Author Topic: I don't get the Roth IRA ladder  (Read 4976 times)

Zummbot

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I don't get the Roth IRA ladder
« on: March 23, 2015, 05:23:06 PM »
So, I have been reading up on the Roth IRA ladder business. I understand the idea, but how the ladder works and how I can get the money out after 5 years gets a little difficult to understand. See here if you don't know what I'm talking about:

http://www.madfientist.com/retire-even-earlier/

It seems like this whole strategy could go poof with a simple rule change from the IRS. And if all of your money is tied up in tax-deferred accounts that means no early retirement without paying a huge penalty to get your money out. I like the idea of retiring a couple years early, but isn't it excessively risky to bet your early retirement on this loophole staying open? I'm hoping someone more knowledgeable of this whole thing could chime in.

I'm thinking of getting about $150k or so in my 401k and let it marinate for a few decades until I'm of age, as outlined in strategy 1 by MMM here: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

Then the rest of my savings can go into post-tax investment accounts to get me to retirement age, after which the 401k funds (and social security) take over. This way my post-tax money is accessible at any time I need it, and I don't have to worry about waiting 5 years to get it and/or the IRS shutting the loophole down. Thoughts?

Eric

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Re: I don't get the Roth IRA ladder
« Reply #1 on: March 23, 2015, 06:10:00 PM »
Here's the thing.  The government likes to collect tax money.  The idea that they would decide that it's in their best interest to force you to pay your taxes later rather than now doesn't make much sense to me.  Because that's all the Traditional IRA to Roth IRA conversion does.  It pre-pays taxes.  In my mind, this isn't a loophole at all, but rather a specific design of the tax code that enables the government to collect their tax monies earlier than normal.  So I guess this isn't a big concern of mine.

But even if you don't believe the above, there is still the 72(t) SEPP withdrawal method, to get your money out of your 401k/t-IRA penalty free.  Most of us are focusing on the Roth Pipeline idea because it's more flexible and gives you more money to work with, as those substantially equal periodic payments are generally not enough to live on alone.

And finally, if both of those options are obliterated by a government that decides that your current tax money is unwanted,  that "huge penalty" you mention is only 10%.  That's only a few grand on a mustachian sized retirement budget, and should be fairly simple to come up by earning just a little extra from time to time in some manner.

kpd905

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Re: I don't get the Roth IRA ladder
« Reply #2 on: March 23, 2015, 06:28:31 PM »
I'm thinking of getting about $150k or so in my 401k and let it marinate for a few decades until I'm of age, as outlined in strategy 1 by MMM here: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

The problem with this is that you probably give up $5000+ in tax savings per year by forgoing the 401k.

And regarding the huge penalties for withdrawing early, let's take a look:

Let's say you contribute to your 401k all along and save your marginal rate of 25% federal tax + state tax on the contributions.  Now you retire and you need 40k per year.  You just pull it straight out.  How much tax do you pay?

If you are single, you pay 10% federal tax on $40k, plus your 10% penalty for a total of 20%.  So you still come out ahead by contributing to your 401k during your working years.

If you are married, let's say you pull out $50k.  You pay 7% federal tax on that $50k, plus your 10% penalty for 17%.  So you save a lot by going with the 401k.

secondcor521

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Re: I don't get the Roth IRA ladder
« Reply #3 on: March 23, 2015, 07:25:08 PM »
It seems like this whole strategy could go poof with a simple rule change from the IRS.

...

and/or the IRS shutting the loophole down. Thoughts?

The IRS implements the laws that Congress passes and the President doesn't veto.  Congress and the President are probably concerned with approximately a million other things before they get to a loophole that only a few dozen thousand Americans probably are even aware of, let alone understand and are able to use.  And then when they got to the Roth IRA pipeline they'd have to agree and pass a law.

I just don't see it happening.

rpr

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Re: I don't get the Roth IRA ladder
« Reply #4 on: March 23, 2015, 08:07:27 PM »
I'm thinking of getting about $150k or so in my 401k and let it marinate for a few decades until I'm of age, as outlined in strategy 1 by MMM here: http://www.mrmoneymustache.com/2011/11/11/how-much-is-too-much-in-your-401k/

The problem with this is that you probably give up $5000+ in tax savings per year by forgoing the 401k.

And regarding the huge penalties for withdrawing early, let's take a look:

Let's say you contribute to your 401k all along and save your marginal rate of 25% federal tax + state tax on the contributions.  Now you retire and you need 40k per year.  You just pull it straight out.  How much tax do you pay?

If you are single, you pay 10% federal tax on $40k, plus your 10% penalty for a total of 20%.  So you still come out ahead by contributing to your 401k during your working years.

If you are married, let's say you pull out $50k.  You pay 7% federal tax on that $50k, plus your 10% penalty for 17%.  So you save a lot by going with the 401k.
kpd905 -- This is a great post. To illustrate it further.

Let's consider a hypothetical couple (MFJ) in the 25% fed bracket and 8% state bracket. Let's say they plan to save 36K in two 401ks and 11K in 2 Trad IRAs. Taxes saved by contributing = 47K*0.33 = 15.5K.

If they were to retire before age 59.5, move to a state tax free place and withdraw 47K, then
Fed taxes = $3101
State taxes = 0
10% penalty = $4700

Total taxes + penalties = $7801

Total saved from contributing to 401k and IRAs = $7699!!! This is huge.

MDM

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Re: I don't get the Roth IRA ladder
« Reply #5 on: March 23, 2015, 08:34:25 PM »
The IRS implements the laws that Congress passes and the President doesn't veto.  Congress and the President are probably concerned with approximately a million other things before they get to a loophole that only a few dozen thousand Americans probably are even aware of, let alone understand and are able to use.  And then when they got to the Roth IRA pipeline they'd have to agree and pass a law.

I just don't see it happening.

Although I agree with your general conclusion, don't underestimate the desire of Congress to appeal to class envy / fair play (call it what you will) when it comes to the tax code.  E.g., from http://en.wikipedia.org/wiki/Alternative_minimum_tax#History:
Quote
A predecessor "minimum tax" was enacted by the Tax Reform Act of 1969[16] and went into effect in 1970. Treasury Secretary Joseph Barr prompted the enactment action with an announcement that 155 high-income households had not paid a dime of federal income taxes.[17] The households had taken advantage of so many tax benefits and deductions that reduced their tax liabilities to zero.

If anything, the more people who do this the less likely Congress will move to upset them.

Zummbot

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Re: I don't get the Roth IRA ladder
« Reply #6 on: March 24, 2015, 05:27:25 AM »
Thanks for the perspective guys, that helps me to understand it better. I hadn't realized that it's a good deal even if you take the penalty!
Sol, I'm going to give you the benefit of the doubt and guess you just had a bad day. If that's all you have to contribute feel free to just pass on by any future questions I might post. Thanks.

boarder42

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Re: I don't get the Roth IRA ladder
« Reply #7 on: March 24, 2015, 06:51:59 AM »
Thanks for the perspective guys, that helps me to understand it better. I hadn't realized that it's a good deal even if you take the penalty!
Sol, I'm going to give you the benefit of the doubt and guess you just had a bad day. If that's all you have to contribute feel free to just pass on by any future questions I might post. Thanks.

It was his sarcastic/funny way of saying why do anything b/c it could all go poof.  the govt could decide tomorrow that we're in a socialist/communist society and no matter you networth you're working til you're 80.  it only makes sense to make decisions based on current tax code and current laws.  b/c anyone can speculate what they could change to but you're planning then for an unknown change in govt.  that takes years and is a mess.  Fully fund all tax preferred accounts to their max and use Trad. if you're in the 15% or higher tax bracket usually... definitely if you're in the 25% bracket.

Chuck

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Re: I don't get the Roth IRA ladder
« Reply #8 on: March 24, 2015, 08:49:43 AM »

And finally, if both of those options are obliterated by a government that decides that your current tax money is unwanted,  that "huge penalty" you mention is only 10%.  That's only a few grand on a mustachian sized retirement budget, and should be fairly simple to come up by earning just a little extra from time to time in some manner.
Isn't 10% on top of income tax on earnings? I thought the Roth tax protection of earnings went poof if you withdrew early...

curler

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Re: I don't get the Roth IRA ladder
« Reply #9 on: March 24, 2015, 09:05:09 AM »

And finally, if both of those options are obliterated by a government that decides that your current tax money is unwanted,  that "huge penalty" you mention is only 10%.  That's only a few grand on a mustachian sized retirement budget, and should be fairly simple to come up by earning just a little extra from time to time in some manner.
Isn't 10% on top of income tax on earnings? I thought the Roth tax protection of earnings went poof if you withdrew early...

Yes, but for many here their income after FIRE will be so much lower than while they were working that the difference in tax rates will more than offset the additional 10%  (e.g. 10% tax that I pay in retirement plus 10% penalty is less than 25% tax I pay while working).