Author Topic: So the Roth conversion ladder works much better if you have 401k?  (Read 2000 times)

Nick_Miller

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Love the Mad Fientist, all his podcasts, etc., (he's awesome!) BUT the more I look at the numbers for the Roth conversion ladder, the more I realize that it really only works well if you can pour huge amounts of $ into a 401k in the first place.

http://www.madfientist.com/how-to-access-retirement-funds-early/

I say this because you can save about 3 times as much money each year in a 401k as you can into an IRA, so if you don't have access to a 401k, you can only contribute $5,500 per year (assume a single person), so after let's say 20 years of maxing out your IRA, you only have $110,000 in contributions, which are the only part of your Roth that you can withdraw penalty-free before age 59.5. Approximately $110,000 in contributions, assuming you just withdraw $24,000 per year to live (very low), doesn't even give you 5 years of ER.

Whereas if you would have been able to max out a 401k for 20 years, (about $370,000) and then convert to IRA and then convert to Roth, the entire amount from your 401K becomes a "contribution," right? Meaning that you could withdraw $24,000, giving you 15 years of ER while you let your interest keep accumulating over that time.

So I guess my question is, can anyone really use the Roth conversion ladder without having a 401k as the basis of it all? Or does it just become a thinner leg of your stool without a 401k, forcing you to focus more on taxable investments?

I'm still a newbie, so if I'm totally off with my reasoning, please show me the light. I'm honestly confused about this.

secondcor521

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #1 on: May 23, 2017, 07:55:21 AM »
You are mostly correct.

The contribution limits on 401k's [1] are currently about 3x (about 4x if you're older and can do catchup contributions) the IRA contribution limits, so piling up investments is easier in 401k's.

You can immediately roll a 401k to a traditional IRA [2] with no tax consequences.  You can then convert money from the traditional IRA to a Roth IRA; the conversions get added to your tax return as ordinary income.  The conversions are *not* contributions, but after 5 years they can be withdrawn without the 10% penalty.

Supplementing a Roth conversion ladder with a taxable account can be necessary in some cases.  In fact, I am doing a Roth conversion ladder myself and my 5 year ladder is a combination of savings, a taxable account, my Roth contributions, and my Roth conversions.

One final note - the 5 year Roth conversion ladder time frame is based on the calendar year when you make the contribution and when you make the withdrawal, so you can convert some money in December 2017 and withdraw it in January 2022 and that money will escape the 10% penalty even though the actual elapsed time was more like 4 years and 1 month.

[1] A technical correction - 401k's are very common in private industry, but there are other plans such as 403b's and 457's that have similarly large annual contribution limits that I think would work just as well for Roth conversion ladders.

[2] Technically, it's a rollover IRA, but it functions nearly identically to a traditional IRA.

Nick_Miller

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #2 on: May 23, 2017, 09:29:15 AM »
I will take "mostly correct" any day of the week!

Thanks so much for the clarification. I was most confused obviously about WHY the conversions can be withdrawn penalty free after five years, and I guess I thought that they were just treated as "contributions" because that was the only thing that made sense to me, but now I see it's just a unique treatment.

My wife and I are currently maxing out Roth IRAs each year. She DOES have a 401k and we're on schedule to max it out this year, or come pretty damn close. However, my work does not offer one, so we're pretty much maxed out on tax-advantaged vehicles this year.

I was thinking of next year; I should have a book being published with a decent amount of income for 2018, and I was considering setting up a solo 401k and basically putting all that income into that just to give our tax-advantaged savings a boost because plugging along at $11,000 per year, or even $29,500 per year, just seems really slow to reach the RE number. From reading about solo 401ks, it seems that you can sock away an obscene amount of money (over $50K) each year, assuming you have that much income!
« Last Edit: May 23, 2017, 09:48:01 AM by Nick_Miller »

BlueHouse

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #3 on: May 23, 2017, 10:58:10 AM »
From reading about solo 401ks, it seems that you can sock away an obscene amount of money (over $50K) each year, assuming you have that much income!
yep.  I will turn 50 this year, and I'm putting $60k into my 401k.  Honestly, that is crazy and I'm thrilled about it, but I also feel a bit guilty because as I make more money, I really see how many more benefits go "to the rich".  I don't consider myself rich yet, but I'm really trying to get there and it's true that it becomes easier and easier as you have more money. 


seattlecyclone

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #4 on: May 23, 2017, 11:23:59 AM »
you can only contribute $5,500 per year (assume a single person), so after let's say 20 years of maxing out your IRA, you only have $110,000 in contributions, which are the only part of your Roth that you can withdraw penalty-free before age 59.5.

This really depends on if you contributed to a traditional or Roth IRA. If you made $110,000 in Roth contributions, you're correct that this is the only amount you can withdraw early without penalty. However if you made $110,000 in traditional contributions and the money grew to $250,000 by the time you retired, you could convert that whole amount to Roth, pay tax on it, and withdraw it penalty-free five years later. This is more along the lines of where the "conversion ladder" comes from.

The true conversion ladder would have you convert a smaller amount each year, just as much as you think you'll want to withdraw in five years. This keeps your tax burden lower, and also allows for more of the growth to happen in the traditional account where that money would then be able to be converted in a future year.

CanuckExpat

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #5 on: May 23, 2017, 10:39:08 PM »
The true conversion ladder would have you convert a smaller amount each year, just as much as you think you'll want to withdraw in five years. This keeps your tax burden lower, and also allows for more of the growth to happen in the traditional account where that money would then be able to be converted in a future year.

If you are able to convert more than you anticipate needing in five years, while keeping your taxes owing the same, wouldn't you want to convert as much as you could?

That way the growth can happen in your Roth where it will be tax free on withdrawal? I suppose it's a trade off between tax free withdrawal, and access before age 60?

FIbyFive

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Re: So the Roth conversion ladder works much better if you have 401k?
« Reply #6 on: May 25, 2017, 07:36:03 AM »
I will take "mostly correct" any day of the week!

Thanks so much for the clarification. I was most confused obviously about WHY the conversions can be withdrawn penalty free after five years, and I guess I thought that they were just treated as "contributions" because that was the only thing that made sense to me, but now I see it's just a unique treatment.

My wife and I are currently maxing out Roth IRAs each year. She DOES have a 401k and we're on schedule to max it out this year, or come pretty damn close. However, my work does not offer one, so we're pretty much maxed out on tax-advantaged vehicles this year.

I was thinking of next year; I should have a book being published with a decent amount of income for 2018, and I was considering setting up a solo 401k and basically putting all that income into that just to give our tax-advantaged savings a boost because plugging along at $11,000 per year, or even $29,500 per year, just seems really slow to reach the RE number. From reading about solo 401ks, it seems that you can sock away an obscene amount of money (over $50K) each year, assuming you have that much income!

I can second the idea of opening a self-employed 401k! Just finished the process last week, and we are excited to contribute up to $54,000 pre-tax starting with 2017 year. It's a bit of a hassle to set up compared to SIMPLE IRAs or SEP IRAs, but I think the contribution nuances far outweigh the initial time cost.

Fidelity has 0 fee Solo 401ks, and also enable you to roll traditional IRA accounts INTO the 401k - not a very useful feature for many, but it is very beneficial in the case of earning large amounts of money. Best of luck!