The Roth Rescue; Why Early Retirement Planning Requires a different plan


When I first started thinking about retirement, I never pictured myself being able to retire very early.  I had never seen it done before.  Heck, my own parents worked until death and age 70, the latter having only stopped working due to the business she worked for went bankrupt and closed its doors.  So what is a young lad to do?

I knew great options existed, so I took full advantage of work pre-tax retirement accounts.  I put money into my 401(k), as much as I could to avoid the 28% (now 25%) Federal tax bracket.  Prior to this account, I had already opened up a traditional IRA (age 18) which I later converted to a Roth IRA as soon as a law was passed allowing Roth IRA’s (1998).  In addition to my 401k plan, I would invest additional dollars into a Roth IRA each year as needed or as I could afford to do so.  Unfortunately, my reason for choosing a Roth over a Traditional, tax deductible IRA was not based on data or “proof” it was better at all.  In fact, I just thought having taxable and non taxable (Roth) assets was the prudent path to take to “diversify” my taxes in retirement.  Boy, was I wrong.

Our Early Retirement Goal:

Have enough money in investment accounts, in order to be able to live off returns, for five years, while we convert traditional IRA’s to Roth IRA’s.  The result is we will be able withdraw principle, tax and penalty free, after the five year waiting period. This strategy is what is known as “Roth laddering.” Five years is the waiting period between a Traditional-to-Roth IRA conversion, and when principle can be withdrawn from the conversion without tax or penalty. It’s an IRS waiting period.

 Diagnosis:  Too Little in Taxable Assets, Cash, etc. Call 911

State of our early retirement assets in 2015; too little in taxable accounts

In early 2015, we decided to switch from planning an “old age” retirement plan, to an early exit strategy.  Our first step was to determine how much accessible assets we had.  We had about $59,000 in a legacy account with Procter & Gamble (PG) stock that we had been adding funds too.  In addition, we had around $17,000 in our Capital One 360 savings account, which also functioned as our quasi emergency fund.  I calculated that we were going to need AT LEAST $200,000, in taxable assets, in order to retire early.  We had a $131,000 deficit.  We had a very sick patient.

At the time of our Stage One diagnosis, we were only contributing $17k per year, to our taxable brokerage account.  At this pace, assuming no appreciation in our investments, it was going to take nearly 9 years to retire early.  Take a deep breath, what’s that noise?  That’s the sound of me sighing at this pathetic realization.  I was already 38 years old, well past the age of the internet’s most famous early retirees.  In 9 long years of additional work, I was going to be 47, only 8 years short of an old age retirement of 55. While most of “mainstream” America would say that age 47 is an incredibly young age to retire, this is ancient for those of us looking to achieve financial independence.  Furthermore, my frustration lied in the fact that total assets (401k’s plus IRA’s) would be well above the amount needed to produce a decent retirement income.

Enter the cure, the Roth Rescue

What I view as perhaps the easiest solution, for those short on taxable investments for an early retirement, is to withdraw Roth contributions and purchase taxable investments.  The strategy is simply; immediately with draw ALL Roth contributions for both spouses, and invest these amounts in taxable accounts.    In our situation, we had $64k in total Roth IRA contributions that we had invested over the years.  Adding $64k to our existing $59k in taxable investments immediately skyrocketed our tax accessible to $123,000.  Suddenly, our goal of having over $200,000 in taxable investments, to fund years 0-5 of early retirement was within reach.  We are already 61% of the way there.

Other Options were considered

Contrary to popular belief, early retirement doesn’t generally include dumpster diving

Extreme expense reduction was thought of, and while certainly possible, wasn’t considered politically feasible.  A second serious solution considered was simply to retire and take IRA distributions WITH a 10% penalty.  However, this solution also would require waiting longer to retire, as more funds would be needed to cover the extra 10% in taxes that would need to be paid.  Also considered were “rule 72t” distributions, which also would have avoided the 10% penalty, but the withdrawal rates allowed would have been too small to make ends meet.  Also, rule 72t is complicated and, if not done exactly right, could result in penalties as well as income taxes owed to the IRS.  The risk was just seen as too large for a relatively small benefit.

 

Deconstructing “Old Age” retirement planning & Why Early Retirement Requires a Different Plan

Contributing to a 401(k), or a Traditional IRA are fantastic ways to save and invest for an “old age” retirement.  I refer to these plans as “old age” retirement vehicles, because they restrict the ability to withdraw from them, without a 10% additional income tax penalty, prior to age 59.5.

First, let’s review what the internet defines as old age:

  1. the later part of normal life.

As if this definition isn’t bad enough, conjuring up images of electric wheelchairs, combined with a side of senility and the smell of urine wafting throughout the Nursing Home, the synonyms listed for old age are worse and add insult to injury:

synonyms:  declining years, advanced years, age, agedness, oldness, winter/autumn of one’s life, senescence, senility, dotage

This is the age the Government wants you to be to retire, without a 10% income tax penalty.

When one starts working full time and is perhaps broke and in debt, it’s nearly impossible to picture retiring early. Therefore, planning for an age 59.5 retirement seems like a reasonable plan.  At least as you age, you have some sense of comfort and certainty that you won’t be eating dog food or greeting customers at Wal-Mart.

At some point in my 30’s, I learned that loopholes existed to withdraw funds early without the dreaded 10% penalty.  For example, if one quits/retires at age 55, one can withdraw funds from that specific 401(k) plan without incurring an additional 10% income tax penalty.

 

According to the 401(K) help center

Leaving Your Job On or After Age 55

The age 59½ distribution rule says any 401k participant may begin to withdraw money from his or her plan after reaching the age of 59½ without having to pay a 10 percent early withdrawal penalty.

There is an exception to that rule, however, which allows an employee who retires, quits or is fired at age 55 to withdraw without penalty from their 401k (the “rule of 55”).

What retirement looks like at age 55, just prior to decline, feeding tubes, and immobility

Due to learning about this loophole, I decided I would begin to plan for an earlier retirement, perhaps age 55, to give myself a few years to live life prior to my incapacitated years.  The tentative plan was to continue to roll any and all 401(k) plans into subsequent 401(k) plans, so as to be able to withdraw these funds at 55, without penalty.

I pictured myself regaining my life back, and as seen on the right, having a great time prior to my golden, or aka, electric wheelchair years.  Still though, the pre-tax contributions were piling up, and even among declines some years, our retirement account values were growing, with seemingly no end in sight.  I felt the need to explore earlier retirement possibilities and I am glad we rescued our Roth Principle contributions.

For those that have made the firm decision to make an early exit, I highly recommend the Roth Rescue strategy outlined above.

What are you doing to prepare for the first five years of early retirement?  Do you regret making contributions to a Roth IRA?

11 comments

  1. Thanks for sharing the Roth Rescue strategy!!! I was vaguely familiar with it but you brought a ton of clarity around the subject. When it comes to early retirement we would definitely take a hard look at this strategy to see if it makes sense for us. While I’d love to not touch it, I’m not sure that will be in the cards 🙂

  2. Interesting strategy! I am curious though, where did the 200k number come from? Is it projected expenses, part of a withdrawal plan, or the selected magic number where you feel comfortable?

    Based on the pension formulas in my career field I love finding out why “X” is the number that would make someone put a bullet in their career!

    1. First off, I think your name is fantastic and the story behind it is even better.

      To the real question: I am 40 years old so I don’t meet any definition of a Government allowed early retirement without a 10% penalty. I don’t work for the Government so a 457 plan is unavailable to me.

      I plan on using a “Roth laddering” strategy for years 0-5 of early retirement. $200k is simply my estimate (based on spending) of how much I will need to fund all or parts of those first five years of the Roth laddering “waiting period.” I also include investment gains in my calculations. As I withdraw those assets, the remaining assets will also be gaining in value over time. In reality, the number could be higher that I need. As of today, we are at $205k “ish” so we are at least moving in the right direction.

      1. Excellent computation! Thanks for clearing that up. I look forward to more articles!

        (Glad you liked the name, there’s a distinct benefit to crack heads around: they are so creative!!)

  3. These are things I had not even thought of. For me, 46 is the earliest I would retire (I will be vested in my pension at that point). That gives me 9 years to figure out what to do. I wonder if paying down my school loans first and then investing in taxable accounts would be more prudent then investing in an IRA?

    1. That’s a good question and thanks for the comment. I think if your loans are under 4%, I would invest. The first $2500 of student loan interest is tax deductible. It lowers your AGI, so it’s MORE valuable than mortgage interest.

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