A Not-so-Taxing Climb Up the Roth IRA Ladder

A Not-so-Taxing Climb Up the Roth IRA Ladder

As I mentioned in our How We Plan on Reaching FI post, when we started to map out our journey to financial independence, we were basing our calculations of our “stash” as only the money available in our taxable brokerage accounts. This was probably the result of me discovering the prospect of FI through the blog of Mr. Money Mustache and being so feverish with excitement to consume all of the content that I glossed over the fact that we could actually use the money in our tax-deferred retirement accounts (401k, IRA, etc.) to help us retire early. Not only can we use it, we can utilize it to possibly not ever pay taxes on (some of) the amount that is in the account, which was never taxed in the first place!

This is made possible by a strategy called the Roth IRA Conversion Ladder. The Roth IRA functions like most other retirement accounts, except that:

  1. Contributions to it are not tax-free. In other words, one traditionally funds a Roth IRA with after-tax money.
  2. Distributions (of cost basis AND earnings) are tax-free, provided that you are at least 59.5 years old and have had the Roth IRA account open for at least five years.

Roth IRAs have become popular in recent years, with many personal finance gurus telling folks to fund the Roth IRA first and not worry about paying taxes later down the line, as they would with a traditional retirement vehicle like a 401k or Traditional IRA. That would make sense, if people expected to be paying higher taxes in retirement. But that is rarely the case, unless you have a serious windfall. With no W-2 income coming in, you are likely not going to be in a higher tax bracket in “retirement” than you would during your income-earning years.

Contributions to a Roth IRA are currently capped at $5,500 per year. Conversions to a Roth IRA from a Traditional IRA are not limited however. The rub is that, when you do the conversion, it is considered a taxable event and is classified as “earned income”, so you pay the taxes when the conversion happens. Obviously you wouldn’t want to convert your entire Traditional IRA to a Roth IRA in one fell swoop, as it would throw you into a much higher tax bracket, and would result in you losing more of that money in taxes than you actually had to. So you convert it piece by piece, so as to transfer the largest amount possible, while at the same time incurring the smallest tax liability.

After the conversion from year Y has sat in the Roth IRA for 5 years, you can withdraw it – just the contribution aka “conversion amount”, not any earnings (these can be withdrawn after 59.5 years old penalty free) – and you pay no taxes on it at that time.

There is a bit more to it than that, but these articles explain the Roth IRA Conversion Ladder far better than I ever could:

How to Access Retirement Funds Early | Mad Fientist

Climbing The Roth IRA Conversion Ladder To Fund Early Retirement

The basic idea is:

  1. Acquire 25x of yearly expenses across all accounts.
  2. Quit job, roll 401k money over to a Traditional IRA.
  3. Convert X amount of money from the Traditional IRA to a Roth IRA. X should cover living expenses 5 years from the year in which it is converted, adjusting for inflation.
  4. During years 1-5, take distributions from your brokerage account to cover living expenses.
  5. From year 5 until we reach 59.5, each year live off of the “seasoned” conversion amounts from five years prior and continue to the conversion ladder as needed (I could go deeper into “as needed” because the ideal situation would be to shelter all of your tax-deferred savings from tax ever again, but that really depends on your age when you retire).
  6. After 59.5 withdraw directly from your IRA (or wherever else) as fits your needs.

Some Notes

Before we delve too deep here, let me admit that these scenarios do not factor in dividends and how they are taxed, nor do we factor in qualifying for health insurance subsidies. We figure that we can’t predict how dividends are going to pay out, and that it won’t move the needle all that much in the grand scheme of thing. We also think that our health insurance laws will look radically different when we hope to reach FI (2027) than they do now.

The purpose of these scenarios is to illustrate how it is possible to take your tax-deferred savings, convert them, and possibly never be taxed on them. Beyond that, the focus will be able also paying no federal taxes (a la capital gains) on any distributions from our brokerage account during years 1-5.

Also, and more importantly – I am not an accountant, lawyer or financial professional. I have been doing my homework on this for a while and am mostly sure about most of this. That being said, if any of my math or assumptions are incorrect, please let me know in the comments.

Our Scenarios – Variables & Taxes

At the beginning of 2027 we decide that we have enough in our investment accounts (whether they be our pre-tax 401ks or our post-tax brokerage accounts) to cover 25x of our yearly expenses, and roughly following the 4% rule, we can retire early if we so choose.

We have figured out that we need $40,000 per year in living expenses. To keep things neat and tidy, we quit our jobs at the end of 2026 such as to incur no W-2 income for the 2027 tax year. We have four children, but only three of them are under 17 when we decide to stop working. 

Since we are married and filing taxes jointly, we get a $24,000 deduction off our taxes. That means that we can earn up to $24,000 of “earned income”, without ever paying a cent of federal taxes. Since we have 3 child dependents, we also get (under current tax law) a $2,000 child tax credit per child. Unlike a deduction, which reduces our taxable income; a credit reduces our tax liability, dollar for dollar.

In clearer terms – A tax deduction reduces the taxable income, which is then used to calculate our tax liability by using our progressive tax brackets. A tax credit then reduces our tax liability even further. There are various tax calculators out there, I used this one as it’s pretty simple and lays out everything in plain terms.

Another factor in all of this is how we are funding our lifestyle from year 1 to year 6 – by distributions from our taxable brokerage account. Withdrawals from these accounts do NOT count as earned income, but rather as capital gains – which have their own separate tax brackets. The top end of the 15% bracket (which is 0% tax on LTCG) is $77,400 for married couples filing jointly. So as long as we stay under $77,400 for our adjusted gross income (AGI) any long-term (assets held for more than 1 year) capital gains are taxed on 0%

Scenario 1 – Married Filing Jointly, 3 Child Dependents

Using the calculator and some knowledge of how our progressive tax system works, I have found it makes the most sense to calculate in whatever capital gains we will be taking from our brokerage distribution first since that is the money that we need that year.

We need $40,000 in Year 1, and let’s say $30,000 of that is basis (our initial investment) and $10,000 is capital gains. That gets us our living expenses for the year and puts us at $10,000 of AGI so far.

Since Roth IRA conversions operate under tax years and not years as defined by months, we could then wait until the end of 2027 to do our Roth IRA conversion for the amount that we want to live on in 2032. That amount would then be able to withdraw on January 1, 2032.  Check out this for more information on the five year rules regarding Roth IRAs.

$77,400 – ($0 earned income + $10,000 LTCG) gets us to $67,400 in wiggle room that we could still have before any conversion would send our AGI over the top of the 15% tax bracket and into TaxLand on our capital gains. Now, adjusting for five years of inflation (multiply by 16%) we would need $46,400 in 2032 to have the same purchasing power as $40,000 in 2027. Since this falls under the $67,400 that we can have in “earned income + capital gains” to determine our federal tax bracket we can do one of three things.

  1. Convert ~ $20,000 more to the Roth IRA to work towards eventually depleting the traditional IRA balance before Required Minimum Distributions (RMDs) kick in at age 70.5 which can have unintended tax consequences.
  2. Harvest ~ $20,000 of capital gains in our brokerage account by selling shares and then immediately buying back the same asset to increase our cost basis in that investment. This is called Tax Gain Harvesting and is explained better here.
  3. Do nothing 🙂 Though I would definitely lean towards filling up that 0% tax bracket in some way.

So let’s go ahead and convert the maximum amount possible to our Roth IRA at $0 federal taxes.

Our AGI is $77,400 ($67,400 in Roth IRA conversion + $10,000 in capital gains) which determines our tax bracket for both capital gains and normal income. Our earned income is $67,400. The standard deduction chops $24,000 off of the top of this, which brings our taxable income down to $43,400. Plugging this through the brackets, this results in $4,827 of federal tax liability. However we have three dependent (they have to be under 17 at the end of the tax year) children, they reduce our tax liability by $2,000 each. This brings our federal tax liability to $0. We are under the 15% bracket, so our $10,000 in capital gains are also incurring $0 federal tax liability.

Scenario 2 – Married Filing Jointly, 2 Child Dependents

Eventually, children grow up, shed their tax break cocoon, sprout their wings and fly away. This doesn’t change the principle of the math a whole lot, it just reduces our tax credit by $2,000 per child over 17 years of age. Going from three child dependents to two doesn’t change the math all that much though. Using the same numbers as Scenario 1, with $10,000 in capital gains from the brokerage distribution, the maximum we could convert to Roth IRA without incurring any federal tax in these years is $60,500. Basically we are finding this number by reversing the tax bracket process by using a spreadsheet or the aforementioned tax calculators. Two kids covers $4,000 of tax liability, so we need to figure what amount of taxable income gets us right at (preferably right under) that number, in this case that happens to be $36,500, we then add in the standard deduction of $24,000 to complete the process and get us to $60,500 taxable earned income.

To cover the other two scenarios:

Married Filing Jointly, 1 Child Dependent – Assuming a $10,000 capital gains hit on the brokerage distribution, the most that we could convert from a Traditional IRA to a Roth IRA (without incurring any federal taxes) with one child dependent would be $43,840.
Married Filing Jointly, No Child Dependents Assuming a $10,000 capital gains hit on the brokerage distribution, the most that we could convert from a Traditional IRA to a Roth IRA (without incurring any federal taxes) with no child dependents (and assuming no other special tax treatment other than the standard deduction) would be $24,000.

Putting it All Together

  • Retiring at the beginning of 2027 (or end of 2026, however you want to see it)
  • Need to cover living expenses of $40,000 per year, adjusting for inflation each year
  • As such our total stash is 25x our yearly expenses, or $1,000,000
  • This is split between $650,000 in tax-deferred accounts (401k / Traditional IRA) and $350,000 in taxable brokerage accounts.
  • After quitting our day jobs, our 401ks are rolled into a Traditional IRA.
  • We open Roth IRAs to begin our conversion ladder (I already have one open)
  • Assets in each account (Traditional IRA, Roth IRA, Brokerage Account) will be invested in broad-based low-fee index funds, assuming an average return of 7% per year. We can argue asset mix between stocks and bonds at a later point, I am just trying to keep it simple here.
  • Withdrawals from all accounts are adjusted for inflation of 3% per year, the actual formula I used ended up being 3.2% exactly)

This table details how we would fund our lifestyle for the first five years of “retirement”, how we would fund year 6 until reaching age 59.5, and the balances of each of our accounts over the years.

Interesting notes and takeaways from this table –

  • In 2032, even though we have converted more than $46,400 five years ago in 2027, we only withdraw what we need for that year.
  • Five years before age 59.5 in 2036 no more Roth conversions are “needed”, but we will continue to do them anyways to defer taxes.
  • Despite the Roth IRA balance being above $350,000 in 2040, we can only withdraw the contributions balance, so we withdraw a little more from our brokerage account for this year
  • Even though we converted large sums to our Roth IRA out of our Traditional IRA, the balance in 2041 of $650,824 is pretty much the same as the balance in 2027. Yay compound interest!
  • We plan on converting as many assets to our Roth IRA as we can in the years where we have more child dependents to cover the years where we have fewer (or none).
  • The balances of the IRA and brokerage are the Jan 1 balances BEFORE any withdrawals or conversions are made in that year.
  • The table is based on a 7% rate of return on all assets which leaves us with $1.4 million across all accounts in 2041 but even when I plugged in 1%, we were still left with just over $400,000 in all accounts in 2041.

What we do in 2041 is very much up in the air. At this point we can access the money in our Traditional IRA without penalty, but despite being unearned income, it is taxed the same way as earned income. Also, being over 59.5 we could now access all of the earnings in our Roth IRA tax-free. Federally, distributions from these buckets would be taxed as follows:

Traditional IRA: Taxed as ordinary income, subject to RMDs at age 70.5
Roth IRA: No taxes, not subject to RMDs at age 70.5 
Brokerage Account: Taxed at capital gains rate

There are so many more factors to consider: optimal tax strategies with RMDs in mind, state taxes, dividends, limiting income to qualify for ACA  subsidies (or whatever is around in the future). Not to mention which bucket to pull from past age 59.5. I plan on coming back to this topic and delving into those subjects deeper in the future.

As I mentioned before, I am not a financial or tax professional so if you are convinced that I am understanding something about tax law and retirement accounts incorrectly, please let me know in the comments.

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2 thoughts on “A Not-so-Taxing Climb Up the Roth IRA Ladder

  1. Great analysis! I plan to make use of the roth IRA ladder in retirement as well, but have never really run the numbers and considered the tax implications because it’s still some years in the future. It’s nice to see it done with your real numbers though and I particularly appreciate the table you made as a good visual explanation of how this would work in practice. Thanks!
    Andy recently posted…Get Rich with CompostMy Profile

    1. Thanks for reading and for the kind words!

      I hope to expand upon this a little bit more with state tax implications and other bits that were just too “in the weeds” for one post. I am going to look into how bringing in a small amount of “side income” or even potentially real estate income could affect this strategy as well.
      Mr. Half recently posted…Taking Full Advantage of the EV Tax CreditMy Profile

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