How is the Roth IRA Escape Hatch Loophole Possible?

[BallardStubble]

Pardon my ignorance on this matter, but I'm confused at how this practically works. Maybe I'm just not thinking straight because it's late at night. But anyways, if you can help me understand this, it would put my mind at ease. I understand the loophole of retiring, and transferring over your annual expenses ($30k example) into a Roth IRA account. You then rinse and repeat...forever, correct? Assuming that, you'd have to have $750k'ish in your 401k account to allow that $30k to rebuild annually before removing it, assuming a 4% transfer rate after inflation. But if 401k contributions top off at $18k and you want to have an 8 year working career, your 401k net would only be between $150k-$200k. If you retire at that point (assuming you have other investments and assets), you'd only be able to take that $30k out for a few years before it's depleted.

So, how does this work? Again, please excuse my ignorance on this, I'm sure it's something simple and I'm just being dumb.

[shuffler]

It doesn't work.
If you only save $18k x 8 years, then you haven't saved enough to retire w/ a $30k annual spend.

[arebelspy]

If you only save $18k x 8 years, then you haven't saved enough to retire w/ a $30k annual spend.

Right.  You can't just choose "Ehhh, I only want to work 8 years" and spend whatever level you want.

Let's run some numbers.  Fun!  :)

Assuming 4% SWR..

8 years of working means a savings rate of 72.5%.

A annual FIRE spend of 30k, at 4% WR, means a stache of 750k.

To end with a portfolio of 750k in 8 years, assuming a 7% annual return, you'd need to save $73,100.82/yr.  If you're saving 18k each year in your 401k, that leaves $55,100.82 going to taxable each year.

When you FIRE, approximately 75% of your money will be in taxable accounts.

I'd suggest spending down on that taxable while you roll over those 401k earnings each year, and letting them build within the Roth.

In other words, this is all correct:

Assuming that, you'd have to have $750k'ish in your 401k account to allow that $30k to rebuild annually before removing it, assuming a 4% transfer rate after inflation. But if 401k contributions top off at $18k and you want to have an 8 year working career, your 401k net would only be between $150k-$200k.

You understand it.  :)

[Jeremy E.]

Don't forget you can put money in an IRA too($5,500), that's $23,000 per year total, but you will still have lots in a taxable account.

[BallardStubble]

I apologize in advance for the long reply :/

So, it's used more as a supplemental income than anything else? Ie, $150k in the Roth IRA would allow you to withdrawal $6k annually, needing the other $24k from taxable accounts.

So, new question. Is it even worth it to invest in the 401k? I understand if I take $100 and put it into the 401k, I end up getting $85 of that back since I'll be in the 15% tax bracket when I go to take the funds out. And if I take $100 now out of my paycheck, I get $75 of that immediately, since I'm in a 25% tax bracket, and I can invest that in index funds. But ultimately, that $75 becomes $63.75 once I withdraw my return, so I'm looking at a pretty big tax difference there (let me know if I'm misunderstanding how this works. I'm also in Washington state, so no state income tax here).

However, would it make sense to get that account up to $150k and then to stop investing, which would stop the major growth of the compounding interest snowball at that point just for the tax break, or would I make more money taking that $150k (or $112.5k after taxes) and put that in index funds so I can just constantly focus on that and grow it?

Just doing some quick calculation, I'd probably be looking at this (My 401k has averaged 7%, but I'm going with 4% to account for inflation on returns and 5% for Index Fund Investments):

Year 1: 401k Balance: $18k. Index Fund Balance: $32k.
Year 2: 401k Balance: $36,720. Index Fund Balance: $65,600.
Year 3: 401k Balance: $56,188. Index Fund Balance: $100,880.
Year 4: 401k Balance: $76,435. Index Fund Balance: $137,924
Year 5: 401k Balance: $97,492. Index Fund Balance: $176,820
Year 6: 401k Balance: $119,392. Index Fund Balance: $217,661
Year 7: 401k Balance: $140,168. Index Fund Balance: $260,544
Year 8: 401k Balance: $163,775. Index Fund Balance: $305,571
Year 9: 401k Balance: $188,326. Index Fund Balance: $352,850
Year 10: 401k Balance: $213,859. Index Fund Balance: $402,492
Year 11: 401k Balance: $240,413. Index Fund Balance: $454,617
Net: $695,030 or $27,801 SWR.

BUT, what if I totally ignored 401k investments and just went with Index funds. Then it would look like this:

Year 1 Index Fund Balance: $50k
Year 2 Index Fund Balance: $102.5k
Year 3 Index Fund Balance: $157,625
Year 4 Index Fund Balance: $215,506
Year 5 Index Fund Balance: $276,281
Year 6 Index Fund Balance: $340,095
Year 7 Index Fund Balance: $407,100
Year 8 Index Fund Balance: $477,455
Year 9 Index Fund Balance: $551,328
Year 10 Index Fund Balance: $628,894
Year 11 Index Fund Balance: $710,339
Net Total: $710,339

So, what am I missing here?

[Jeremy E.]

I apologize in advance for the long reply :/

So, it's used more as a supplemental income than anything else? Ie, $150k in the Roth IRA would allow you to withdrawal $6k annually, needing the other $24k from taxable accounts.

So, new question. Is it even worth it to invest in the 401k? I understand if I take $100 and put it into the 401k, I end up getting $85 of that back since I'll be in the 15% tax bracket when I go to take the funds out. And if I take $100 now out of my paycheck, I get $75 of that immediately, since I'm in a 25% tax bracket, and I can invest that in index funds. But ultimately, that $75 becomes $63.75 once I withdraw my return, so I'm looking at a pretty big tax difference there (let me know if I'm misunderstanding how this works. I'm also in Washington state, so no state income tax here).

However, would it make sense to get that account up to $150k and then to stop investing, which would stop the major growth of the compounding interest snowball at that point just for the tax break, or would I make more money taking that $150k (or $112.5k after taxes) and put that in index funds so I can just constantly focus on that and grow it?

Just doing some quick calculation, I'd probably be looking at this (My 401k has averaged 7%, but I'm going with 4% to account for inflation on returns and 5% for Index Fund Investments):

Year 1: 401k Balance: $18k. Index Fund Balance: $32k.
Year 2: 401k Balance: $36,720. Index Fund Balance: $65,600.
Year 3: 401k Balance: $56,188. Index Fund Balance: $100,880.
Year 4: 401k Balance: $76,435. Index Fund Balance: $137,924
Year 5: 401k Balance: $97,492. Index Fund Balance: $176,820
Year 6: 401k Balance: $119,392. Index Fund Balance: $217,661
Year 7: 401k Balance: $140,168. Index Fund Balance: $260,544
Year 8: 401k Balance: $163,775. Index Fund Balance: $305,571
Year 9: 401k Balance: $188,326. Index Fund Balance: $352,850
Year 10: 401k Balance: $213,859. Index Fund Balance: $402,492
Year 11: 401k Balance: $240,413. Index Fund Balance: $454,617
Net: $695,030 or $27,801 SWR.

BUT, what if I totally ignored 401k investments and just went with Index funds. Then it would look like this:

Year 1 Index Fund Balance: $50k
Year 2 Index Fund Balance: $102.5k
Year 3 Index Fund Balance: $157,625
Year 4 Index Fund Balance: $215,506
Year 5 Index Fund Balance: $276,281
Year 6 Index Fund Balance: $340,095
Year 7 Index Fund Balance: $407,100
Year 8 Index Fund Balance: $477,455
Year 9 Index Fund Balance: $551,328
Year 10 Index Fund Balance: $628,894
Year 11 Index Fund Balance: $710,339
Net Total: $710,339

So, what am I missing here?

you can make $12,000 or so and pay no taxes, and with tax loss harvesting you can make even more than that and not pay taxes. In retirement many people have withdrew $25,000+ and not paid tax because of tax loss harvesting + deductions. Also many people work longer than 8 years, and some have a significant other that also maxes a 401k.

[by_1008]

BUT, what if I totally ignored 401k investments and just went with Index funds. Then it would look like this:

If you ignored 401k investments, your tax liability would go up (by 25% of 18k, or 4.5k), so scenario two yearly investments should probably be lower to make things equal.

Also if you ignore the tax implications, then of course scenario two is better because you are assuming 1% greater returns on the same total investment (all at 5% compared, to some at 5% and some at 4%)

[BallardStubble]

Yeah, that would be the tradeoff. Greater potential return by controlling my own investments over having to go with the investment strategies of my 401k provider.

Can someone explain Tax Loss Harvesting for me in layman's terms?

[Jeremy E.]

Yeah, that would be the tradeoff. Greater potential return by controlling my own investments over having to go with the investment strategies of my 401k provider.

Can someone explain Tax Loss Harvesting for me in layman's terms?

I think choosing the 401k is better but read this to better judge,
http://jlcollinsnh.com/2013/06/28/stocks-part-viii-b-should-you-avoid-your-companys-401k/
Here is some things to read on tax loss harvesting
http://www.madfientist.com/tax-loss-harvesting/
http://www.gocurrycracker.com/never-pay-taxes-again/

[BallardStubble]

Quick question on the second article you posted. It has this paragraph:

"For example, let’s say we bought some of the VTI ETF over 1-year ago for $50,000, and it is now worth $84,700.  It must be over 1 year ago in order to be considered a Long Term Capital Gain, an important time frame.  Short Term Capital Gains are taxed at the normal marginal rate.  Our basis in the stock is $50,000, with a $34,700 long term gain.  When we sell it, we will pay NO TAX since we are keeping our total investment income below $70,700 (which also includes our qualified dividend income.)  When we buy the VTI ETF back, our basis is now $84,700.  The gain is locked in tax free, forever (Update: Mad Fientist has added a post on Tax Gain Harvesting as well.)"

When it says total investment income below $70k, does this include base investments or strictly returns. Ie, if I have $600k in index funds and get $30k back, as long as that income ($30k) is under that $70k mark for a married couple filing jointly, I don't pay any taxes beyond the income tax I pay before I have funds to invest in taxable accounts, and absolutely no taxes on 401k contributions if I go the roth IRA conversion route?

In what scenario would I have to pay 15% income tax?

[arebelspy]

So, new question. Is it even worth it to invest in the 401k? I understand if I take $100 and put it into the 401k, I end up getting $85 of that back since I'll be in the 15% tax bracket when I go to take the funds out. And if I take $100 now out of my paycheck, I get $75 of that immediately, since I'm in a 25% tax bracket, and I can invest that in index funds.

Well ideally you'll roll it over to a Roth, then withdraw it tax free, so you'll never pay any taxes on it.  Paying 0% versus 25% is a big difference.

In short: Yes.  You should max your 401k.

Read the MadFIentist's Guinea Pig experiment.  Go here, then scroll about halfway down the page to the "Guinea Pig" articles: http://www.madfientist.com/archives/

It will show you why investing in your 401k is absolutely worth it, with real numbers.

[Jack]

Don't forget you can put money in an IRA too($5,500), that's $23,000 $23,500 per year total, but you will still have lots in a taxable account.

And you can be married, so that's $47,000 per year (assuming both you and your spouse are eligible for and able to max 401Ks, which is an assumption that hasn't worked out for me up to this point...).

[Jeremy E.]

Don't forget you can put money in an IRA too($5,500), that's $23,000 $23,500 per year total, but you will still have lots in a taxable account.

And you can be married, so that's $47,000 per year (assuming both you and your spouse are eligible for and able to max 401Ks, which is an assumption that hasn't worked out for me up to this point...).

good catch, the limits usually change every year so I mess up the numbers sometimes, surprisingly the 2015 and 2016 contribution limits are the same for 401ks and IRAs so I shouldn't mess it up, however still do haha

[zephyr911]

Yeah, that would be the tradeoff. Greater potential return by controlling my own investments over having to go with the investment strategies of my 401k provider.

Can someone explain Tax Loss Harvesting for me in layman's terms?

Selling an investment to lock in a known loss that offsets gains for that year.

[BallardStubble]

Alright, so I've been going back and forth on this all day. I think I have a good understanding of how the Roth IRA Conversion ladder takes place and I've read several articles from jlcollinsnh, Mad Fientist and Root of Good, specifically this article for a breakdown http://rootofgood.com/roth-ira-conversion-ladder-early-retirement/.

So, let's say I have $57,684 to invest annually - this includes tax benefits of maxing out my 401k and IRA accounts for my wife and I (My wife doesn't have a 401k available to her). And let's say I'm able to put $15,200 into my 401k this year (my employer pretty much contributes 3.5% of my salary or about $2k annually), $13,200 is my money and $2k is from my employer. Then I put $2,275 into a traditional IRA. Then, in 2017, the fun stuff starts. This is where I'm able to fully commit $16k to max out my 401k (employer provides other $2k as previously mentioned), $11,000 for IRA accounts between my wife and I and the remaining $30,684 into Index funds. By the end of 2025, I'd be looking at the following, assuming a real rate of return at 5%.

401k Balance: $222k. My Traditional IRA balance: $64k. My wife's traditional IRA balance: $60k. Index fund balance: $338k. Net assets: $684.

Through the conversion ladder, I eventually run out of funds I can roll over from the $260k I have in traditional IRAs in about 18 years with about $20k combined left in my traditional IRA accounts (including employer-sponsored 401k and personal IRAs). I understand I can use my taxable investment income to cover the 1st 5 years of expenses, but that ends up depleting my index fund balance to $250k, by the time I can start withdrawing my $30k, adjusted for inflation, from the Roth. But is that how it's supposed to work?

Once my first conversion batch “ferments” after 5 years, I stop touching my Index funds and allow those to recoup while I spend the converted Roth funds until depleted, at which point the Index will go from $250k to $450k, allowing me to withdraw $22,500 annually?

Or is this design to mix in with each other? Once my index funds are down to $250k after covering the fermentation period, the Roth account will be up to $150k before I take my first $30k out. Would I then want to remove $12k annually from the Roth and $18k from Index?

Through that, after the first $150k is raised through the next 5 years, I’d be able to dump $30k into it from the Traditional IRA, while only taking out $12k. On top of a 5% real return rate, I’d be looking at $555k in my Roth IRA by the time I converted all of my traditional IRA funds to it over 18 years and my index fund net would down to $151k. But then I’d be in some deep shit, as I’d still be 20 years away from retiring and would be out of Traditional IRA funds to continue to take the withdrawals out of the Roth, making me live on a $151k nest egg for 15 years. And that nest egg would definitely get cracked and still not be enough.

So then, would it make more sense to do $20k from Roth and $10k Index? That would give me $428k in the roth account and $293 in the index fund account. Or maybe even $25k Roth and $5k Index? Giving me $381k in index and $348k in Roth. In all scenarios, it seems almost safer to just take the tax hit and invest everything in index funds. I’d lose nearly $70k, but I’d be able to safely withdraw $30k annually forever by 2025 ($53k annually invested instead of $57k on tax adjustments, net out to $614 instead of $684).

Please help me understand when I’m doing wrong or not thinking about. It’s keeping me up at night :(

[arebelspy]

You use "Index" when I think you mean "taxable"--likely your 401 and Roth will be in Index funds too, if that's how you're investing.

I'd keep using up all the taxable, and let the Roth grow as much tax free, as long as you can, not just once the first 5 year seasoning is done.

[teen persuasion]

 

So, let's say I have $57,684 to invest annually - this includes tax benefits of maxing out my 401k and IRA accounts for my wife and I (My wife doesn't have a 401k available to her). And let's say I'm able to put $15,200 into my 401k this year (my employer pretty much contributes 3.5% of my salary or about $2k annually), $13,200 is my money and $2k is from my employer. Then I put $2,275 into a traditional IRA. Then, in 2017, the fun stuff starts. This is where I'm able to fully commit $16k to max out my 401k (employer provides other $2k as previously mentioned), $11,000 for IRA accounts between my wife and I and the remaining $30,684 into Index funds.

The $18k limit does not include amounts contributed by your employer, just by you.  The total limit (employer + employee) is $53k.

You seem to be making this much more complicated than necessary.  Think of your retirement stash #s in total, it is just that parts are stored in different pockets with different rules for access.  Apply the 4% rule to the total, not the individual sections, and take from the pocket that is easiest/best to access at that time.  Yes, that may mean taking some from more than one pocket in a given year.  The total remains the same, regardless of which particular pocket you take from (unless you do things sub-optimally and take from a pocket triggering penalties).

Broad basics:

Withdrawals from tIRA: taxed as regular income, plus 10% penalty if you are under 59.5 yo.
Withdrawals from Roth IRA : contributions always tax free; earnings tax free if over 59.5 yo; earnings taxed as regular income + 10% penalty if under 59.5 yo.
EDIT: Conversions from tIRA to Roth IRA are treated like contributions AFTER 5 years have elapsed.
Taxable investments : tax free if you can remain in 15% marginal bracket.

So you are trying to transfer tIRA funds to Roth IRA accounts within your 0 marginal bracket (ideally) or lower brackets (10, 15%) each year.  Then in the future you can access those funds for free, if you follow the rules.  Meanwhile, access the pockets that currently have a free/cheap option: taxable accounts.  After 5 years, you have the option to ALSO access some of the Roth IRA funds.  Keep repeating the loop (convert a bit, withdraw from free pockets).  Eventually you reach age 59.5, and more pockets become free, or at least cheaper (no penalties).  At this point it may be appropriate to simply withdraw from tIRA accounts (rather than convert to Roth IRA) if it is in your 0 bracket; run the numbers all ways.

[BallardStubble]

Yes, sorry, when I said Index, I meant taxable. It was just getting late last night.

I definitely think I'm overthinking it as well, but I'm just concerned some of the pockets I can take from before 59.5 will run out before I can take from the others without taking sub-optimally.

Do you have an example, in a situation similar to mine ($53 in investments annually after investing in only taxable and $60k in investments annually after maxing out $18k 401k, $11k in IRA and the rest to taxable, in which through this, I can live on passive income after the year 2025 if investments were to start in 2017 (plus $20k from this year).

Thanks!

[arebelspy]

I definitely think I'm overthinking it as well, but I'm just concerned some of the pockets I can take from before 59.5 will run out before I can take from the others without taking sub-optimally.

Here's the down and dirty: take as much advantage of tax free stuff as you can (max them out), and then cross the "optimal withdrawal bridge" when you come to it (or get close).

[MoneyRx]

In Jeremy E's example for the taxable account being more, you have an incorrect assumption that $50k in the first scenario and $50k in the second scenario are the same thing. The $50k/year in the taxable accounts is actually a lot more of an investment (probably ~$65k of gross income vs. <$60k of gross in the tax advantaged) because that is entirely funded with after tax dollars.

[Jeremy E.]

In Jeremy E's example for the taxable account being more, you have an incorrect assumption that $50k in the first scenario and $50k in the second scenario are the same thing. The $50k/year in the taxable accounts is actually a lot more of an investment (probably ~$65k of gross income vs. <$60k of gross in the tax advantaged) because that is entirely funded with after tax dollars.

It wasn't my example... but by_1008 already brought this up