Question about tax strategy re: ROTH

[cheapass]

OK so our plan has always been max out both 401K's and spill over the remaining investment dollars to taxable vanguard account. Then in 8 years when we are scheduled to FIRE, we start the Roth conversion ladder on the 401K's while using our taxable account dollars to live off of during the 5 year soak time.

Recently I've been questioning if we should add in a Roth as the secondary investment vehicle and max that out before we hit the taxable accounts. My concerns are -

1) If we withdraw the Roth funds before 59 1/2 (which we will) and we need to withdraw earnings along with principal, I understand the earnings will be considered a "non-qualified distribution" and will be taxed at ordinary income rates + 10%. Is this accurate? If so, then the taxable account would be preferable because earnings would only be taxed at the capital gains/dividends rate.

2) If the above statement about Roth earnings distributions is correct, how does this affect the conversion ladder? Say you convert money from an IRA to Roth and let it soak for 5 years before withdrawing, wouldn't the earnings still be a "non-qualified distribution" and taxed heavily because it's early? I guess I'm confused about how the conversion ladder gets around the non-qualified distribution penalty.

Thanks!

[boarder42]

umm you should be spilling over into a roth IRA or Trad IRA prior to taxable.  and possibly an HSA if available.  but you're allowed to withdraw contributions from a roth ... you only with draw monies that were put in for 5 years after a roll over or you will be hit with that penalty if the IRS figures it out. or you do the right thing and do your taxes correct in the first place.

it  gets around it b/c its a contribution not an earning.

for example

i retire with the following

700k 401k (rolled into trad IRA)

100k Roth IRA (60k contributions)

200k taxable.

year one i roll 40k*1.03^5 from my Trad IRA to my roth 46.5k and pay taxes on this
Year's 1-4 i draw down my 60k original contributions and 200k taxable
in year 5 i can withdraw that 46.5k but not any gains its made

[cheapass]

umm you should be spilling over into a roth IRA or Trad IRA prior to taxable.  and possibly an HSA if available.  but you're allowed to withdraw contributions from a roth ...

OK. Makes sense about the conversion ladder only pulling out contributions. But I'm still confused about why a Roth is better than a taxable account. What if you need the whole enchilada (contributions + earnings) prior to 59 1/2? You'd be getting raped on taxes on the earnings for the Roth whereas with the taxable you'd be paying very low rates on earnings. Is Roth better if you plan on keeping the earnings in it til you're old?

[boarder42]

it kinda depends on your plan and your balance but you only need a 5 year bridge and saving extra in taxable isnt ideal. a lot more information would be needed to figure out the ideal situation. 

[cheapass]

it kinda depends on your plan and your balance but you only need a 5 year bridge and saving extra in taxable isnt ideal. a lot more information would be needed to figure out the ideal situation.

OK. Maybe you can help me out.

Current Values
$174K 401K's/IRA's
$23K Taxable
$197K Total Invested Assets

Annual Contributions
~$45K to 401K's (IRS max + company matches)
$30K to taxable

FIRE Goal
$1.5M which will produce $60K/yr at 4% SWR ($ values are 2016 dollars)

[boarder42]

yeah you should be doing roth or possibly trad IRA and should also look into HSA.  you're gonn have way too much taxable. 

[boarder42]

just think about your time to FIRE.  you're going to have almost half a million in taxable in 10 years when you hit fire at current savings and contribution rates.  just pulling that down to 19k and maxing an IRA still leaves 326k taxable ... which is more than you need assuming no gains for your five year bridge.

[cheapass]

just think about your time to FIRE.  you're going to have almost half a million in taxable in 10 years when you hit fire at current savings and contribution rates.  just pulling that down to 19k and maxing an IRA still leaves 326k taxable ... which is more than you need assuming no gains for your five year bridge.

Good stuff. I'll have to figure out our MAGI to see if we can qualify for a full or partial IRA contribution for 2016. From my Google research it appears I have until April to make a contribution and we will have all of our tax documents before then. If I am eligible, I'll put it all in a traditional IRA and that will mean I can not contribute to a Roth.

Are the $5,500 limits per individual or per couple?

[cheapass]

just think about your time to FIRE.  you're going to have almost half a million in taxable in 10 years when you hit fire at current savings and contribution rates.  just pulling that down to 19k and maxing an IRA still leaves 326k taxable ... which is more than you need assuming no gains for your five year bridge.

Good stuff. I'll have to figure out our MAGI to see if we can qualify for a full or partial IRA contribution for 2016. From my Google research it appears I have until April to make a contribution and we will have all of our tax documents before then. If I am eligible, I'll put it all in a traditional IRA and that will mean I can not contribute to a Roth.

Are the $5,500 limits per individual or per couple?

Well shit. New information that I've found says that if you're covered by a retirement plan at work (which we both are) and income is >$118K (which it is) there is no deduction for an IRA. I wonder if we can still contribute to a Roth..

[cheapass]

should also look into HSA. 

I understand contributions and earnings to a HSA are all tax-free but you can only use it for medical expenses. If I understand it correctly, you can't use it for insurance premiums correct? It seems extremely limited.

[boarder42]

1. you should be able to still contribute to a roth and the 118k is AGI not gross so maybe even a trad
2. HSA's turn into basically Trad IRA's once you hit 59.5 or somehting like that meaning you can withdraw for non medical and just pay taxes.

but an HSA if you do salary deduct bypasses FICA too its huge. esp. with your salary.

5500 limit is per person.

[cheapass]

1. you should be able to still contribute to a roth and the 118k is AGI not gross so maybe even a trad
2. HSA's turn into basically Trad IRA's once you hit 59.5 or somehting like that meaning you can withdraw for non medical and just pay taxes.

but an HSA if you do salary deduct bypasses FICA too its huge. esp. with your salary.

5500 limit is per person.

Thanks for all the info. Very helpful.

[seattlecyclone]

umm you should be spilling over into a roth IRA or Trad IRA prior to taxable.  and possibly an HSA if available.  but you're allowed to withdraw contributions from a roth ...

OK. Makes sense about the conversion ladder only pulling out contributions. But I'm still confused about why a Roth is better than a taxable account. What if you need the whole enchilada (contributions + earnings) prior to 59 1/2? You'd be getting charged more taxes on the earnings for the Roth whereas with the taxable you'd be paying very low rates on earnings. Is Roth better if you plan on keeping the earnings in it til you're old?

If you need to tap into the earnings prior to 59 1/2 and don't have a pension to start around that time, you likely will run out of money before you die. Try to save enough money to not run out before you die and this will not be an issue.

Also, please avoid comparing higher taxation to sexual assault. The two are not remotely comparable.

[cheapass]

umm you should be spilling over into a roth IRA or Trad IRA prior to taxable.  and possibly an HSA if available.  but you're allowed to withdraw contributions from a roth ...

OK. Makes sense about the conversion ladder only pulling out contributions. But I'm still confused about why a Roth is better than a taxable account. What if you need the whole enchilada (contributions + earnings) prior to 59 1/2? You'd be getting charged more taxes on the earnings for the Roth whereas with the taxable you'd be paying very low rates on earnings. Is Roth better if you plan on keeping the earnings in it til you're old?

If you need to tap into the earnings prior to 59 1/2 and don't have a pension to start around that time, you likely will run out of money before you die. Try to save enough money to not run out before you die and this will not be an issue.

Also, please avoid comparing higher taxation to sexual assault. The two are not remotely comparable.

So if my choices are

1) Use Roth, don't touch earnings til 59 1/2, have to work longer to save more to accommodate this vs. 2) Use taxable, withdraw earnings whenever, retire earlier

I'd choose #2... am I missing something?

[boarder42]

umm you should be spilling over into a roth IRA or Trad IRA prior to taxable.  and possibly an HSA if available.  but you're allowed to withdraw contributions from a roth ...

OK. Makes sense about the conversion ladder only pulling out contributions. But I'm still confused about why a Roth is better than a taxable account. What if you need the whole enchilada (contributions + earnings) prior to 59 1/2? You'd be getting charged more taxes on the earnings for the Roth whereas with the taxable you'd be paying very low rates on earnings. Is Roth better if you plan on keeping the earnings in it til you're old?

If you need to tap into the earnings prior to 59 1/2 and don't have a pension to start around that time, you likely will run out of money before you die. Try to save enough money to not run out before you die and this will not be an issue.

Also, please avoid comparing higher taxation to sexual assault. The two are not remotely comparable.

So if my choices are

1) Use Roth, don't touch earnings til 59 1/2, have to work longer to save more to accommodate this vs. 2) Use taxable, withdraw earnings whenever, retire earlier

I'd choose #2... am I missing something?

you missed entirely what seattle was meaning.  you should use a roth i showed you the math look at it understand it then move on with your life. 

[seattlecyclone]

My point was that if you save enough money to last for the rest of your life, you won't find yourself running out of everything but Roth earnings before you turn 60.

[boarder42]

My point was that if you save enough money to last for the rest of your life, you won't find yourself running out of everything but Roth earnings before you turn 60.

boom

better than i woudl have said it.