as soon as I converted, the full amount converted is considered a "contribution"?

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #8 on: August 05, 2015, 12:17:46 PM »
In this scenario you have zero "contributions" to the Roth IRA. Only amounts you moved directly from your checking account into the Roth IRA count toward this category. Instead you have $200k of "conversions." After the five-year waiting period you would be allowed to withdraw $200k tax-free and penalty-free from the Roth IRA, whether your balance at that time is $200k or $1 million. Any growth would be subject to taxation at your normal marginal rate plus a 10% penalty, which is why you really should wait until 59 to withdraw the earnings if at all possible.

forummm

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Re: 72t vs. Roth IRA conversion
« Reply #9 on: August 05, 2015, 12:35:30 PM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

You have to wait five years, but yes. Any amount that this money grows after being placed in the Roth account should be left there until you turn 59.

Or removed with SEPP.

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #10 on: August 05, 2015, 12:43:49 PM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

You have to wait five years, but yes. Any amount that this money grows after being placed in the Roth account should be left there until you turn 59.

Or removed with SEPP.

Fun fact: you can do SEPP withdrawals from Roth IRAs to avoid the early withdrawal penalty, but these withdrawals will still be subject to income tax if they come out of the earnings! You really do want to wait until 59 to touch the earnings if at all possible.

skunkfunk

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Re: 72t vs. Roth IRA conversion
« Reply #11 on: August 05, 2015, 01:15:14 PM »
Thanks. More clarifying questions:

Let's say I contributed 100K to my 401K and earned 100K in capital gains etc for a total balance of 200K.

I convert 401 K > TIRA > Roth IRA.

Now, I have 200K in my Roth IRA.

Assume my portfolio stays flat for the 5-year waiting period just to make the math simple.

5 years later, I have 200K in my Roth IRA.

Question: Is only 100K eligible as a contribution for penalty-free/tax-free withdrawal, since that is all I actually contributed. Or is the entire 200K eligible since as soon as I converted, the full amount converted is considered a "contribution"?

You won't have 200k. Any amount you roll over will be taxed as income. If it's small enough that you have no tax bill there's no problem. 200k is gonna be a problem.

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #12 on: August 05, 2015, 01:19:09 PM »
Thanks. More clarifying questions:

Let's say I contributed 100K to my 401K and earned 100K in capital gains etc for a total balance of 200K.

I convert 401 K > TIRA > Roth IRA.

Now, I have 200K in my Roth IRA.

Assume my portfolio stays flat for the 5-year waiting period just to make the math simple.

5 years later, I have 200K in my Roth IRA.

Question: Is only 100K eligible as a contribution for penalty-free/tax-free withdrawal, since that is all I actually contributed. Or is the entire 200K eligible since as soon as I converted, the full amount converted is considered a "contribution"?

You won't have 200k. Any amount you roll over will be taxed as income. If it's small enough that you have no tax bill there's no problem. 200k is gonna be a problem.

You don't need to have the taxes withheld from the converted sum. If you have enough funds in taxable accounts to pay the conversion tax, you can put the full $200k in the Roth account. This does highlight the advantages of converting a little bit every year rather than all at once, though. Smaller conversions are likely to be taxed at a lower rate than a big conversion that could push you up a tax bracket or two.

forummm

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Re: 72t vs. Roth IRA conversion
« Reply #13 on: August 05, 2015, 01:33:08 PM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

You have to wait five years, but yes. Any amount that this money grows after being placed in the Roth account should be left there until you turn 59.

Or removed with SEPP.

Fun fact: you can do SEPP withdrawals from Roth IRAs to avoid the early withdrawal penalty, but these withdrawals will still be subject to income tax if they come out of the earnings! You really do want to wait until 59 to touch the earnings if at all possible.

Wow, I didn't know that. How has this not been mentioned on this forum recently? That makes things a little more complicated.

MoonShadow

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Re: 72t vs. Roth IRA conversion
« Reply #14 on: August 05, 2015, 01:34:38 PM »
Thanks. More clarifying questions:

Let's say I contributed 100K to my 401K and earned 100K in capital gains etc for a total balance of 200K.

I convert 401 K > TIRA > Roth IRA.

Now, I have 200K in my Roth IRA.


You won't have this much.  You have to pay taxes during the conversion process.

Quote

Assume my portfolio stays flat for the 5-year waiting period just to make the math simple.

5 years later, I have 200K in my Roth IRA.

Question: Is only 100K eligible as a contribution for penalty-free/tax-free withdrawal, since that is all I actually contributed. Or is the entire 200K eligible since as soon as I converted, the full amount converted is considered a "contribution"?

The entire amount left after taxes.

MoonShadow

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Re: 72t vs. Roth IRA conversion
« Reply #15 on: August 05, 2015, 01:37:59 PM »
Thanks for the reply.

So let's say I have an TIRA. I convert to Roth IRA. From this point onward, you are saying that every dollar I contributed (into my TIRA/401K originally) is now eligible for penalty-free and tax-free withdrawals from my Roth IRA account, even though those contributions were not originally made into the Roth IRA, but rather into the TIRA/401K. Correct?

You have to wait five years, but yes. Any amount that this money grows after being placed in the Roth account should be left there until you turn 59.

Or removed with SEPP.

Fun fact: you can do SEPP withdrawals from Roth IRAs to avoid the early withdrawal penalty, but these withdrawals will still be subject to income tax if they come out of the earnings! You really do want to wait until 59 to touch the earnings if at all possible.

Wow, I didn't know that. How has this not been mentioned on this forum recently? That makes things a little more complicated.

SEPP's are complicated already, and are often a penalty land-mine.  It is false to believe that you actually get to decide how much the actual payment are.  You don't.  The actual "substantially equal payments" are mathmatically derived using one of three official life expectancy tables.  You can choose the table/method, but not anything else.

MoonShadow

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Re: 72t vs. Roth IRA conversion
« Reply #16 on: August 05, 2015, 01:44:40 PM »
It should also be noted that, if you have this 401k with a current employer, and you retire from that employer after your 55th birthday, you don't have to worry about any of this stuff.  Because there is a special 'early retirement' rule that allows you to take normal, "qualified" distributions from this 401k only after 55 years old.

seattlecyclone

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Re: 72t vs. Roth IRA conversion
« Reply #17 on: August 05, 2015, 02:19:30 PM »
Thanks. More clarifying questions:

Let's say I contributed 100K to my 401K and earned 100K in capital gains etc for a total balance of 200K.

I convert 401 K > TIRA > Roth IRA.

Now, I have 200K in my Roth IRA.


You won't have this much.  You have to pay taxes during the conversion process.

Quote

Assume my portfolio stays flat for the 5-year waiting period just to make the math simple.

5 years later, I have 200K in my Roth IRA.

Question: Is only 100K eligible as a contribution for penalty-free/tax-free withdrawal, since that is all I actually contributed. Or is the entire 200K eligible since as soon as I converted, the full amount converted is considered a "contribution"?

The entire amount left after taxes.

Once again...just because a Roth conversion incurs a tax liability does not mean that you have to pay this tax directly out of the IRA. If you have enough money in your taxable accounts to pay the tax on the conversion, there's nothing stopping you from keeping the full $200k in your IRA in this scenario.

brooklynguy

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Re: 72t vs. Roth IRA conversion
« Reply #18 on: August 05, 2015, 02:40:35 PM »
Fun fact: you can do SEPP withdrawals from Roth IRAs to avoid the early withdrawal penalty, but these withdrawals will still be subject to income tax if they come out of the earnings! You really do want to wait until 59 to touch the earnings if at all possible.

Wow, I didn't know that. How has this not been mentioned on this forum recently? That makes things a little more complicated.

Why?  The Roth conversion pipeline, which is the most common early-stash-access plan discussed on the forum, doesn't contemplate or require access to intra-Roth earnings.  As long as you're limiting your annual conversions to an amount not much higher than your projected actual five-year-forward living expenses, you shouldn't need early access to intra-Roth earnings.  Is the issue that you planned to convert excess amounts each year in order to utilize available tax-free space (or maybe to reach minimum ACA subsidy thresholds?) and may end up depleting your tIRA "dry powder" too early?

NoMoarWork

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Re: 72t vs. Roth IRA conversion
« Reply #19 on: August 05, 2015, 02:53:58 PM »
Right, the 200K would be taxable. Plan is to take it in small bits and to offset with paper losses from RE investment properties.

forummm

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Re: 72t vs. Roth IRA conversion
« Reply #20 on: August 05, 2015, 03:31:37 PM »
Fun fact: you can do SEPP withdrawals from Roth IRAs to avoid the early withdrawal penalty, but these withdrawals will still be subject to income tax if they come out of the earnings! You really do want to wait until 59 to touch the earnings if at all possible.

Wow, I didn't know that. How has this not been mentioned on this forum recently? That makes things a little more complicated.

Why?  The Roth conversion pipeline, which is the most common early-stash-access plan discussed on the forum, doesn't contemplate or require access to intra-Roth earnings.  As long as you're limiting your annual conversions to an amount not much higher than your projected actual five-year-forward living expenses, you shouldn't need early access to intra-Roth earnings.  Is the issue that you planned to convert excess amounts each year in order to utilize available tax-free space (or maybe to reach minimum ACA subsidy thresholds?) and may end up depleting your tIRA "dry powder" too early?

I've been contributing the max to a Roth for 15 years (even some years when I could have done a TIRA but I didn't realize it would be better to do that). And I even did a conversion when I had a low income (I regret it now, but what did I know at the time) and the conversion was a lot of money and done during 2009 when the market was almost at the bottom (I thought this was smart to pay tax on it at the bottom and then pull it out tax free after it went back up--and it has doubled already not counting dividends). The point is that I already have a lot of earnings piled up in the Roth (maybe 20% of NW), and that should keep growing by a lot over the next 25 years. That ties up a huge chunk of my NW that I wasn't planning on paying taxes on. I guess it's not a disaster, but I'll need to plan more carefully how to pull it out. If the markets are good after retirement (and I work too long) I won't need the money. But if I get unlucky or I try to retire with less of a safety margin, I might have to pay some tax on it. In part due to the conversion, and in part due to not having 401k access at certain jobs in the past, I do not have that much 401k funds saved up (about as much as the Roth) and no TIRA funds at all.

I'll figure it out. Just more complicated.

brooklynguy

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Re: 72t vs. Roth IRA conversion
« Reply #21 on: August 05, 2015, 03:42:10 PM »
The point is that I already have a lot of earnings piled up in the Roth (maybe 20% of NW), and that should keep growing by a lot over the next 25 years. That ties up a huge chunk of my NW that I wasn't planning on paying taxes on.

Ah, got it.  Well, if you do end up needing to access the Roth earnings, and you continue with frugal living, the income taxes should be low to none, right?

forummm

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Re: 72t vs. Roth IRA conversion
« Reply #22 on: August 05, 2015, 05:32:52 PM »
The point is that I already have a lot of earnings piled up in the Roth (maybe 20% of NW), and that should keep growing by a lot over the next 25 years. That ties up a huge chunk of my NW that I wasn't planning on paying taxes on.

Ah, got it.  Well, if you do end up needing to access the Roth earnings, and you continue with frugal living, the income taxes should be low to none, right?

Hopefully. We were planning to increase spending in retirement. But we'll see. Part of the key to success is being flexible and resourceful. I'm not very worried. I'll probably oversave as it is.