Utilize the Roth IRA for Early Retirement

This post is a guide on how to utilize the Roth IRA for early retirement, how our family uses the Roth, and how to open an IRA and track its progress.Are you interested in learning about using the Roth IRA for early retirement?

Anyone seeking financial independence must understand how to utilize the Roth IRA for early retirement in the context of their own retirement plan. Its usage will not be the same for everyone.

Government incentives and laws consequently shape and complicate all of our retirement tactics. When the retirement savings laws were written, the ages were likely chosen carefully and hotly debated.

We have to contend with the IRA/401k withdrawal age (59 ½), the minimum Social Security age (62), full retirement age for Social Security (66, or 67 if born after 1959), and the IRA/401k Minimum Required Distribution age (70 ½), all set by the regulators and subject to change.

For the early retiree, these age milestones are planning factors rather than targets.

Roth IRAs further complicate retirement planning when you encounter government limits on contributions based on income. For 2018, a single person with a Modified Adjusted Gross Income (MAGI) below $120,000 ($122,000 in 2019) can contribute the full amount of $5,500 to a Roth. For incomes up to $135,000, partial contributions are allowed. After that, nothing.

For married people filing jointly, those numbers are $189,000 and 199,000 in 2018 and $193,000 and $203,000 for 2019.. Most people won’t know their MAGI until they do their taxes, so that can make contributing to a Roth confusing during the year if you are near the limits.

Click the following link for more on the Spousal Roth IRA.

For the official explanation of how this all works, check out IRS Publication 590-A/B, “Individual Retirement Arrangements (IRAs)”.

Note: Adjusted Gross Income (AGI) is line 37 of your Federal 1040 for 2017 tax return and line 7 on your 2018 tax return.

MAGI adds back in certain deductions, but for most filers, it’s the same number. More on AGI vs. MAGI here.

Why the Roth IRA for Early Retirement?

My plan is to retire at age 55, one year before my Dad retired. Unless my target date changes, my full retirement will happen about four years before I can access my 401k or traditional IRA money. Once I turn 59 1/2, I’m not as worried.

Any money contributed to a Roth account is after-tax money, as opposed to 401k and traditional IRA money which is pre-tax. Pre-tax detracts from your MAGI. After-tax money does not, even though the government uses the MAGI to set limits on your Roth contributions.

Here is where the Roth IRA comes in handy for me. The money that I contribute can be withdrawn without penalty and without any tax at any time. However, the earnings made from contributions in the Roth are not eligible for early withdrawal.

So If I put $10,000 into my Roth and it grows to $12,000 through appreciation and dividends, I can withdraw the original $10,000 without penalty at any time. The $2,000, however, must stay until I turn 59 ½ or I must pay a 10% penalty and taxes on it.

So here’s my plan:

  1. Max out contributions on a yearly basis for the next 14 years, as long as I remain eligible.
  2. If needed, withdraw up to ¼ of the contributed money each year between ages 55 and 59 ½.
  3. After age 59 ½, start traditional IRA withdrawals if needed. Save Roth IRA funds until later in retirement to maximize tax-free growth

A big risk with this plan is if mine and my wife’s combined income, or more specifically our MAGI, would increase to surpass the income limit of $199,000 (2018). While this is an outlying possibility in the future, it would be a welcome problem.

Building the Account

This post is a guide on how to utilize the Roth IRA for early retirement, how our family uses the Roth, and how to open an IRA and track its progress.

Senator William V. Roth, Jr.

Mrs. RBD is now a stay at home Mom (SATM). But prior to the birth of our son, she had a pretty lucrative career in crisis communications. She had a nice income to supplement mine and continued to work part-time for another year after her maternity leave.

In the years she worked, her income took us over the threshold for contributing to a Roth. So 2013 was the first year we were not able to contribute to the Roth since before we were married.

As a bachelor I was a little late to the Roth game, only opening an account a year or two before we got married. So the balance on my Roth is relatively low compared to my 401k and traditional IRA.

This low balance needs to change. One of my goals is to deposit $450 per month into this account to max it out for the year. I plan to extend the goal for the next 18 years.If I contribute $5,500 to my Roth IRA for the next 12 years, and $6,500 for the 6 years from age 50-55 (so-called catch-up contributions), the total comes to $105,000, assuming the $5,500 level doesn’t change over time, although It will likely rise with inflation.

Add that to my previous contribution amount of $9,500 and it takes me to $114,500 of contributions between opening the account and when I am 55. If during the four years between ages 55 and 59 ½ I need additional income to live off of aside from my investment income, then I can tap all of it at once, or a quarter of this cash each year without penalty or tax consequences.

That amount is $28,625. I don’t want to need it, but it’s a built in backup in case my dividends, rental and other income doesn’t cover my living expenses.  Whatever money is left in the account that was earned investing over the years would stay until I turn 59 ½ or longer, depending on my situation at the time.

I could even use this $114,500 lump sum to put the final kibosh on our mortgage, or use it to supplement college education costs for my kids.

Investment Allocations

Half of the money in this account is invested in the Fidelity Mid-cap Value Fund (FDVLX) and has returned 24.76% over the past 5 years with a .67% expense ratio. I picked this fund years ago because I was looking for mid-cap exposure. It has proved to be a good investment so I’ll be sticking with it for now. Sorry to you managed fund haters out there.

Compare this to the Vanguard Total Stock Market Index (VTSMX) which has returned 20.03% and a .17% expense ratio, or better yet the Vanguard Mid Cap Index (VIMSX) which has returned 23.11% and a .24% expense ratio.

I’ve more recently added another $6,000 of newly contributed cash in my Roth put into the Vanguard VTI index ETF. Occasionally I invest in dividend growth stocks in this account as well.

Any money I contribute to my Roth is in addition to maxing out my 401k.

During the research for this blog post, I learned that the law allows for us to open a Spousal Roth IRA in the form of a Roth, even though my wife is not working. This would allow us to double our future Roth savings.  Since this is news to me, I need to take a closer look into this and see if it fits into our monthly savings budget.

Conversions of IRAs to Roths

In the past, a taxpayer’s income needed to be less than $100,000 to be able to convert from a traditional to a Roth IRA. The IRS rules have since changed and there is no longer an income cap in place. This is a new workaround so that wealthy people can take advantage of the Roth.

My wife and I both have traditional IRAs, but we are not considering converting them to Roths in the foreseeable future. While converting is widely recommended, I don’t want to give more of my money to the government today. We’d end up paying a 25-28% tax on our current balances. No thanks. In retirement, I don’t plan on having an income higher than I do today, so my tax rate should be lower.

A Roth IRA for early retirement can be a powerful tool for the extreme early retiree. Check out the post by Jim Collins with the Mad Fientist discussing tax-advantaged accounts. The Mad Fientist explains how to create a Roth conversion ladder which can be used to access funds prior to age 59 1/2 without paying penalties.

There’s plenty of opposing viewpoints on Roth IRA investing on the internet too. 

Open a Roth IRA

When it comes to opening a Roth IRA for early retirement, you have plenty of options. My primary brokerage TD Ameritrade offers a full range of IRAs and Roths to suit any investors needs.

Click  Here To Open an IRA with TD Ameritrade

Alternative investments, such as my favorite Lending Club, also offer IRAs to investors. By using peer to peer lending instead of stocks or mutual funds to build your IRA, you’ll more broadly diversify your retirement income streams and still get the tax advantages.

Open a No Fee IRA with Lending Club Today

Tracking Your Roth IRA

The best tracking tool I’ve found for IRAs is Personal Capital. I used to primarily track net worth and all of my assets through a complicated spreadsheet. Now, Personal Capital does it all for me in real-time. Best of all it’s 100% free.

Since my wife and I both have a Roth and Traditional IRA, plus a big 401k and taxable stock brokerage accounts, tracking our finances gets complicated. Mint.com is another option, but I prefer that tool for budgeting while Personal Capital is absolutely the way to go for investing.

 

Conclusion

As always, retirement planning is amoebic. But I think this strategy of beefing up my Roth is a winner based on my future needs. It will serve as backup income in case my taxable investment income isn’t enough. The way you use the Roth IRA will likely be different whether you plan to retire at 30, 40, or 65.

I expect there is more I need to learn about the Roth IRA and how I can best utilize it. Some of my readers may point out other suggested uses, add an opinion or contradict something I’ve written here. I welcome any feedback, and maybe a suggestion you provide will help me or the readers who pass through here reach our retirement goals.

Note: This article may contain affiliate links. If clicked upon and information is submitted, the author may be compensated at no additional cost to the reader.

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24 Responses to Utilize the Roth IRA for Early Retirement

  1. Fast Weekly February 11, 2014 at 12:51 pm #

    Nice article RBD. We make it a point to max out our Roths every year. When our son is born next month, my wife will take a step back and stay home with him. I can’t wait to see the little guy :o) Have a great day

    -Bryan

  2. retirebeforedad February 11, 2014 at 2:11 pm #

    When you’re on the cusp, it sucks. You can contribute for 2013 up until April 15th. So if you end up under 188k, its possible. Of course if you’re over that number then its not a terrible position to be in 🙂
    -RBD

  3. Dan Mac @ DGSInvesting February 11, 2014 at 3:32 pm #

    Sounds like a good plan RBD. I usually do my retirement savings in my 401k through my employer. This year I have decided to back off of those contributions (still doing enough to get full employer match) and opening a Roth IRA since I can then invest in dividend growth stocks (which isn’t available option in my 401K.

    Also interesting to see you can open a spousal IRA account. My wife and I were discussing this since she recently stopped working. I wasn’t sure she could open an IRA account since she will have no income. I’ll have to look more into this as it could increase our retirement savings limit.

    • retirebeforedad February 11, 2014 at 4:40 pm #

      Dan Mac,
      Glad you caught that about the spouse. I was surprised to learn that about it too and it almost didn’t make it into this post. Need to do more research, but it appears this may be a new avenue to help later on, and we’ll get to shelter some more dividend income. Thanks for stopping by.
      -RBD

  4. writing2reality February 11, 2014 at 9:10 pm #

    For me, it is a matter of diversification. My Roth accounts provide an offset to my current pretax retirement accounts like my 401(k) and also my taxable accounts. At the end of the day, having money invested in taxable, Roth, and traditional retirement accounts provides a multitude of planning possibilities, especially for those retiring before the traditional retirement age. Just another avenue of attack.

  5. SavvyFinancialLatina February 12, 2014 at 4:39 pm #

    2013 will be the first year we maximize the ROTH IRA and traditional IRA. I didn’t maximize my 401K last year, but I came close to it. I have plans to maximize in 2014. We’re going as much as we can to save and invest in our 20s so it has more time to grow.

    • retirebeforedad February 12, 2014 at 8:03 pm #

      Savvy Latina,
      Great mindset to have in your 20’s. I was investing heavily in my retirement accounts in my early 20’s and that money is still growing. I also took some time off to travel, which depleted things a bit, but I never touched the retirement cash. Now its compounding. MAX OUT, I love it.
      -RBD

    • JC @ Passive-Income-Pursuit February 13, 2014 at 4:04 pm #

      Can you max out both? Or are y’all doing one each and maxing both of those out?

      • retirebeforedad February 13, 2014 at 4:13 pm #

        Right now we only have one Roth for me. But everything I’ve read about the Spousal Roth IRA is that you can max out both, $5500 each. Even if the spouse has no income. This was exciting news to me, now I need to decide if we can swing it!.

    • Erik November 6, 2014 at 1:41 pm #

      SavvyLatina,

      Very smart thing to do! My wife and I did the same. You will be SOOOOOOOOOO happy you did one day!

  6. JC @ Passive-Income-Pursuit February 13, 2014 at 4:03 pm #

    We’re in the same situation where converting just doesn’t make financial sense. Our MAGI is too high for 2013 and I expect it to continue to be so for the foreseeable future. It’s a good problem to have I guess. The Roth IRA is great since not only are the gains/dividends tax free you can also withdraw your contributions. That’s a big boost for early retirees if you’re looking at retiring semi close to “normal” retirement age.

    • retirebeforedad February 13, 2014 at 4:11 pm #

      JC,
      My goal for the time being is closer to ‘normal’ retirement age. So this strategy fits in nicely. If I open a second account for my wife, it may help me retire even earlier. I’m hoping to revise my retirement date at some point, but I need to do a lot of calculating. Converting would be painful to take that tax hit for sure. Thanks for stopping by.
      -RBD

      • DividendDreamer September 15, 2014 at 11:31 am #

        As soon as the Roth came available, I was on it. The traditional IRA was a good option and the tax reduction was very compelling, but the Roth is hard to beat. You mentioned so many of the reasons why it is compelling. I would also add that I chose to contribute equally to mine and the wife’s with one of our children designated as the beneficiary on each account. When we pass, the kids will have one passed to each of them. With the rules as they were set, it should be very profitable for the next generation- I hope.

        Keep cranking,

        Robert

  7. Tom February 15, 2014 at 7:05 pm #

    roth is a great idea…the gov’t just needs to keep their word and not screw anyone who takes advantage of it.

  8. JB February 16, 2014 at 4:00 pm #

    Greetings,

    Came to this blog via Div Mantra.

    Question: is anyone here participating in a Roth 401k ? I toss it around deciding if I should put a portion of my retirement savings in to it. From what I have read it all depends on your future tax bracket.

    Note: The first 7.5% contribution go’s traditional to capture the CO. match.

    Thanks for your opinions in advance.

    • retirebeforedad February 16, 2014 at 7:57 pm #

      Hi, thanks for chiming in. I don’t have the option for a Roth 401k with my work. I like that I have the pretax contributions with my regular 401k. I still can take advantage of a Roth IRA in my other accounts. For you, the most important thing is to make sure to get that match, no matter what. If you get that only through the traditional, stick with that and max it out. Open a normal Roth elsewhere for even more tax advantaged savings.
      -RBD

  9. Justin @ Root of Good February 23, 2014 at 3:41 pm #

    This sounds like a great strategy that fits your situation. I always tried to “keep taxes as low as possible today and figure out a way to keep them as low as possible in retirement”. Well, now I find myself in retirement at age 33, and I plan on pulling from my taxable accounts at first, and while I’m depleting taxable accounts, I’ll slowly convert traditional IRAs to Roth IRAs. Basically take advantage of the “Roth IRA Conversion Ladder”.

    • retirebeforedad February 23, 2014 at 4:34 pm #

      Justin,
      Thanks for stopping by. This works for me if I do retire at 55. If I end up retiring at an earlier date, it may not be as helpful without as much time to build it up. That Mad FIentist link is a great resource for the Roth conversion ladder.
      -RBD

  10. Martin March 17, 2014 at 12:23 am #

    RBD,

    great review. One point got my attention. You mentioned the contributions to IRA or 401k lower your MAGI. Is that correct or I misunderstood?

    If it is correct, then that can be a great tool for planning. When your MAGI crosses over a limit for contributions to ROTH, you can increase contributions to a traditional IRA or 401k or both to lower you MAGI back below the limit (of course unless you are already maxed out everywhere, and or over limits everywhere, but that is not my case at all).

    • retirebeforedad March 17, 2014 at 8:08 am #

      Martin,
      Thanks. Contributions to a traditional 401k does lower your MAGI since it lowers the amount on line 7 of your 1040. I believe a Traditional IRA would also lower MAGI if a person had not already maxed out an employer 401k. Contribution to a Roth IRA would not lower MAGI. These account are great retirement tools in many ways, its too bad they weren’t simplified long ago.
      -RBD

      • Joe December 8, 2014 at 3:38 pm #

        One correction – Full retirement for Social Security is 67 for anyone born after 1959.

  11. Ben February 4, 2016 at 9:21 pm #

    Most would probably agree that the majority of investors share the goal of diversification. However, because of annual contribution limits in a Roth, wouldn’t it make sense to limit the number of individual stock’s in said Roth? eg. if you held 30 stocks in a Roth, you would be very limited to how much you could contribute to each position each year ($5,500 total).

    ergo, the question at hand – is there an appropriate or broad-stroke rule of thumb regarding the number of positions that “should” be held in a Roth before one starts using alternative vehicles like a SEP or cash account?

  12. ed September 23, 2016 at 12:58 am #

    “So If I put $10,000 into my Roth and it grows to $12,000 through appreciation and dividends, I can withdraw the original $10,000 without penalty at any time. The $2,000, however, must stay until I turn 59 ½ or I must pay a 10% penalty and taxes on it”

    I’ve been looking for that piece of information all over but I don’t seem to find it, everywhere I go they don’t make that distinction between your contributions to your ROTH vs the earnings of those contributions, they just call it distributions pre 591/2 vs post 591/2. do you have a link to a another source that I can read thanks.

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