Author Topic: Help Me Understand the Roth IRA Conversion Ladder?  (Read 4548 times)

letitbeknown

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Help Me Understand the Roth IRA Conversion Ladder?
« on: June 04, 2015, 08:30:28 PM »
Hi MMM community,

I've been reading the Mad FIentist blog and I came across his article explaining the "Roth IRA Conversion Ladder" technique for turning pre-tax retirement contributions into post-tax withdrawals while minimizing taxes and fees.

http://www.madfientist.com/traditional-ira-vs-roth-ira/

This sounds like a great idea for traditional retirement, but it doesn't seem to make sense for early retirement. The Mad FIentist claims that you can avoid early withdrawal penalties by waiting at least 5 years before making Roth IRA withdrawals. The IRS website, however, doesn't seem to support this claim.

There's a flow chart on the IRS website explaining when Roth IRA withdrawals are subject to early withdrawal penalties and when they're not (scroll about halfway down or Ctrl+F "additional tax on early distributions").

http://www.irs.gov/publications/p590b/ch02.html

The flow chart seems to say explicitly that you have to wait at least 5 years before making Roth IRA withdrawals AND you have to be at least 59 1/2 years old. Mad FIentist seems to claim otherwise: that you can withdraw that money even if you're younger than 59 1/2 as long as you wait 5 years.

In short, Mad FIentist says it's you only have to meet A OR B requirements to avoid early withdrawal penalties (5 year wait OR 59 1/2), whereas the IRS website says you have to meet A AND B requirements (5 year wait AND 59 1/2).

Does anyone have any information to support or disprove Mad FIentist's advice on the conversion ladder strategy? Does anyone have any personal experience using this strategy as part of FIRE (58 or younger)?

I just want to make sure that if I (or others) follow this advice, that I don't run into tax problems down the road.

Thanks so much!

kpd905

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #1 on: June 04, 2015, 08:41:53 PM »
This line from the article is something I haven't heard:

"On October 15, 2010, Justin converted all $80,000 in his traditional IRA to his Roth IRA. His Forms 8606 from prior years show that $20,000 of the amount converted is his basis.

Justin included $60,000 ($80,000 − $20,000) in his gross income."

Can someone explain what they are saying here?  I think it just means that $20,000 of it was non-deductible at the time he put it into his traditional IRA?  I guess I just never thought of thought because I would just put money into a Roth IRA if I couldn't deduct the traditional IRA contribution.
« Last Edit: June 04, 2015, 08:56:50 PM by kpd905 »

MDM

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #2 on: June 04, 2015, 09:06:23 PM »
I think it just means that $20,000 of it was non-deductible at the time he put it into his traditional IRA?  I guess I just never thought of thought because I would just put money into a Roth IRA if I couldn't deduct the traditional IRA contribution.
Yes, exactly.

Once upon a time there was no such thing as a Roth IRA....

kpd905

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #3 on: June 04, 2015, 09:10:44 PM »
Yes, exactly.

Once upon a time there was no such thing as a Roth IRA....

Good point. 

I am still having trouble finding the exact form that allows withdrawal of conversions after 5 years. 

Although if you plug some numbers into part 3 of form 8606, and have your total amount of conversions higher than your distribution, it shows up as being a non-taxable event.

http://www.irs.gov/pub/irs-prior/f8606--2014.pdf
« Last Edit: June 04, 2015, 09:26:17 PM by kpd905 »

forummm

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MDM

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #5 on: June 04, 2015, 09:32:43 PM »
It is confusing because at first glance it appears the distribution has to be a "qualified distribution" to be non-taxable - but that isn't true.

Can't find the clear explanation that I know exists and have to run now.  Maybe someone will have posted it by the time I get back and find it. :)

MDM

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #6 on: June 04, 2015, 10:55:18 PM »
Ok, what I remembered doesn't answer the specific question here, but it is related.  See http://www.mymoneyblog.com/can-i-really-withdraw-my-roth-ira-contributions-at-any-time-without-tax-or-penalty.html regarding the ability to withdraw Roth contributions tax- and penalty-free at any time.

Jags4186

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #7 on: June 05, 2015, 05:50:11 AM »
If you read the flow chart it explicitly says

"The portion of the distribution allocable to earnings may be subject to tax..."

That means your contributions are not subject to tax, I.E. You can withdraw the exact amount of your rollover 5 years later, but no more without penalty.

MDM

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #8 on: June 05, 2015, 08:58:06 AM »
If you read the flow chart it explicitly says

"The portion of the distribution allocable to earnings may be subject to tax..."

That means your contributions are not subject to tax, I.E. You can withdraw the exact amount of your rollover 5 years later, but no more without penalty.

Unfortunately two similar words, "contributions" and "conversions", have different meanings for Roth IRAs.  And sometimes the distinction is made via the adjective: regular contributions vs. rollover contributions.  The flowchart covers regular contributions, not conversions or rollover contributions.  E.g., a regular contribution is withdrawable at any time without tax or penalty, but a penalty is assessed on conversions withdrawn within 5 years.

As kpd905 mentioned (and publication 590 states): "To figure the taxable part of a distribution that is not a qualified distribution, complete Form 8606, Part III."

letitbeknown

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Re: Help Me Understand the Roth IRA Conversion Ladder?
« Reply #9 on: June 05, 2015, 02:55:28 PM »
Thanks for all the responses! This topic might be even more complex than I thought. I'm working my way through the linked articles, so hopefully that sheds more light on the subject.