For some reason, I’ve been doing a string of tax articles lately that have been surprisingly well received, so I figured I’d keep going. Why ruin a good thing, right?
401(k)’s. They’re great aren’t they? They let you defer taxes on your income, giving you a tax refund, and anything you earn in them is tax-free!
Only problem is, there’s a catch. Money inside your 401(k) is kinda like a raw pot roast. You can’t eat it right away.
First you have to withdraw the money, just like you have to cook the pot roast before eating it. And like a pot roast, if you cook it too fast, then the whole fucking thing gets burnt to a crisp and you have to hack off half of it just to find something edible.
I’m…I’m not a great chef.
ANYHOO, the point is, because 401(k) withdrawals are taxed at your marginal rate, if you withdraw it too fast, you’ll end up getting a big chunk of it taxed away. That’s bad.
So the trick is to withdraw it slowly. When you leave your job, your earned income effectively drops to $0. And remember, we all get $11k-$12k of income tax-free. In Canada, it’s called the Personal Deduction, and in the USA it’s called the Standard Deduction. Historically, the standard deduction in the US was much smaller than the Canadian one, but with the most recent Trump tax cuts, as of 2018 they’re now about the same. If you’re married (like us), you can get $24k out of your 401(k)’s every year tax-free after retirement.
One big problem though. If you’ve reached Financial Independence and you retire in your 30’s or 40’s, you can’t actually withdraw from your 401(k) because you get hit with an additional 10% penalty for any withdrawal you take before the strangely-precise age of 59 1/2.
Canadians, count yourself lucky on this one. RRSP’s have no age requirements for withdrawal, so the only thing Canadians need to worry about is withdrawing their accounts slowly enough.
But for Americans, there IS a way to get your money out tax-free too! It just requires you to jump through a bunch more hoops.
It’s all based on the IRS rule that Roth IRA conversions, rather than contributions, can be withdrawn penalty-free 5 years after the conversion has taken place.
What The Hell is a Roth IRA Conversion?
OK, I’ll tell you! Stop yelling at me!
Anyway, a Roth IRA Conversion is money taken from your Traditional IRA and then transferred over, or converted, into your Roth IRA. Now remember that Traditional IRA contributions are tax-deductible, so when you do a conversion, the amount gets added to your taxable income. So it’s kinda sorta like a withdrawal, in that you want to do it slowly enough so that you don’t get hit with a tax bill, only instead of withdrawing into your checking account, it goes into your Roth IRA.
Which is great, since you can withdraw from your Roth IRA tax-free and penalty-free, but only after 5 years. Note that each withdrawal has its own 5-year countdown. So a withdrawal done in 2000 would only be available for withdrawal in 2005, a withdrawal done in 2001 would only be available in 2006, and so on.
Now you might be thinking that’s great, but this is for Traditional IRAs. What does this have to do with 401(k)’s?
Well, it’s true that you can’t do a conversion from a 401(k). BUT, you CAN perform what’s called a 401(k) rollover, and transfer your balance from a 401(k) into a Traditional IRA. The IRS allows you to do this because if you leave your employer, they want to give you a way regain control over your retirement savings in case you left on bad terms, or the employer goes bankrupt. AND because this is going from a tax-deferred account to another tax-deferred account, a 401(k) rollover is completely tax-free.
Important: Everything I wrote here applies equally to 401(k)’s, 403(b)’s, and TSP’s. But 457’s (which are for state employees) actually don’t have an age restriction for withdrawals. You can just directly withdraw from those whenever you want penalty-free. And, as long as you do it slowly enough, it would be tax-free as well!
Putting It All Together
So here’s how we put this all together.
When you’re working, you contribute to your 401(k) to take advantage of any employer-matched contributions, those sweet, sweet tax deductions, and of course tax-free growth. AND if you happen to work for certain types of companies, you may be able to double your tax-deferred contributions in a process I like to call Double Fisting Your Retirement Accounts.
Over the course of your career, you may end up starting and contributing to multiple 401(k)’s.
Then, when you do quit, you roll-over all of them into a Traditional IRA. This is done tax-free.
Now you have a big-ass Traditional IRA. It’s full of tax-deferred money you saved over the years, and like a big ol’ raw pot roast, you want to eat it but you can’t. Yet.
So now you start to convert it. Being careful to keep your conversions to within your Standard Deduction of $12k per individual or $24k per married couple, each year on January 1st, you fill out the paperwork with your IRA provider to convert $24k into your Roth IRA.
The next year, you convert another $24k.
You do this for 5 years. On the 5th year, you are now eligible to withdraw that first IRA conversion tax-free and penalty-free!
And so on, and so on.
You may have noticed a certain ladder-like shape to this diagram, which is why this technique is referred to as a Roth IRA Conversion Ladder.
And of course, once you turn the magical age of 59 1/2 (why does the IRS pick such weird numbers?), you can stop with this ladder business and just do regular withdrawals.
And that’s how you access your 401(k) money before the age of 59 1/2.
Comments? Questions? Has anyone done this themselves already? If so, let’s hear it in the comments!
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