The Role of a Roth IRA in Early Retirement

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When it comes to people’s retirement goals, the current tax code has a fairly rigid assumption that you will retire after age 59½. For this reason, distributions before you turn 59½ from so-called retirement accounts are called early distributions. Early distributions are sometimes subject to a 10% penalty, but each account has a different set of exceptions that avoid this penalty.

If you want to retire before age 59½, then which accounts you save in and which accounts you withdraw from take a bit of extra consideration. If you save too much of your assets in the wrong account type, you’ll find that you are losing much of your precious financial freedom to federal taxation.

In this series, I am reviewing the role each type of account plays in an early retirement. This week, we are looking at one of the all-star best account types: the Roth IRA.

Roth IRAs are amazing tax saving tools. Roth IRAs are a type of Individual Retirement Account that allow investors to grow their money tax-free. Even though there is no deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59½. The long-term benefits can be significant. There are also several distribution rules that make Roth IRAs great savings tools for early retirees.

You can withdraw up-to your regular contribution basis.

First of all, at all times and at any age, you can withdraw as much as you have contributed to a Roth IRA without tax or penalty.

For example, if you contribute $10 today, you can take out your $10 basis at any time and owe no tax or penalty regardless of your age, your Roth IRA’s age, or the reason for the distribution. With an annual return of 8% and regular Roth IRA contributions from age 25 until an age-50 early retirement, your contribution basis might represent 30.11% of the account value after this 25-year career. This means if you do regular Roth contributions, perhaps over a quarter of your Roth IRA savings would be available for penalty-free early retirement withdrawal.

To take advantage of tax-free penalty-free Roth withdrawals of your contribution basis, you need to keep careful records of your contributions. You can read about how to do this in “Keep Track of Your Roth Contributions.”

After 5 years, you can withdraw Roth conversion / backdoor Roth basis.

Another source of penalty-free early withdrawals in a Roth IRA are the assets from Roth conversions.

A Roth conversion is the process of moving funds from a pre-tax environment (like a traditional IRA, SEP IRA, or employer sponsored qualified retirement plan) to the post-tax environment of a Roth account (normally a Roth IRA) by paying tax on that transfer now.

In order to perform a Roth conversion, you have to have already funded a pre-tax retirement account. Normally, pre-tax retirement account contributions are either excluded from taxable income, like 401(k) or 403(b) deferrals, or you receive a deduction for those contributions, like SEP IRA or traditional IRA contributions. If you are engaging in a backdoor Roth contribution strategy, then you are regularly doing Roth conversions of a nondeductible traditional IRA contribution.

If you fund your traditional IRA this year for a $6,000 deduction and immediately convert it to Roth IRA for a $6,000 IRA tax this year, it is tax equivalent to contributing to your Roth IRA directly but changes when you can withdraw those funds.

The day that you convert traditional IRA assets to Roth IRA starts a 5-year clock for those particular assets. After that 5-year period beginning after the conversion is complete, you can withdraw your conversion basis from your Roth IRA without penalty or tax. You can read more about this in “How Roth Conversions Affect Your Contribution Basis.”

If you want to use Roth conversions to generate available funds for withdrawal, you would need to do what is commonly called a Roth ladder. In a Roth ladder, you contribute to traditional IRA early in your working career. Then, as you approach retirement, you switch to Roth IRA contributions and begin Roth conversions of your traditional balance.

This year, you convert the money you anticipate withdrawing in 5-years. In this way, you are starting the 5-year clock for the assets you will need later.

This strategy is effective at avoiding the 10% penalty but may or may not be the wisest tax strategy overall. An analysis of the projected tax life for your particular early retirement plan would be in order to determine when and how much to contribute to traditional or convert to Roth.

With a tax, you can withdraw from earnings

In addition to being able to withdraw contribution and Roth conversion basis, you can also withdraw from your so-called earnings tax-free if you meet an exception. The exception list is:

  • You have reached age 59½.
  • You are totally and permanently disabled.
  • You are the beneficiary of a deceased IRA owner.
  • You use the distribution to buy, build, or rebuild a first home.
  • The distributions are part of a series of substantially equal payments.
  • You have unreimbursed medical expenses that are more than 10% (or 7.5% if you or your spouse was born before January 2, 1952) of your adjusted gross income (defined earlier) for the year.
  • You are paying medical insurance premiums during a period of unemployment.
  • The distributions are not more than your qualified higher education expenses.
  • The distribution is due to an IRS levy of the qualified plan.
  • The distribution is a qualified reservist distribution.

Alas, because of how the IRS orders your withdrawals, this exception list only becomes useful if you have already exhausted the contribution basis in the account.

The IRS assumes the ordering of your withdrawals to be:

  1. regular contribution basis, which is never taxed and never subject to penalty;
  2. the taxable portion of your oldest Roth conversion;
  3. the nontaxable portion of your oldest Roth conversion;
  4. repeating numbers 2 and 3 on your next oldest Roth conversion;
  5. and then finally Roth IRA earnings, the portion not attributable to any kind of contribution basis.

That being said, if you have exhausted your contribution basis and still need to tap your Roth IRA before age 59½, this exception list can come in handy.

You need to wait until age 59½ for qualified distributions.

Qualified distributions from your Roth IRA are never subject to tax or penalty. Unfortunately, most early retirees will not be able to take advantage of qualified Roth distributions right away. For the distribution from your Roth IRA’s earnings to be a qualified distribution, you need to meet both of the following:

  1. A Roth IRA of yours has been set-up for at least 5 years.
  2. The payment or distribution is one of the following:
    1. Made on or after the date you reach age 59½,
    2. Made because you are disabled,
    3. Made to a beneficiary or to your estate after your death, or
    4. One that meets the requirements listed under First home under Exceptions in chapter 1 (up to a $10,000 lifetime limit).

The most common way to meet the second part of this two-part requirement is to be older than 59½. For this reason, most early retirees are unable to make qualified distributions until they are a little older.

For the first requirement, you need to have contributed to Roth for the first time more than 5 years ago.

This is one of the reasons that you should open a Roth IRA and contribute to it today. If you have earned income this year and have never opened a Roth IRA, open a Roth IRA right now and contribute $1 to it immediately.

Once you have had one Roth IRA opened and funded for five tax years, the requirement is satisfied for all of your earnings in all Roth IRAs regardless of how long particular contributed dollars have been in particular accounts. Getting that clock out of the way will help you get easier access to your retirement funds.

If you are planning an early retirement and would like a partner to plan your account types, you can simply Contact Us to get started as a client. Our prospective client meetings are free, and we look forward to meeting you!

Photo by Becca Tapert on Unsplash

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Chief Operating Officer, CFP®, APMA®

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.