- You know what I love about the financial independence
and early retirement community?
They are masters at hacking the system
to take advantage of little loopholes
when it comes to investing and saving money.
They're especially good at finding ways
to do very out of the ordinary things,
such as access money in your retirement accounts,
like a 401k and 403b before the age of 59 and a half.
And the best way to do this
is through something called a Roth conversion ladder,
which is how most people are going to be able
to withdraw money
from their largest retirement investment accounts early.
In this video, we'll go through what a Roth conversion is.
We'll talk about how it plays
into an actual Roth conversion ladder.
How you can benefit from it
by potentially saving thousands of dollars.
And then I'll also walk you through, step-by-step,
what to do to implement this in your life.
Then after that, I will give you a real life example,
so you can see it in action.
Hey, I'm Jarrad with two As and two Rs.
And on this channel,
we like to talk about all things personal finance,
investing, and financial independence.
If you're feeling generous in this moment,
then please do me a huge favor
and Hulk smash that thumbs up button.
It's free and it makes me 10% happier.
Quick disclaimer, nothing that I say in this video
is of course financial advice.
After you watch this video,
I do encourage you to do your own research as well
and to talk to an accountant
before going through any of this, just to be safe.
The traditional way that most people are going to access
their largest retirement accounts, like a 401k or a 403b,
is by waiting until the age of 59 and a half.
This age wasn't just made up for fun though.
The reason is because if you withdraw any money
from either of those retirement accounts before that age,
then you'll pay an early withdrawal penalty.
This isn't an issue for someone
who is going to retire at a normal age,
but it's not very helpful
to someone who is going to need to use some of that money
during their early retirement.
Since this is usually going to be
the largest investment account,
the early retiree is going to need to find a way
to be able to get ahold of some of that money
before that age without incurring any penalty.
Entering a Roth IRA hack called the Roth IRA conversion.
In case you weren't aware,
contributions to a traditional 401k and 403b
are made with pre-tax dollars.
So you're basically putting off
paying taxes on that money today
so that you can pay them
when you decide to withdraw money from those two accounts
at some point in the future.
On the other hand,
a Roth 401k is funded with after-tax dollars.
So you were basically paying taxes on that money today
so that you won't have to pay taxes
on that money in the future
when you withdraw from that account.
A Roth conversion is how an early retiree
is going to help pay for expenses
between the day that they leave work
until the age that they can start withdrawing money
without incurring a penalty.
Doing a Roth IRA conversion allows you to take the money
from a traditional 401k or 403b and move it into a Roth IRA
so that it can not only grow tax-free
but so that you can also access that converted money as well
because it's considered a quote, unquote,
Roth IRA contribution.
Just so we're all on the same page,
let's cover how Roth IRA contributions work.
At this point in time,
an individual can contribute up to $6,000 per year
into a Roth IRA.
Because that $6,000 has already been taxed,
you'll never pay taxes on that contribution ever again
and you can withdraw it from your Roth IRA
at any point in time without paying penalties.
Now, if that $6,000 was invested in a Roth IRA,
which it should be,
and it grew to, say, $10,000,
then of that $10,000,
you can withdraw $6,000 of it at any point in time
because it's your contribution
that you already paid taxes on.
But you cannot withdraw any of the $4,000 gain
without paying penalties.
When you do a Roth conversion from a 401k or 403b
to a Roth IRA,
then that money is considered a contribution
and can be withdrawn at any point in time,
just like that $6,000 that I just mentioned.
For example, if you did a Roth conversion of,
we'll say, $50,000 from a traditional 401k to a Roth IRA,
then you can withdraw that $50,000
without paying any penalties.
Heads up that there is a waiting period
before you can use this converted money,
but we'll cover that in just a minute.
Now this is a rule that you 100% have to know about
or else it can cost you quite a bit of money,
so don't miss that part of the video.
We can't ignore the elephant in the room
with this whole Roth conversion process.
And that's the taxes that you'll pay
for converting the money into a Roth IRA.
On the surface, yes, this stinks.
No one actually wants to pay taxes for doing this.
And to be honest,
there's no way of getting around it with a Roth conversion.
But if you had to choose between paying more taxes
or less taxes,
then which one would you choose?
Because with a Roth conversion,
you'll most likely pay taxes at a rate
that's less than what you're paying
with your current income.
The money you convert will be taxed as income
by the federal government,
so those are the tax rates that we need to pay attention to.
Let's say, before quitting your job,
you and your significant other
had a combined income of $150,000,
which would put you in a 22% tax bracket.
If you decide to leave work and retire early,
then your taxable income will immediately drop to zero
because you're of course a bum who doesn't have a job.
If you converted, say, $45,000 from your 401k or 403b
to your Roth IRA,
then that amount would be taxed as income.
But the question is, how much?
Since you were married filing jointly,
we'd account for the standard deduction of $25,100,
which would drop your taxable income to $19,900.
That would move you from the 22% tax bracket
down to the 10% tax bracket.
And you'd only have to pay $1,990
on your $45,000 conversion.
One other thing to note
is that this is all based on the tax rates today.
Now, I've lost my crystal ball the other day,
so I can't really predict
what the tax rates are going to be in the future,
which means that these tax rates could change over time.
This isn't anything to be too concerned about,
it's just something that you want to keep in mind
when you start to do those Roth conversions.
There's one more important step to the Roth IRA conversion,
and that is the ladder portion.
When you convert money from a 401k or 403b
to a traditional IRA, then to a Roth IRA,
you have to wait five years before you can touch that money.
Think of it like planting a seed today,
then having to wait five years
before you pick the fruit from that tree to start eating it.
For someone who is retiring at age, we'll say 40,
they'd start their first conversion that year,
which then would give them full access to that money
at the age of 45,
because 40 plus five years is 45.
The next year at the age of 41,
they do another conversion
so that they can access that money at the age of 46,
because 41 plus five years is 46 years old.
This process would be repeated
for however long the money was needed
or until you reach the age of 55.
One thing to keep in mind is that every year
you might be converting a little bit more
than you originally did to account for inflation.
But once again, this is nothing to worry about,
it's just the cost of doing business in general.
Whether you were doing a Roth conversion or not,
you'd still have to account for inflation
with your normal expenses.
55 is the magic number because at that point
you'd have enough Roth IRA conversions completed
to where your expenses would be covered through
when you can fully access that traditional 401k money
at the age of 59 and a half.
So you wouldn't necessarily need
to convert any money at that age if you didn't want to.
As you can see, you're essentially building
what looks like a ladder
by converting money today
that you plan to live off of in five years,
hence the name Roth conversion ladder.
I don't wanna downplay the fact
that this whole process is going to take
a decent amount of planning.
Let's be honest, you're gonna have to project
how much money you're going to need
to live off of in five years.
I don't know about you, but I barely know
what my life is gonna look like in five months,
let alone five years.
That's why it's always important
to be able to stay flexible with your spending.
You should have a little bit of cash reserve to help out
if you happen to reach that five-year period
and you need a couple thousand dollars more to live off of
than you originally thought.
This is something that I'm sure a lot of people
pursuing financial independence or early retirement
already know how to do,
but it's at least worth mentioning
to keep up on that flexible spending skill
that you've learned along the way.
Another disclaimer with the Roth conversion ladder.
There's going to be that five-year window
where you're converting money from your 401k or 403b
to your Roth IRA and potentially not earning any money.
For this period of time,
you're going to wanna have some cash
set aside to live off of.
And this can come from things
like cash set aside in a bank account
or even money from a taxable brokerage account
that you've been accumulating,
leading up to that early retirement date.
I know this sounds outrageous
because the amount that needs to be set aside
could be quite a bit of money,
but let's be honest,
no one ever said that retiring early would be easy.
Keep this in mind,
and I say this all the time to burn it into your memory.
Everyone is going to retire at different ages.
For some, it might be in their 30s,
others, it might be in their 40s,
and others, it might be in their early 50s.
The goal is to have the option to retire at an earlier date
than the average person.
So if you can't do it in your 30s or 40s, then who cares?
Because at least you can make it happen in your early 50s,
which is still pretty darn young
in the grand scheme of things.
One more thing to note is that I would caution everyone
to make sure that retiring early and not working
is something that they really wanna do.
Now, it's not like you can't hop back
into the workforce again if you want to,
but in my opinion,
most people are going to end up finding out
that not earning an income, doing something productive,
is going to get very old really quickly.
The good news is that you can test out retiring early
by doing something like a mini retirement
for one to two years
to see what it actually feels like.
I made a video where I walk you through
everything you need to know about taking a mini retirement
that I'll link up down in the description
and at the end of this video as well.
If you have any additional questions,
please leave them down in the comments below.
And don't forget the Hulk smash that thumbs up button
before you go, please.
Also down in the description,
I will have a link to get in the waiting list
for our private financial independence group
that will be opening up soon.
Down there you'll also find free stocks, resources,
and play lists to help with your financial independence
and investing needs.
I'll see you in the next one, friends, done.