The incredible complexities of Roth IRA rules may not matter to an early retiree sustained by side hustle income or a sizable brokerage. Think side-income Lean FIRE hustler on one end of the spectrum vs a high-income Fat FIRE investor on the other.
But most Americans on a FIRE journey likely land somewhere in the middle: they want to retire without a side job and have respectable after tax investments, but not enough to sustain living expenses until 59 ½.
While this middle-of-the-road early retiree can still access IRA money through IRS loopholes, there is a major catch: navigating complex Roth rules. A simple google search will yield loads of articles, with long bulleted lists that seem to inform every scenario except FIRE.
But don’t worry. Secret Life of FI has you covered. You can ignore all of the mental gymnastics needed to unravel arcane Roth rules. Instead, just follow these 2 simple rules:
- Contributions: All Initial Roth IRA/401K* contributions can be withdrawn any time.
- Conversions: If you convert pre-tax (IRA/401K) to a Roth (where you will pay normal income tax), you can withdraw that same converted amount after a 5 year waiting period. Additionally, each Roth conversion (if you do multiple), has its own 5 year waiting period.
Note: to avoid the the pro-rata tax penalty on the Roth 401K, first convert to a Roth IRA. Once converted, the original Roth 401K contributions become immediately available and penalty free like Roth IRA contributions.
Please keep in mind that the earnings from either contributions or conversions are still untouchable until you are 59 ½, so these rules are for originally contributed or converted amounts only. With that said, an early retiree can still access plenty of cash using these two rules if they plan carefully.
Let’s run through a few case studies to demonstrate how this might work in practicality.
1) Randy the Regular Roth Contributor
Randy is 55 years old and just hit his FI target of $800K, which includes $500K of Roth. On top of his pretax 401K, Randy has been contributing regularly to Roth accounts. He’s maxed Roth IRAs out the last 15 years at $5K a year ($75K total contributions), and he’s also invested $10K a year through an employer Roth 401K for the past 10 years (or $100K total contributions).
In short, Randy has $175K in total contributions vs $325K in total earnings in his Roth IRA/401K accounts. Randy can’t touch the $325K in earnings until he is 59 ½ years old, but he can withdraw the $175K in original contributions penalty free.
Solution: Randy retires, he rolls his Roth 401K account over to his Roth IRA, and he gains access to $175K that will sustain him until he is 59 ½ when he can access the rest.
2) Annie the Anti-Roth Anarchist
Annie hates paying taxes and never contributed to a Roth. Instead she maxed out her traditional pre-tax 401K in her working years and saved all excess cash in a brokerage. This badass Boston punk rocker managed to hit FI by age 40 with a nest egg worth $1.25M. Of that total, she has $1M in pre-tax 401K and $0.25M in her brokerage.
Her brokerage money is impressive but will run out in 6 or 7 years. Further, unlike Randy, she never contributed to a Roth, so she has no initial contributions she can pull whenever she wants.
Fortunately for Annie, she can still early access the entirety of her $1M traditional 401K through the Roth conversion method. Unlike original Roth contributions which can be pulled immediately, conversions (pre-tax 401K transferred to Roth IRA) have a 5 year waiting period, so while Annie can access this money, she has to wait it out.
Solution: Annie retires and lives off her brokerage for 5 years while following the Roth conversion method to access her 401K.
Bonus: Remember that Annie hates taxes right? Annie knows if she converts her entire 401K to a Roth in one year, she will pay max tax. Instead, she melts her tax burden down to near zero by spreading out her conversions as described in the how-to-retire tax free method on Secret Life of FI. This entails converting small amounts every year at a low tax rate, and then withdrawing that same amount 5 years later for each and every year she converts.
3) Debbie the Dabbler
Debbie the dabbler swings both ways. She’s been playing both fields since her early career because she couldn’t decide whether Roths were better or not. At 50, she hits FI and retires with $2M total: $0.6M in Roth IRA, $1.2M in a per-tax 401K, and $0.2M in brokerage.
No doubt, Debbie’s $2M nest egg is a towering achievement, but it still poses a common early retirement challenge. In short, $0.2M in her brokerage is not only too little to survive on until she is 59 ½ – it also won’t survive the 5 year period necessary to execute the Roth conversion method employed by Annie in our second example.
There is one other piece of data we haven’t examined: how much of Debbie’s $0.6M in Roth is basis from original contributions. Fortunately, Debbie is a meticulous record keeper, and she therefore knows that her $0.6M Roth is made up of $0.2M in earnings vs $0.4M in contributions (both from IRA contributions as well as from Roth 401K contributions she rolled over into her Roth IRA).
Solution: Debbie retires and immediately initiates a conversion ladder by converting $80K a year from her 401K to her Roth, starting the 5 year clock. During that 5 year wait, Debbie exhausts her $0.2M brokerage first, and she next withdraws $0.4M from her Roth penalty free (her original contributions, not the earnings). These funds are more than enough to bridge living expenses until Debbie is eligible to pull the additional $80k a year from her Roth that she adds yearly through the conversion method.
Satisfying the tax man
In all 3 examples, our early retirees followed just 2 simple rules of Roth withdrawals to access the basis (not earnings) in their retirement funds while avoiding early withdrawal penalties or taxes. Clearly, accessing original contributions is the most flexible and immediately available, but withdrawing conversions really only differs in that it has a minimum 5 year waiting period.
These simple rules specifically for withdrawing Roth contributions or Roth conversion principle is easy to follow. However, the record keeping of Roth contributions/conversions vs earnings can get murky.
Your 401K and/or IRA custodians may not be able to track basis vs earnings on a Roth IRA in the way they do for stocks you hold in your brokerage. First, they won’t know about other IRAs you hold with multiple custodians, so they may not know your total Roth net worth basis vs earnings. Second, even if you roll all of your IRA/401Ks to one custodian, some of your contribution or conversion record will not transfer with it.
For example, if you rollover $1M in Roth 401K (lets say with Fidelity) to a Roth IRA (let’s say with Vanguard), Fidelity cuts a check for $1M to Vanguard but doesn’t report that half the $1M is earnings and the other half is contributions. Vanguard will then show $1M was converted in their records, with no mention of initial contribution amount.
The IRS doesn’t track this for you either, but they are happy to collect taxes and penalties if you withdraw your Roth contributions/conversions before you are 59 ½ and don’t know how to file it properly.
To ensure your contribution/conversion withdrawal remains tax/penalty free as you know it legally should, be sure to file IRS Form 8606, Part III on your tax return. Most reputable online tax software preparation services will guide you through this, but if you are unsure, don’t be afraid to hire or consult a CPA (especially the first year you file a Roth contribution withdrawal).
Either way, you will be responsible for keeping a clean record of your Roth contributions and conversions, knowing the difference, and knowing when you can pull each of the two buckets of money. The best way to track this is to maintain a record of 5498 Forms that show your contributions and is issued by your IRA/401K custodians.
What is a 5498 Form? Here is a good primer. In short, your IRA/401K custodians issue this form every year to the IRS (and you) to report on how much you contributed (or converted) vs the fair market value of the Roth (earnings and basis). You never needed 5498 forms to file taxes while contributing; but you do need them when withdrawing contributions/conversions before the age of 59 ½ as they are the record of the exact initial amounts you contributed/converted in your Roth.
Summary: Simple is Sophisticated
There are literally dozens of other nuances to Roth IRAs and Roth 401Ks, including hardship type exceptions that allow additional withdrawal opportunities. But these additional pathways are incredibly complex and are too low dollar to matter to those on the FIRE path. For practical purposes, mastering withdrawals of Roth contributions and conversions are the only rules that matter, and they are the most simple ones to follow.
Simply put, if you want to retire, say, 20 years early – and have you enough money to do so – there are truly only 4 ways to fund your living expenses before you reach 59 1/2:
- Side hustle / rental / part-time income
- Cash stockpile (bank, CDs, brokerage, etc.)
- Roth contributions withdrawals
- Roth conversion withdrawals (after 5 years)
So you can either save a sh*load of cash, pick up side income, or exploit 2 simple IRS loopholes to access Roth money. Its as simple that. Some early retirees will pursue some combination of all 4 methods rather than relying on one method alone. How you choose to do it will depend on your specific asset picture, target living expenses, and age of early retirement.
If you choose to go down the Roth path, keep it simple and follow these two simple rules: (1) contributions can come out immediately and (2) conversions come 5 years later. Keep your tax records while you are contributing and you’ll be golden when you’e ready to finally turn in you badge and walk away from the work desk. Happy trails FIRE investors.