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Episode #497 - The Rules for Roth Withdrawals
Roger: "The arrow that hits the bullseye is the result of 100 misses." -A Buddhist saying.
INTRODUCTION
Well, hey there.
Welcome to the Retirement Answer Man show. My name is Roger Whitney. I am your host, and this is a show dedicated to helping you not just survive retirement but have the confidence to lean in and rock retirement. You know, why are you going to have that confidence? Because you're going to do the work consistently, and when you fail, you're going to get back up and you're going to improve and do it again. That's how you gain confidence.
Now, before we get started on the show, we're going to talk about Roth IRAs and continue this series. I want to share something with you that is a little bit personal, so you're welcome to zip through this or if you want to hear it.
I was thinking of this quote, "the arrow that hits the bullseye is the result of a hundred misses." If you're like me, physically you probably have tried to manage improved habits of nutrition and exercise, et cetera, and done well and fallen down and done well and fallen down. I feel like I've really been getting dialed in the last year or so, and I definitely have lost weight.
I think I'm down from about 216, 217. It says I weighed on this report. Let me go where it was. I think it said I weighed 207. But my official scale, while I weigh myself, said 204, 205. Anyway, I'm reading Outlive by Peter Attia, and he was talking about the four horsemen, which are major diseases, major causes of death, coronary artery disease, diabetes, cancer, and Alzheimer’s.
Those are the four horsemen that he identified, and then he got into the discussion about fat. Your body fat. And there's the fat that hangs on the outside, but then there's what's called visceral fat on the inside that's what's under your muscle line that is all inside your belly and that's like the really bad fat.
You could actually not have a lot of the subcutaneous fat, but you could have visceral fat, and that is a contributor to these four horsemen that are some of the leading causes of death. So, it's important to know these numbers so you can work to manage those numbers, because every action you have is a vote for increasing or decreasing the risk of these things happening.
That's the way I look at it anyway. So, this is the agency that you have. So, I went and got this DEXA scan. D E X A scan. Wasn't that expensive, 50 bucks. It was a mobile thing. I went to my local bike shop when they were going to be there for the day, to get my first body scan. You just lay on a table and this light thing goes over you for about five minutes and then they send you this report of a lot of things, bone density, your percentage fat, the amount of visceral fat you have, where the fat is on your body, it's like more information than you need. I still haven't really figured out how to read this thing. I need to do a little bit more research.
One thing that stood out to me, that was very easy to understand, was that my total body fat percentage, I'm going to say this publicly on July 13th, when I took the scan, 2023 was 28.4%. So, of my total weight, 28.4%. of my body is fat. Now, if you look at the scales that were on the report, and if you look at the scales that you see online for a male at age 56 or in that range, that's on the high end of what my body fat percentage should be. I don't like that. Although I've done all this work, I have more work to do to lower this number, to vote for decreasing the risk as I age of these four horsemen. Coronary artery disease, diabetes, cancer, Alzheimer’s. It's interesting because at least the comments I get when I see people, wow, you look so fit. You're like jacked, you're fit, which is awesome. I definitely appreciate the affirmation. So, you wouldn't think, I didn't think that that was the percentage of fat that I was.
So, I'm taking action on that. Not because I want to be lean and cut and everything else. It's because I want to be as proactive as I can and to build better habits that can improve the trajectory of my health as I age.
This is an area, it seems like, a pretty obvious area that I can take proactive steps, even though I've shot the arrow to be better at it, I haven't quite hit the bullseye, and this is part of improvement. So, I want to get to 20% body fat. in roughly 12 weeks. I think that's reasonable from some very high-level research.
Am I overshooting? Am I too aggressive, not aggressive enough? I don't know, but it gives me a target to shoot for, which I can build habits in implementing. So, I like that.
So, I'm just publicly telling you I'm going to work on my habits, the rhythm in which I eat dinner, I'm going to track my food, because I think I've been lying to myself about the quantity of meals that I've been eating and the portions of those meals. I'm going to have to put some guards around when I’m at my weakest which is at the end of the day when I’m tired. My ultimate goal here in order to achieve this is to have more energy and cast votes at decreasing the risk for these things, so. That's going to be my personal journey.
I'll keep you up to date as much as you want to be. Maybe Bobby will have some ideas when we get him on the show next. But with that, let's move on and start talking about Roth IRAs and then get to your questions.
PRACTICAL PLANNING SEGMENT
We've spent some time talking about how to get money into Roth IRAs, these tax-free assets through contributions and conversions. Today, we're going to talk about the rules to take money out of Roth IRAs. They're much more complicated than you think they would be due to the fact that the IRS structured the withdrawal protocol to avoid some unintended consequences that we actually don't have to get into here.
So, we're going to outline today the rules around taking money out of Roth IRAs or Roth 401ks.
Now, for some of you, I'm going to save you a ton of time. Because there is a golden rule that if you hit these two bogeys, you don't have to worry about any of the stuff I'm about to talk about, whether it's you've already hit it, or you know that you're not going to take any money out of Roth accounts before you've hit these two attributes of this golden rule. So, I'm going to save a lot of you a lot of time.
If, number one, you are over 59 and a half, check that box today, or you know that you're not going to take a Roth contribution or Roth amount out before you're 59 and a half. Okay you've checked that box. Plus. You've had money in a Roth IRA for at least five years. So, if you're 60, but you just did your first Roth conversion and put your first dollar into a Roth, you have not hit this golden rule, but if you did it when you were 50 and you're 60, you've hit the golden rule.
So, you have to be 59 and a half and you have to have had money in a Roth IRA for at least five years. And we'll talk about the rules around the five-year rule. If you hit those two things, you can take money out without any penalty, without any tax, forever. So that means you can ignore everything I'm about to talk about. Over 59 and a half, and you've had money in your Roth IRA, or the account that you're taking the money out of, for at least five years. It doesn't matter whether it's conversions or contributions, etc.
So that's the golden rule, so I just saved a lot of you a lot of time.
Now, what if you haven't hit those, or you want to understand a lot of this geeky stuff? Now, because this stuff is very complicated, By the way, unless you have one of those crazy brains where you remember everything in detail on stuff like this, I would suggest that when you're doing your planning or especially when you're getting ready to take money out of a Roth, you go find a structure to think through it in an organized way. If you miss It could have unintended consequences that may be irreversible. That's why the importance of standard operating procedures and protocols and checklists are so important.
In fact, I'm tasking Troy in my office to build a protocol or a checklist around Roth withdrawals. Once we have that completed and printed up, we'll share in our Six Shot Saturday email. That way you can follow a protocol to check the boxes so you don't miss something that might be important.
Before we get into the five-year rule, there's a couple things to understand. One is the ordering of withdrawals. So, if you have a Roth IRA, you may have contributions there. You may have conversions in there. You may have earnings in there. So, it's a mix of these three different flavors within one Roth IRA.
So, the ordering of withdrawals, so if you take out a dollar, it's going to assume you're taking all of your contributions first. So, let's assume you take out 100, 000 and you have 50, 000 of contributions.
That 100, 000, it's going to say 50, 000 of that is all of the contributions that you made. The next order is any conversions that you've done in a Roth IRA. So, let's assume you've done 20, 000 in conversions. So, you've taken out 100,000, 50,000 that are the contributions that you made, and then 20, 000 of that are going to be from the conversions, the only conversions that you've done, and then the last in the hierarchy are your earnings, so 30, 000 in this example. That means when you go to do a subsequent withdrawal, all you have are earnings left. So, it goes first, you're taking out of your contributions. Second, you're taking out of your conversions. If you've done multiple conversions, it's going to go from oldest to newest.
Then, you're taking out your earnings. So, that's the ordering of withdrawals. Let's assume you have, like, four different Roth IRAs for whatever reason you have. The IRS, when they're applying this ordering in the five-year rule that we're going to talk about, aggregates all those as one big bucket of Roth IRAs.
So, in this ordering and applying what's called the five-year rule, which we're about to get into, it's important that you know if you have multiple Roth IRAs in your name, the IRS doesn't care. They're going to look at it all as one when they're figuring out if you're going to have some tax or penalty applied to the withdrawal. Again, this is only applying to people that are not 59 and a half and haven't had money in a Roth IRA for over five years.
So, if you haven't hit the golden rule, you're going to want to be aware of what's called the five-year rule and there are actually multiple five-year rules, and you can see how this can get really complicated.
So, what is the five-year rule? Well, first, let's start, when does the five-year rule start? The clock starts on January 1st of your first contribution to any Roth IRA, and we're going to focus on IRAs here. So, January 1st, of the year you make a Roth contribution, or a Roth conversion is going to be the beginning of the five-year rule clock.
So as an example, let's assume you make a contribution in April of 2024 to a Roth IRA, and it's your first contribution ever. But you're making it for the 2023 tax year, because you have up until April 15th to do that. So, if that's your first contribution ever, the clock is going to start on January 1st, 2023, even though you made the contribution in April of 2024, that means the five-year rule will be satisfied in terms of having that first dollar in that Roth IRA on January 1st of 2028.
So that is the start. It's always January 1st of that first dollar. Now, if you want to withdraw money from your Roth IRA and you haven't met that golden rule that we talked about previously, how does this five-year rule interact with your withdrawals, because that's really what it's for.
So first off, let's talk about your contributions to a Roth IRA. Contributions can be taken out with no tax or no penalty anytime. So, it's after-tax dollars that you put into this Roth. You can take out that money anytime you want to, doesn't matter what age you are.
Let's use an example here. Let's assume you have contributed 10, 000 to a Roth IRA and you are age 57. You had a great year in the market, and the next year your Roth IRA is worth 12, 000, and you are 58. And you need some cash, and you decide you want to take it out of the Roth IRA that you've just funded a year ago.
Didn't hit the five-year rule, you're not over 59 and a half, you haven't had money in there for five years, so how does this work? Well, you could take out 10, 000 from that 12, 000 Roth IRA with no tax, no penalty, even though you're only 58 years of age at this time. That's money that you already paid tax on. You put it in there. And because of ordering rules, although the accounts, you've earned 2, 000. Remember, Contributions come out first, and then conversions, and then earnings. So, you'd be left with 2, 000 left in that Roth IRA if you took out that 10, 000 a year later. No problem. Doesn't matter whether you're 57, whether you're 27, etc. It's your money.
What if I want to take out more than 10, 000? What if I want to take out the entire 12, 000 because of whatever? How does that interact with this five-year rule? So, let's go back to the fact set. I put in 10, 000 when I was 57. A year later, it grew to 12, 000. Now I want to close it out and take the whole 12, 000 back.
How is that going to work from a tax perspective? Well, 10,000 would come out tax and penalty free because it's my money. Those are my contributions. But the other 2, 000 because I'm under 59 and a half and I haven't had the money in there for five years, is going to have taxes applied to those two thousand dollars the earnings as well as the penalty for taking it out over 59 and a half.
Now, what if I wait a little bit?
What if I say I turn 60 and it's worth 12, 000 and I want to take the money out? Well, again, if I take the 12, 000 out, I made the contribution when I was 57, three years ago. I'm 60 now. The 10, 000 contribution has grown to 12, 000, and then I have decided to close the account. So, I've met the 59 and a half. part of that golden rule, but I haven't met the five-year rule, meaning that the dollars have only been in there for three years, not five years. So how would the withdrawal work on those contributions?
So, if I close the account and take out the 12, 000, I've met the 59 and a half, but I haven't met the five-year rule, so the contributions would come out, fine. There would be no penalty on the earnings, but they would be taxed as income. So, you already hit 59 and a half, so there's not going to be that premature withdrawal penalty, but you're going to be taxed on the earnings of 2, 000.
So that's how the 5-year rule interacts with Roth contributions. Doesn't matter when you take your contributions out, and they're always the first to come out, but when you take out earnings, they're going to look at, are you 59 and a half, and have the dollars been in there for five years? That's why this five-year rule is important.
If you don't plan on taking this money out for a long time prior to 59 and a half, and the money will definitely be in there five years, you don't have to worry about this. But if you do, it becomes something you want to pay attention to.
Now let's move to Roth conversions.
Remember, that's moving money from a pretax IRA, paying tax on it, and then putting it into a Roth IRA. How does this work with this five-year rule? So now we're talking about conversions. So again, we're going to assume you haven't hit the golden rule, which is you've had money in a Roth IRA for at least five years and you're over 59 and a half. We're going to assume that you have not hit that golden rule, because if you hit that, you don't care about this. But if you haven't hit the golden rule, how does it work if you do a Roth conversion, moving money from a pretax IRA to a Roth IRA, and you want to take money out, but you're under 59 and a half? Let's start there. So, you haven't met the five-year rule and you're under 59 and a half.
Well, if you haven't met the five-year rule, the conversion amount would be penalized if you were to take it out. So, you would have the premature penalty and the earnings would be taxed and penalized and remember that ordering rule of contributions come out first, conversions come out second, oldest to newest and then earnings.
So, the calculation for being under 59 and a half and not meeting the five-year rule would be first the conversion comes out and that's going to have a penalty on it because you're under 59 and a half and you haven't met the five year rule and then the earnings are going to be taxed and penalized if any part of that withdrawal is earnings.
What if you're over 59 and a half? Well, if you're over 59 and a half and the five-year rule has not been met, then there's going to be no tax or penalty on the amount that you converted because you're over 59 and a half, and the conversion you've already paid tax on. So, it essentially acts like a contribution in that sense. But you will have a tax on the withdrawal of the earnings, assuming that you blow through your conversions on the withdrawal.
So, let's use an example. That's usually the best way to do it. Let's go back to that 10, 000. Let's assume that you are 59 years old, and you do a 10, 000 Roth conversion into your first ever Roth IRA. So, you don't have any contributions there, and that account grows to 15, 000 when you are 62. So, we know you're over 59 and a half. But you haven't hit the five-year rule in terms of having money in that Roth IRA for at least 5 years. If you want to take out 12, 000 when you're 62, how is this going to be taxed?
Well, if you take out 12, 000, 10,000 of that, the amount of your conversion in this case, that's going to have no tax and no penalty because you've already paid taxes on it and you're over 59 and a half. But the 2, 000 is going to be taxed as income because you haven't hit the five-year rule, but you're over 59 and a half, so there's not going to be a penalty on this.
So that's the basics of the five-year rule. Now let's turn to the Roth 401k. Oh man, a whole other segment. Again, if you've hit that golden rule, over 59 and a half, money's been in there five years. No problem. No worries. Go have a margarita. But if you want to address these and you haven't hit that golden rule, withdrawals work roughly the same way in terms of the tax ordering with a couple little nuances.
The big one is going to be the five-year rule. How does that work with a Roth 401k? Well, it's five years since the original date of your first contribution to a Roth 401k. But what if you move that money? Let's say you leave that employer. You have three choices. You can leave it in that Roth 401k, assuming the plan allows you, or you could roll that over to your Roth IRA. So, let's use an example here. That's always easy. Let's take this 10, 000. You worked at ABC company, and you contributed 10, 000 to a Roth 401k. It grew to 12, 000 over whatever period of time. And let's assume you had that in there for five years.
Okay. You've had this in there for five years. You leave ABC company and then A, you decide to keep it there. Okay, you've had the money there for at least five years. So, if you're under 59 and a half and you were to take money out, your contributions can come out tax free and no penalty, regardless of age. But your earnings wouldn't be taxed in this case if you're over 59 and a half. But if you're under 59 and a half, the earnings would be taxed and have a penalty to them.
Now let's turn to Roth 401k withdrawal rules. And you're like, oh man, more rules. Yeah, lots of rules, IRS here. They are very similar to Roth IRA withdrawal rules, but there are some wrinkles we just want to make sure we highlight here.
First off, let's talk about Roth 401k withdrawals. So again, if you've hit the golden rule, which is 59 and a half, you're over 59 and a half, and you've had money in a Roth 401k for over five years, either now, or you know you're not going to touch this money until after those two things occur, then fine, you can ignore all this. No tax, no penalty on contributions and earnings, etc. Those are qualified withdrawals.
Unqualified withdrawals, though, you have to hit, one, the five-year rule. That comes into play. Now, if you are under 59 and a half, you can take contributions out with no tax or penalty, and earnings will have a tax and penalty, just like a traditional 401k in that sense.
But early withdrawals, money that you take out prior to 59 and a half, the way those are treated in the ordering is a little bit different. That is, let's assume you have a 10, 000 balance, and you have 9, 000 of contributions and 1, 000 of earnings. Any monies that you take out prior to being age 59 and a half, an early withdrawal, rather than going in that ordering of contributions first, conversions, and then earnings, it's actually prorated.
Meaning that if you were to take a withdrawal of this 10, 000 balance, 10% of that, in this example, of a 10, 000 account with 9, 000 contributions, 1, 000 earnings, 10% of that withdrawal is subject to tax and penalty. So, they're not going to go into the hierarchy in quite the same way that you would in a Roth IRA.
So that's one thing I want to point out.
The main thing I want to point out about the five-year rule when it comes to Roth 401ks Is that the five-year rule starts in the year that you make your first Roth 401k contribution. Doesn't matter if you have a Roth IRA, it's only about Roth 401ks. So, the five-year rule clock starts when you make that first contribution.
We tend to move employers, right? We don't stay typically, or maybe we switch employers or we retire and you have this Roth 401k, and you have three choices if you leave an employer where you have a Roth 401k.
Number one is, you can keep it there, assuming the plan lets you, and that preserves that five-year clock.
Or you can roll that to, say, your new employer's Roth 401k, assuming that they accept that. Now, the holding period from that first dollar going into the Roth 401k at your old employer should carry forward, but there may need to be some trustee coordination because the new Roth 401k may not know when you made that first contribution at your old employer.
So, you're going to have to be a little bit proactive to make sure there's some coordination there. Because otherwise you might lose that Roth clock in terms of the five-year rule when you move it from one 401k plan to the other because that first dollar going in doesn't necessarily transfer over to the new manager of your new employer's 401k plan.
The third option is, you can roll that Roth 401k into a Roth IRA, just like you can do that with traditional assets, right? So, what happens to this five-year rule if you move it from a Roth 401k to a Roth IRA? If you do that, let's assume you had that money in that Roth 401k for 10 years. You've been contributing, you're planning on taking money out when you're 60, and you're 60 years old, you roll that Roth 401k that has met the five-year rule into a Roth IRA.
What happens? Well, if this is a brand-new Roth IRA, that's never had a dollar, you're going to lose that holding period, and you're going to reset the clock. Because when you establish your Roth IRA, and you put your first dollar in, is when the clock starts for the five-year rule for Roth IRAs, remember?
So, if you roll a 401k that's a Roth, into a brand-new Roth IRA, you reset the clock in terms of the five-year rule. So, you have to wait another five years to get through that second part of the golden rule. You've had money in a Roth IRA for five years. So, you're going to lose that holding period. So, if you were to take money out and you start to get into earnings, then you may have some tax on those earnings.
So that's one reason why it's best practice if you're doing, especially a Roth 401k to at least open up a Roth IRA now and convert even five bucks into it. So, you can start that clock. So later on, when you receive the rollover from a 401k, you don't have to worry about this. So that's an important consideration.
Those are the basics of Roth withdrawals. Now what we're going to do next week is talk about how you think through deciding whether you want to pull this powerful tool out of the toolbox and apply it to your retirement journey. But for now, let's move on and answer your questions.
LISTENER QUESTIONS
Questions, questions, who's got questions If you have a question for the show, you can go to the interweb and type in www.askroger.me and you can type in your question, leave an audio question and we'll do our best to answer it on the show and help you take action to rock retirement.
ON TAKING MONEY FROM A 401K AND MOVING IT TO A ROTH IRA SO THAT SOMEONE CAN MANAGE IT
So, our first question comes from Caroline.
Caroline: Hi, my name is Caroline.
What do you think about taking money out of a 401k while you're still working and putting it into an IRA that someone manages, and you will be paying for them to manage that money?
Thank you!
Roger: Good question, Caroline. There are actually two parts to that question.
One is, what do I think about taking money from a 401k and moving it to an IRA? I want to talk about that briefly, but first I want to talk about what I think the main question is, which is moving it to an IRA so somebody can manage it for a fee. Let's talk about that one first because I think that's the central question.
Essentially, this is hiring a financial advisor to manage the assets and then they're going to probably make a percentage of the assets as a fee, AUM fee on the assets that they're managing.
Caroline, if it's just simply about managing the assets in an IRA rather than a 401k, I don't like it. I don't think it's worth doing for that reason.
Here's my logic. Number one is, if you want a financial advisor or a financial planner, a retirement planner I think would be better. There are other ways to compensate retirement planners. If all of your money is in the 401k, you can compensate them by the hour. You can hire someone to create a flat fee plan for you to tell you what to do with your IRA.
You could hire someone that you pay a retainer for. I don't think it's wrong to pay somebody an AUM fee if they're managing the entire retirement process and planning, but if it's all about investment management, I don't think it's worth it. Investment management isn't that hard. I mean, you have to do it consistently.
The behavioral part is much harder than the actual, what do I choose? But I think you should have a retirement planner, if anybody, and allocating your assets is a part, but definitely not the whole, or the main thrust of the entire process. So, if this is just about managing assets, nah, I'd leave it in the 401k.
Now, where there can be some caveats with that, Caroline, is your 401k options. Why might you move it to an IRA, whether you got somebody managing it or not? Well, it could be. that you don't have good investment options, because every 401k is different.
So as an example, the 401k at my firm is held at Vanguard.
The investment options cover all the asset classes, almost without exception. Investment choices, the menu of options to put money into, are very low-cost index-based investments. So, there's not a lot of investment costs in the monies that go into these investment assets.
On the opposite extreme, though, there are some 401ks where they have limited investment options, what you can put your money to, and the fees within those investment options are 1%, 2% or more, depending on the structure, and that's a lot.
So, if you have a plan that has very many options and the investment choices are really expensive on their internal expenses, maybe it's worth it moving it to an IRA so you can manage the investments and control costs a little bit. Some other reasons why you might not move it from a 401k is creditor protection, because a 401k is going to have the most robust creditor protection of tax deferred assets in terms of investment accounts.
IRAs have creditor protection, but it varies state by state, and you'll have to compare how important that is to you. But the key here, Caroline, is it okay to pay somebody to help you make a plan and be a decision-making partner? I truly believe that. I must. I'm in that business. But if it's all about just simply managing the assets? Managing the assets is part of a much bigger hole in a robust planning process.
It sounds like, I'm just inferring this, that the recommendation is to move the assets to the IRA so they can get paid to manage the IRA. Well, you can figure out how much that's going to cost you on an annual basis, and then you can decide, is it worth that amount for all the other services that they're doing for me? If it is worth that amount, you can still decide, well, maybe I pay you by a retainer, or I pay you by invoice rather than moving your 401k and taking out of tax deferred assets.
They don't have to be tied together. So, the way you phrased it and the way I'm feeling about this, it doesn't sound great to me.
HOW TO DECIDE WHETHER TO CONVERT FUNDS INTO A ROTH IRA
Our next question comes from Jim about his IRA, and I'm going to try to summarize here because Jim, you shared a lot of information, which is great.
He says,
"Hey Roger, I'm curious about something related to spending down my IRA. When I do the math on Roth conversions, it's not clear to me that I'd get a significant benefit from converting some of my IRA to a Roth.
I have about 1. 2 million in IRA, 1. 1 million in taxable accounts, I'm 64 years old, my wife and I have about 100, 000 in income. I was considering doing some Roth conversions each year for the next three years. However, I also need some money to cover fund spending, trips, toys, etc. I was thinking of taking money out of the IRA to do that.
If I take from the IRA, yes, I'm going to incur the taxes, and I'll pay that from my taxable accounts, and this will reduce my IRA for RMD purposes. I was originally going to convert about 300, 000 to Roth over the next three years and invest aggressively for growth. I thought this would help maybe with long term care in the future.
The problem is, a lot of that conversion would be in the 22% bracket, so I'd need 90, 000 to 100, 000 in tax money to cover it. And I'm wary of depleting my taxable assets. Is it reasonable for me to simply spend down some of my IRAs so the RMDs aren't as high as they would be otherwise? Or is the Roth a better idea?
Or is it a mix of both?"
Well, Jim, you really hit the nail on the head on Roth conversions, and this is a personal decision based on a lot of unknown factors, and so you just want to try to make sense of it in as organized a way as you can. We're going to try to build a basic framework in the next episode, actually, to try to just have a basic framework to organize all of this because you're not going to get to a crystal-clear decision, or rarely will you ever. One thing that people mostly forget about here is by converting, you get the advantage. Yes, 22% tax bracket, I understand, but that's actually not a bad tax bracket historically, and that's based on your joint income. So, we tend to assume we'll always be joint, and where the Roth could come into play as an advantage is If one of you were to prematurely die and the other went to a single bracket, you'd have more tax flexibility in terms of those RMDs.
But to answer your question specifically, Jim, there is nothing wrong with simply drawing from your pretax accounts to pay for fun, to fill up tax brackets. This is something I probably do in my practice more than Roth conversions. Each year, you're going to look at how much you need for the next year.
You're going to look at what your taxable income is, and try to do an estimate of, well, how far am I within the 12% bracket until I get to the 22? And then, how much into the 22 do I want to go, or am I comfortable going in each year? And then you make a judgment call of, I'm going to proactively take money out, to help build my income floor to pay for this fun stuff. That is perfectly reasonable, and then you can decide over and above whether you do some Roth conversions you don't necessarily have to be super aggressive about it. You can be in between when it comes to taking some money out, doing Roth conversions, maybe do a Roth conversion one year, you take some money out another year.
You don't have to be really aggressive about it either. So, I think it is going to come down to a personal decision. I just want to make sure you factor in the fact that you may switch tax brackets. You want to estimate what your required minimum distributions will be if you don't do any, and you can build a simple spreadsheet to estimate what those RMDs would be, and also estimate what those RMDs would be if you took out money to pay for fun stuff so you can get an idea of where that would put you when you reach 73 or 75, depending on your age. But I think it's reasonable. I take money out. with clients all the time simply to pay for life.
ESTIMATING SOCIAL SECURITY INCOME USING THE DETAILED CALCULATOR
Our next question comes from Kathy related to social security estimates.
Kathy says,
"My husband will reach full retirement age in six months and I will be there two years later.
I've heard and read that the closer one is to full retirement age, the more accurate the benefit estimate is on the ssa.gov website. Given our proximity to full retirement age for Social Security purposes, are we, quote unquote, safe to use the website estimates to calculate the income that we'll be receiving in retirement?"
I'm going to be real simple here, Kathy. Yes, I think you're safe in using those estimates. When I've done the calculations using a detailed calculator for someone that's even 5 years out that's retired, 9 times out of 10, the estimate isn't too far off, even though essentially, social security estimate is calculating, assuming you worked to retirement age, but given where you're at, I think you're totally fine in using those estimates.
Those estimates are going to be wrong anyway, but they're within range that I don't think you need to go much deeper here. You can move on to doing more important things.
CLARIFYING THE FIVE-YEAR RULE START DATE
Our next question comes from Barry, related to the five-year rule start date.
He said,
"Hey Roger,
I've been enjoying your podcast for several years."
Barry, I'm glad you're sticking around.
"And I particularly enjoy the expanded non-financial retirement subjects".
"Oh, good. Good, because I'm wondering about that. I'm not sure how that's being received, so I'm glad you're liking it, Barry."
Barry says,
" I am 62 years old and plan to retire in five years. My initial foray into Roth contributions was through making Roth 401k contributions in my 401k plan.
Two years later, I established a Roth IRA outside of my employer's plan by making a conversion of some conventional IRA funds. My question is, when does my five-year clock start ticking for the five-year rule? From the initial Roth 401k contribution or from the later date of my IRA conversion?"
That's a great question, Barry.
Unfortunately, an IRA and a 401k are two different tax advantaged vehicles, despite having both the Roth name around them. Therefore, the money that you started putting into your Roth 401k doesn't have any impact on the start date for your Roth IRA five-year clock. Your Roth IRA five-year clock starts with your first IRA contribution.
Now, if you leave your Roth 401k at your employer's plan, which may be an option, and you withdraw contributions and earnings without taxes and penalties since you're over 59 and a half, and you won't have any tax on your earnings if you started contributing at least five years before you retired. So, you may have the option of just leaving the Roth 401k.
Now, if you roll your Roth 401k into your Roth IRA, then the five-year rule timeline is based on that first little conversion you did into your Roth IRA. Now, since you're 62, remember, if you violate this five-year rule, you're going to pay taxes on the earnings only, and when you're drawing money from it, it's coming from contributions first.
So, this just means you're going to want to decide whether you keep your Roth 401k separate or roll that into an IRA. You may want to keep it separate if you can take withdrawals from that, assuming that you've already hit the five-year rule there, because if you roll that over, then it's going to be based on that Roth IRA.
Now remember, because of the Secure Act 2. 0, there's no need to roll it over in terms of avoiding required minimum distributions because they fixed that. So hopefully that helps you on your way, Barry.
DECIDING WHETHER TO CLAIM SOCIAL SECURITY EARLY
Our next question comes from Delroy, and he's thinking about Social Security and Roth conversion strategies.
"Hey Roger,
I listen to your shows and love them. Can you please help me with the below situation?
I'm 61, turning 62 in 2023. I plan to apply for my social security even though I do not need it. My rationale is I am projected to get about $2,500 a month if I take Social Security at age 62. If I delay to 67, I get.
3, 050 a month. I think that if I take at 60 over the next 5 years, I would have collected 150, 000. However, if I wait to 67, it would take me 272 plus months to cover what I had missed. Don't you think it would be better to collect at 62?
I am thinking of transferring all of my IRA assets to Roth two years before I apply for Medicare.
So, do you think this is a great idea? I would leave items in the same investments and let them grow tax free."
So, Delroy, for your question, I want to focus on the Social Security claiming strategy, and not the Roth conversion strategy, because we're going to talk about a framework to think about that next week.
All right, your logic is, you're 61, you're going to turn 62 sometime this year, and you're going to apply for Social Security, even though you don't need it, and that's an important consideration here. Your rationale is, by claiming at 62, You're going to earn 150, 000 extra between 62 to age 67, which would be your full retirement age, which if you delay taking it, it will take you out to your mid 70s before you broke even in terms of waiting to get your benefit at your full retirement age.
So, I get that logic from a math standpoint, but I think there are some considerations that you want to make sure you consider here.
Number one is every year you delay taking Social Security, your base is going to increase not just by the fact that you're waiting, but by the inflation adjustment that's happening along the way.
Just the natural increase is about 8%, and that's a free of market volatility increase. of your guaranteed income for the rest of your life. So that's number one.
Another one is, and I don't know if you're married or not Delroy, but if you are married, this could impact your or your spouse's benefit, depending on who has the higher benefit.
If we assume you have the higher social security benefit. Their spousal benefit is going to be permanently impacted by your decision to take it early and how much they receive as a survivor benefit, assuming that you predeceased them, is going to be impacted because of this permanent decrease in the benefit that you're going to get. That needs to be factored in here.
Another aspect is by delaying Social Security, you have more space available to you from a tax perspective to be able to do Roth conversions or strategic withdrawals from your pretax assets considering that you don't even need this income in the first place.
There's another aspect here I want to make sure I drive home that is beyond the spreadsheet. Social security is the pillar of social capital. It's guaranteed income that is inflation adjusted, that will last for as long as you live, and if you're married will go on for your spouse. Now Delroy today, who's a spry 61, about to be 62-year-old, does the math and I don't need the income, but man, I'm only going to live to 75 anyway. Why would I wait that long?
Math wise, I get some of your logic there, but you also have to think of Delroy when he's 75 or 80, or Mrs. Delroy, who isn't as spry as they used to be. They could live to 90 or to 100 and by maximizing the guaranteed inflation adjusted benefit, that social capital is going to de risk and make the plan much more resilient for Delroy, future Delroy, because we don't know what's going to happen with your financial assets between now and then or your health, et cetera. It's going to be mistake free money that's guaranteed. regardless of where you or your wife, if you're married, are cognitively.
So, I think at the math part, you do want to think about this for sure and we've had instances where we've taken social security early. Rarely have we ever done it before for retirement age, unless it was needed. You're saying it's not needed.
I would caution you in doing this because you may not have the outcome that you want, especially if you have income and since you don't need the money, it may give you much more room to do some Roth conversions. So that's my caution Delroy. Thanks for listening, buddy.
With that, let's move on to the Bring It On segment.
BRING IT ON
Today in the Bring It On segment, we're going to talk about mindset, and I want to talk a little bit about intentions and I'm almost going to read you, verbatim, a journal I had to myself talking about intentions. I think this is really important when it comes to fostering an action posture in our life.
Intentions, they're great, but they can really get in the way of actually doing things. And in the meantime, you can miss your life. So let me get to my journal entry and I'll read you what I wrote to myself.
You never get time back. That's why intentions are dangerous. You could waste your life with intention.
"Waste no more time arguing what a good man should be. Be one." That's Marcus Aurelius. I have that quote up here in my office.
It really is that simple. I need to stop drinking, which is an intention. Stop drinking is an action. I should call my kids more. Intention. Call a kid. Action. In this light, intentions are revealed as weak platitudes that give us a dose of feeling better in the moment without actually having to do anything.
All along, tick, tock, tick, tock, tick, tock, time marches on. Eventually you get to, I wish I would have. A bit pathetic when you look at it like this.
We all do it. It's a matter of degree. Do we catch ourselves or do we become ingrained in this intentional habit which spirals us downwards and allows us to miss our life.
We tell ourselves, have you ever told yourself this? We're too busy right now. That's a lie. That doesn't mean we have to do more and pursue every idea we think of. Is it okay to hold up the idea and say, should I examine it? The key is to decide. As an aside, that's my word for the year, decide, which means, etymologically, to cut.
If you have something that pops up as an intention, you basically have three choices. I will do this now, I will consider another day, or I will not do this.
These are the decisions. They give clarity. They are true. Choosing one may be uncomfortable. It may be uncomfortable at the moment, but it is the truth. It doesn't give you that mental crutch of having both your feel good and doing nothing, which is essentially what an intention does. It makes you feel good at the moment. Oh, I have an intention of stopping drinking, and then you go about your day.
This in between has disastrous effects, not just on your life, which could be missing it, it poisons your soul and confidence in yourself. You set up intentions which make you feel good in the moment, you don't actually follow through on your intentions, and then you shame yourself later on.
Intentions are easy when we're on the couch. So, be careful of your intentions. As you foster your mindset, catch yourself when you're saying, I need to do this. My intention is not to do this. Make a decision. Either, if it's about calling a kid, just call them. Right then, right there. Doesn't take two seconds.
Even just send them an audio message or a text. Or mark it down to do later, or say, No, I'm not going to do that and close that loop. You're going to feel better about yourself. And you're not going to miss out on your life.
So that's my journal entry to myself. All right. With that, let's get on and set a smart sprint.
TODAY’S SMART SPRINT SEGMENT
On your marks, get set.
And we're off to set a baby step that we can take in the next seven days. It's not just rock retirement, but rock life.
All right. In the next seven days, I want you to think about this intention thing. Catch yourself and decide whether I'm going to do it or I'm going to defer it. And that's cool. Or I'm not going to do it.
Close the loop. Don't miss your life. Catch yourself and see the conversations you have.
CONCLUSION
I don't have intentions of doing this show every week. I do the show every week. Whether I'm sick, whether I'm busy, whether I'm rushed to get out the door. I don't have an intention to make this show about you. I want this show to be about you. I focus on trying to help you take action. This show is about you.
I want to keep it that way, and I appreciate you walking this journey with me and trying to not just rock retirement but live a great life.
The opinions voiced in this podcast are for general information only and not intended to provide specific advice or recommendations for any individual. All performance references are historical and do not guarantee future results. All indices are unmanaged and cannot be invested in directly. Make sure you consult your legal, tax, or financial advisor before making any decisions.