How to Access all that Sweet Pretax Money Once You Retire

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Theoretically, this is a blog about pursuing financial independence. I get distracted easily. At the heart of the blog I want to teach people about the power of getting your finances in order. I’ve talked about our philosophy on investing, how it’s super important to save your money, and even how the best vehicle for quickly building wealth is through your pretax accounts. We haven’t talked about how to access your pretax money, until today.

If you accidentally follow all the steps to financial independence for a decade or so you might find yourself retiring early and in need of a way to access that sweet pretax money. If you’re following along with the whole early retirement cult, I mean club, then you’ve probably realized that having millions of dollars available to you once you turn 59 1/2 does you no good if you’re only forty. So, what’s the deal? Can we get at that sweet, sweet money, or nah?

Yes we can. To illustrate how we’re going to go about it, please enjoy a few crudely drawn stick figures with accompanying scenery.

Side note: My wife bought me a Samsung Chromebook for my birthday, so the drawings will be a bit overboard for the next few articles. Just FYI.

Step One: Retire early with all that sweet, sweet money and immediately have a dance party in your kitchen.

 

 

Step Two: Roll the money over from your 401k/403b/457 into a Traditional IRA

Your 401(k), 403(b) and 457 are all pretax accounts. So is your Traditional IRA. That means rolling over these accounts into your Traditional IRA is not a taxable event. Once you leave your job, roll all your pretax accounts into your Traditional IRA account.

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So you go around and collect all the money from your various pretax accounts and load it onto your ship of savings.

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Please notice the small detail of tiny bags of money being added to the ship. Very impressive illustrator work.

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Okay. Here we are.  Still very excited about retiring early. Next we take our ship full of money and head to our Traditional IRA Resort that is hopefully sponsored by Vanguard.

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Once you get to the Traditional IRA Resort you unload your bags of money onto the beach.

Like so.

You sing a couple songs, you dance a wild dance, and when you look back towards the beach you see your funds have magically transformed into a big bag of Traditional IRA money. Fun, huh?

Wonderful. So, now instead of having three separate pretax accounts, all of our money is in one large Traditional IRA nest egg. It’s more of a blob, you get the idea.

Quick note: There are two types of 457(b) plans-Governmental and non-governmental. Governmental plans act essentially as a second 403(b). Non-governmental plans don't allow rollovers to an IRA once you leave your employer. Your choices for what to do with a non-governmental 457(b) are generally A) Leave the money where it is with your employer if they allow you, B) take the money as a lump sum payment, or C) have the money distributed to you over the course of five years. Both b and c are taxable events. Check with your employer to find out which type of 457(b) account you have access to. 

Also, not that it really relates to this post but a non-governmental 457(b) account isn't held in trust, which means if your company goes belly-up creditors may be able to take your money. Not ideal.

Magic Time

Next you’ll convert somewhere between just the amount you need to live on and as much as you can without paying taxes to your Roth IRA.  This is a taxable event since you’re moving money from the pretax Traditional account to the post-tax Roth account. You can’t spend this money until five years after you convert it. More on that in a minute.

The reason you wait until you’re retired to do this conversion is so you’ll be in a lower tax bracket. If you make $100,000 per year during your working career and you transfer $40,000 from your Traditional to your Roth account you’ll be taxed on $140,000 worth of income. Not real smart. So, you wait until you’re no longer earning that $100,000 per year salary. Now you’re only taxed on the $40,000 you need to convert.

Wait, what?

Let’s say you have a portfolio of $1,000,000 and you need $40,000 to live off for a given year. Once you’re retired the conversion is your only taxable income. You’ll move $40,000 over from your Traditional IRA to your Roth, and you’ll only be taxed on that $40,000. But, the full $40,000 won’t get taxed because you still get your standard deduction of $24,000 (if married filing jointly) as well as any child credits and any other write-offs. It’s not uncommon for early retirees to end up paying zero tax on their converted money. Neat, huh?

Let’s see how the process works using tiny stick figures and a map of the high fees….get it? High fees. High seas. Ya done messed up, Plutus.

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Okay. So we’re grabbing a small pile of Traditional IRA money and loading it onto our very nice ship while we continue to have a dance party.

Then, we sail a rather indirect voyage over to the Roth IRA Promised Land. Don’t worry about taking the long way. You’re retired now, you’ve got time.

Next we plop that Traditional IRA money onto the shores of the Roth IRA Promised Land. Finally, we go about our day doing whatever we were doing before, probably having a dance party.

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Look how cute we are!

Anyway.

Every year you make the trip to Traditional IRA Resort where you’ll grab however much money you’ll need five years from that year. Then, you take that money across my very nice drawing until you reach the Roth IRA Promised Land. If you retire in 2020 you’ll take money in 2021 that you’ll use in 2025. The next year you’ll take money that you’ll use in 2026 and so forth. Follow? Follow.

This is called the Roth Conversion Ladder made famous by The MadFientist. You should have been reading his post on the subject this whole time since he does a better job of explaining. But, since you’re already here, let’s look at some more pictures.

Wait, why five years from now?

Excellent obvious next question. There’s a five year waiting period from when you convert money from a Traditional IRA account to a Roth IRA account before you can spend the principal tax and penalty-free. They do this because you were mean to that one kid in third grade and even though you feel awful about it the rest of us have to pay for your tomfoolery. Also, the government can be bags of dicks sometimes.

Anyway, so after five years of waiting around this magically happens.

It’s now the year 2025 and the money you converted in 2021 has turned from a beautiful blue Traditional IRA color that you can’t spend, to a golden Roth IRA color that you’re allowed to spend tax and penalty-free.

Weehoo and Boom.

Note that the money is converted from Traditional to Roth as soon as you move it over, you just can't spend it for five years. After those five years are up, each additional year another pile changes from blue to gold and thus the Roth IRA ladder is created.

Also, note that you're allowed to spend only the principal, not the earnings. Once you reach age 59 1/2 you can spend the interest on that money. I don't know, talk to a tax gal.

What do you do for the first five years?

Right. So that’s nice that you can slowly convert pretax money into post-tax money without really paying taxes on it. But, you have to wait for five years to start spending it. What do you do to support yourself during those five years? You can do a couple of things:

When you decide to retire early you’ll want at least five years worth of expenses saved up in an after-tax brokerage account or high yield savings account. You’ll live off this money the first five years of retirement.

After the initial five years are up you’ll be on your never ending Roth IRA conversion ladder.

Another option is to just spend the money you just converted to a Roth IRA but you’ll be penalized 10% on any amount you take out that hasn’t been in there for at least five years. This option isn’t as good as the first option but you can do it if you want.

Here’s a good article about Roth IRA withdrawal rules if you just can’t get enough.

Wait, won’t you eventually run out of money to convert and then you’ll be old and sad?

Ideally, no. You’re only spending between 3-4% of your portfolio in a given year. On average your portfolio will increase by much more than 3-4%, so you should actually end up with more money than you started with. The 4% Rule, as it’s called, is a fairly conservative estimate that takes inflation into account. Read more about the 4% Rule here, if you don’t believe me.

It should look something like this:

2021 Traditional IRA Value= $1,000,000- $40,000 you convert

Traditional IRA earns roughly $70,000 in interest over the course of the year.

2022 Traditional IRA Value= $1,030,000- 41,200 (4% of $1,030,000)

Traditional IRA again earns roughly $70,000 in interest over the course of the year. (Some years you’ll earn much more, some years less.)

2023 Traditional IRA Value= $1,058,800-$42,352 (4% of $1,058,800)

And so on and so forth.  Many early retirees are opting to spend less than 4% to lower their risk of running out of money. In the real world if you have several years of bad returns you could opt to spend a little less those years.

Also, there’s a better than good chance that you’ll earn some money in early retirement through whatever hobbies you pick up. Maybe you decide you want to be a scuba instructor for the summer just to keep from getting bored. Even though the retirement police will sound the alarm, you’re allowed to earn money in early retirement. Financial independence is about living the life you choose, not about sitting on your couch being bored all day. Your life of freedom can include earning some money, but it doesn’t have to.

Anyway, that’s how you access all that sweet pretax money once you retire.

Dance party!

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If you enjoyed this article feel free to share it with your friends and enemies. I won’t mind. 

 

Author: MrBurritoBowl

Mr. Burrito Bowl is a 34-year-old man from Whitefish, Montana who likes to draw stick figures and say things that sometimes relate to finances, but not always.

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