Roth Conversion Questions

[prognastat]

I am working towards FIRE and I have some Roth 401k investments in my work 401 from when I was making less money though more and also some Traditional 401k in it too which right now is about equal, but more of it will be in my Traditional 401k of my work account going forward since it will be more advantageous tax wise and I plan to do a "Roth Conversion Ladder" once in FIRE using the standard and personal deductions to cover most if not all of it to limit taxes to well below my current rate.

I am also planning on doing a "Mega Backdoor Roth" since my employer's plan allows up to 10% to be contributed after tax on top of the Traditional and Roth 401k limits. They allow conversions 4 times a year on this. I am planning on rolling this over to a Vanguard Roth IRA every quarter while I am still working.

Now I know there is a 5 year limit on withdrawals on conversions and deposits if you want to withdraw the principal of the deposited or converted amount tax free.

From what I understand converting a Traditional IRA to Roth IRA as part of the "Roth Conversion Ladder" makes the whole amount of the conversion even if part of it was growth count as principal instead of growth. I was wondering though if the same goes for the whole amount available including growth of my work Roth 401k amount once I convert it to a Vanguard Roth IRA after leaving my job.

I am hoping that through a combination of the "Mega Backdoor Roth" contributions, many of which will have been well past the 5 year limit at the point that I plan on FIRE, and possibly some after tax investments along with minimizing my costs will allow me to get through the 5 year withdrawal limit.

The reason I am wondering about the Roth 401k to Roth IRA conversion though is because I need to know if I should put more in the Roth 401k, and then use that to cover the amount of spending that the "Roth Conversion Ladder" won't if the whole amount from the Roth 401k will count as principal in the Roth IRA instead of a large portion being growth. Or if instead I need to have more invested in taxed accounts to cover this difference.

The final question is if it would be worthwhile doing all of these things at all or if simply doing the "Roth Conversion Ladder" and covering all expenses with it and simply paying the taxes would be the more advantageous way to go about it and simply use the "Mega Backdoor Roth" to cover the 5 year gap?

[dandarc]

Roth 401K to Roth IRA is not a conversion - just a rollover.  Your basis (the amount contributed) will follow as "regular" contributions, so you can withdraw those, but withdrawing beyond that could result in tax and penalties.  As a reminder, the current ordering rules for withdrawals from your Roth IRA are:

1.  Regular Contributions - no tax or penalties ever
2.  Conversions in chronological order - first in first out
     2a.  On each conversion, taxable amount first - could have tax and penalty here
     2b.  On each conversion, non-taxable amount second - no tax or penalities here
3.  Earnings - tax and penalties apply unless a qualified distribution

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

[prognastat]

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

Lol my one worry. However given that so far the IRS has moved towards lightly endorsing it rather than discouraging it I'm hopeful they don't.

Thanks for the help.

The only question I have left then is whether just putting it all as Traditional 401k and taking the hit on withdrawing more than covered by the standard deduction and personal exemptions is more or less advantageous than adding more to my Roth 401k right now while my rate is probably higher.

Currently my average tax rate is just over 10% after the standard deduction and personal exemptions, however this is with maxed Traditional 401k deposits lowering our AGI. I calculated that if we transfer 40k a year using the "Roth Conversion Ladder" instead of just the amount covered by the standard deduction and personal exemptions the average tax paid on all of it would be about 5%.

If I instead started adding more to my Roth 401k or non-retirement accounts, once I get enough in the Traditional 401k to cover transferring only the 20k yearly using the conversion ladder, rather than continue in the Traditional 401k though my actual rate would bump to about 16% for those years.

Given this at least to me it seems like it might be more advantageous to just keep putting it all in Traditional 401k while using the Mega Backdoor Roth and the minimum needed in either Roth or non-retirement accounts to cover the 5 years withdrawal limit, but I'm worried I might have missed something in that logic

[dandarc]

Given this at least to me it seems like it might be more advantageous to just keep putting it all in Traditional 401k while using the Mega Backdoor Roth and the minimum needed in either Roth or non-retirement accounts to cover the 5 years withdrawal limit, but I'm worried I might have missed something in that logic

Agree - For the early retiree, traditional usually makes the most sense.

[prognastat]

Thanks for helping me clear that up.

Now the only worry is that i work on this for 8-10 years and then they close down the ability to do the conversion ladder XD.

[Spork]

Roth 401K to Roth IRA is not a conversion - just a rollover.  Your basis (the amount contributed) will follow as "regular" contributions, so you can withdraw those, but withdrawing beyond that could result in tax and penalties.  As a reminder, the current ordering rules for withdrawals from your Roth IRA are:

1.  Regular Contributions - no tax or penalties ever
2.  Conversions in chronological order - first in first out
     2a.  On each conversion, taxable amount first - could have tax and penalty here
     2b.  On each conversion, non-taxable amount second - no tax or penalities here
3.  Earnings - tax and penalties apply unless a qualified distribution

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

Just to clarify on 2a.  (I think I understand what you're saying, but I'm not sure.)  My assumption is that the taxable amount has taxes paid on it at the time of conversion, then bakes for 5 years, then comes out tax free.  I think "could have tax and penalty" refers to taking it out before 5 years (but not after).  Correct?

[dandarc]

Roth 401K to Roth IRA is not a conversion - just a rollover.  Your basis (the amount contributed) will follow as "regular" contributions, so you can withdraw those, but withdrawing beyond that could result in tax and penalties.  As a reminder, the current ordering rules for withdrawals from your Roth IRA are:

1.  Regular Contributions - no tax or penalties ever
2.  Conversions in chronological order - first in first out
     2a.  On each conversion, taxable amount first - could have tax and penalty here
     2b.  On each conversion, non-taxable amount second - no tax or penalities here
3.  Earnings - tax and penalties apply unless a qualified distribution

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

Just to clarify on 2a.  (I think I understand what you're saying, but I'm not sure.)  My assumption is that the taxable amount has taxes paid on it at the time of conversion, then bakes for 5 years, then comes out tax free.  I think "could have tax and penalty" refers to taking it out before 5 years (but not after).  Correct?

Right - once 5 years has passed since the conversion, the whole conversion amount falls into 2b.  So unlikely to run into this unless you need money faster than you anticipated when setting up the pipeline.  MegaRoth / Regular or Backdoor Contributions / Taxable account available will all help avoid this by having additional aged basis to tap in the Roth or another source of funds all together. 

Usually you'll have the whole conversion amount in either 2a, or 2b, but if your conversion had a non-taxable part to it (MegaRoth or Backdoor Roth, as examples of ways to make this happen), then you pay tax / penalty only on the taxable portion - and you'd do that even if your withdrawal doesn't tap the whole conversion amount, because the rules say your distribution tapped the taxable portion first.

[dandarc]

Thanks for helping me clear that up.

Now the only worry is that i work on this for 8-10 years and then they close down the ability to do the conversion ladder XD.

Unlikely they'll also take away the SEPP option, and often even paying the penalty you come out ahead of a taxable account, so you'll have options even if that does happen.

[prognastat]

Thanks for helping me clear that up.

Now the only worry is that i work on this for 8-10 years and then they close down the ability to do the conversion ladder XD.

Unlikely they'll also take away the SEPP option, and often even paying the penalty you come out ahead of a taxable account, so you'll have options even if that does happen.

Yeah it's not a very serious worry to me since I am relatively sure it is not going to happen.

It's unlikely the conversion ladder will be changed and even if it does it is even less likely that both that and SEPP will be closed without any new way of accessing the funds. On top of that these changes would have to happen without me hearing anything about it throughout the time I am building up my stache.

And even worst case scenario it just means working a few extra years to build up non-retirement investments to last till 59.5 and then dig in to them.

[seattlecyclone]

Roth 401K to Roth IRA is not a conversion - just a rollover.  Your basis (the amount contributed) will follow as "regular" contributions, so you can withdraw those, but withdrawing beyond that could result in tax and penalties.  As a reminder, the current ordering rules for withdrawals from your Roth IRA are:

1.  Regular Contributions - no tax or penalties ever
2.  Conversions in chronological order - first in first out
     2a.  On each conversion, taxable amount first - could have tax and penalty here
     2b.  On each conversion, non-taxable amount second - no tax or penalities here
3.  Earnings - tax and penalties apply unless a qualified distribution

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

Just to clarify on 2a.  (I think I understand what you're saying, but I'm not sure.)  My assumption is that the taxable amount has taxes paid on it at the time of conversion, then bakes for 5 years, then comes out tax free.  I think "could have tax and penalty" refers to taking it out before 5 years (but not after).  Correct?

Right - once 5 years has passed since the conversion, the whole conversion amount falls into 2b.  So unlikely to run into this unless you need money faster than you anticipated when setting up the pipeline.  MegaRoth / Regular or Backdoor Contributions / Taxable account available will all help avoid this by having additional aged basis to tap in the Roth or another source of funds all together. 

Usually you'll have the whole conversion amount in either 2a, or 2b, but if your conversion had a non-taxable part to it (MegaRoth or Backdoor Roth, as examples of ways to make this happen), then you pay tax / penalty only on the taxable portion - and you'd do that even if your withdrawal doesn't tap the whole conversion amount, because the rules say your distribution tapped the taxable portion first.

Actually for 2a there's only the 10% early withdrawal tax. You already paid regular income tax on that money when you converted it, you don't get charged again for an early withdrawal.

[prognastat]

Roth 401K to Roth IRA is not a conversion - just a rollover.  Your basis (the amount contributed) will follow as "regular" contributions, so you can withdraw those, but withdrawing beyond that could result in tax and penalties.  As a reminder, the current ordering rules for withdrawals from your Roth IRA are:

1.  Regular Contributions - no tax or penalties ever
2.  Conversions in chronological order - first in first out
     2a.  On each conversion, taxable amount first - could have tax and penalty here
     2b.  On each conversion, non-taxable amount second - no tax or penalities here
3.  Earnings - tax and penalties apply unless a qualified distribution

Overall your plan is sound - between regular Roth contributions and properly aged conversions from your Mega-Roth activity, you should have a decent buffer to prime the Roth IRA pipeline.  Assuming the technique continues to be legal, of course.

Just to clarify on 2a.  (I think I understand what you're saying, but I'm not sure.)  My assumption is that the taxable amount has taxes paid on it at the time of conversion, then bakes for 5 years, then comes out tax free.  I think "could have tax and penalty" refers to taking it out before 5 years (but not after).  Correct?

Right - once 5 years has passed since the conversion, the whole conversion amount falls into 2b.  So unlikely to run into this unless you need money faster than you anticipated when setting up the pipeline.  MegaRoth / Regular or Backdoor Contributions / Taxable account available will all help avoid this by having additional aged basis to tap in the Roth or another source of funds all together. 

Usually you'll have the whole conversion amount in either 2a, or 2b, but if your conversion had a non-taxable part to it (MegaRoth or Backdoor Roth, as examples of ways to make this happen), then you pay tax / penalty only on the taxable portion - and you'd do that even if your withdrawal doesn't tap the whole conversion amount, because the rules say your distribution tapped the taxable portion first.

Actually for 2a there's only the 10% early withdrawal tax. You already paid regular income tax on that money when you converted it, you don't get charged again for an early withdrawal.

That's interesting, so in the 40k scenario even if it was withdrawn in under the 5 years adding up the 5% paid when converting and 10% early penalty would still put it only at a 15% rate. Not that I would be doing this, but still interesting to see it still be quite low.

[Daisy]

Does anyone know if the 10% penalty is on AGI or the total amount withdrawn from the IRA? In other words, can we apply deductions?

For example, pull out $40k. You only pay income tax on $40k minus deductions, but is the penalty $4k?

[Spork]

Does anyone know if the 10% penalty is on AGI or the total amount withdrawn from the IRA? In other words, can we apply deductions?

For example, pull out $40k. You only pay income tax on $40k minus deductions, but is the penalty $4k?

Not 100% certain, but my limited understanding is that the $40k gets added to your ordinary income and taxes are figured out as normal (with deductions, etc).  Then... add a $4k additional on top of that.

There are also a list of exceptions to the 10% penalty: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-tax-on-early-distributions

[seattlecyclone]

If the $40k is just a straight withdrawal from your pre-tax IRA, you'll have $40k added on to your income and taxed accordingly. Then you'll have an extra $4k (10% of $40k) added on to the tax on top of that.

[Daisy]

Thanks.  That's what  i figured. So it could affect the calculations of which method is best. I assume the MadFIentist  took it into account.

[prognastat]

Thanks.  That's what  i figured. So it could affect the calculations of which method is best. I assume the MadFIentist  took it into account.

Yeah that is what we were talking about.

So from what I understand withdrawing/conversion from a traditional 401k or traditional IRA are considered income and are taxed accordingly.

The standard deduction, personal exemptions and child dependents will lower the income counted for taxing.
Standard Deduction(2016):
$6,300 for singles/married persons filing separate returns and $12,600 for married couples filing jointly.
Personal Exemption(2016):
 $4,050

Whatever is left after your deductions is taxed at the appropriate rate for the amount when you convert it from a Traditional IRA to a Roth IRA.

Then if you wait 5 years from the conversion you can withdraw the deposited amount without growth tax free and without penalty. However if you withdraw before the 5 years is up there is no additional tax, but there is an additional 10% penalty.

Mathmatically it makes most sense to wait the 5 years and not be hit by the 10% penalty. However if you are currently paying 20% tax on average and saving a very high % to traditional 401k yet transfer only 40k from your Traditional IRA to Roth IRA for example in FIRE you would still only effetely be losing 15% of your money as opposed to the 20% that would have been taken out by investing it after tax in a Roth 401k/IRA. Of course the higher your withdraws in retirement are the closer it will be to breaking even.

[Daisy]

Yes I understand the tax benefits of avoiding the 25% tax while working by putting into 401k and then doing the Roth conversion pipeline while FIRE'd to stay in 15 % bracket.

But the other method where you bypass the Roth and just take out straight from the traditional IRA and pay the penalty it seems like that 10% affects the whole withdrawal so was wondering if it was still a viable option as the MadFIentist says it is.

[prognastat]

Yes I understand the tax benefits of avoiding the 25% tax while working by putting into 401k and then doing the Roth conversion pipeline while FIRE'd to stay in 1 % bracket.

But the other method where you bypass the Roth and just take out straight from the traditional IRA and pay the penalty it seems like that 10% affects the whole withdrawal so was wondering if it was still a viable option as the MadFIentist says it is.

I might be wrong, but I suspect at that point there is no difference between taking it out of the Roth before the 5 year window is up. In the 40k example you would be paying 5% income tax plus 10% early withdrawal penalty so 15% just like the 5% income tax on the conversion of Trad IRA to Roth IRA and then the 10% early withdraw penalty on the Roth IRA in the first 5 years. I think the only time you get the better deal is if you leave it in the Roth IRA for 5 years to avoid the 10% early penalty and only pay the 5% income tax you paid when doing the conversion.