Pay No Tax on Roth IRA Conversion - Retire by 40 (2024)

I’m about to blow your mind today. I have been wondering if I could contribute to my i401k and do a Roth IRA conversion in the same year. Mrs. RB40 is planning to retire soon and I want to start building a Roth IRA ladder when she does. I wasn’t sure if there would be any benefit to doing these two things at once.

1. Contribute to my i401k – We would defer tax.
2. Roth IRA conversion* – We want to build a Roth IRA ladder so we can avoid the 10% early withdrawal penalty.

Normally, you have to pay tax when you do the Roth IRA conversion. I thought we would be in the 15% bracket and wouldn’t have to pay much tax. However, it turns out much better than that. We won’t have to pay any additional tax on the Roth IRA conversion. That’s mind blowing! How can this be possible? First, let’s review why we want to build a Roth IRA ladder and then I will show you how to pay no tax on aRoth IRA conversion.

*The conversion will be from my traditional IRA to Roth IRA. I rolled over my old 401k into a Roth IRA when I left my job. All the money in this account is pre-tax.

Roth IRA ladder

If you’re like us, you have invested a lot of money in your tax-deferred retirement accounts. I have been maxing out my 401k for 20 years and there is a sizeable sum in there. The problem is when you retire early (before 59.5), you will need to pay the 10% early withdrawal penalty to access those tax-deferred accounts. A great way to avoid the 10% penalty is to build a Roth IRA ladder. Here is how it works.

1. Convert 1 year of living expense from the tax-deferred accounts to Roth IRA. (This is a taxable event.)
2. Wait 5 years
3. Withdraw the 1 year of expense from the Roth IRA

Just repeat this every year until your 59 ½. The reason you don’t have to pay the 10% penalty is because the penalty doesn’t apply to your contribution to the Roth IRA. For conversion and rollover, this exception kicks in after 5 years. That’s why you need to wait 5 years to withdraw.

There is a big drawback to this process. You will need fund 5 years of living expenses before you get the first penalty free withdrawal from your Roth IRA. Also, the Roth IRA conversion is a taxable event. That means you need to pay tax on the amount you convert. This is bad because your fund will be drained by living expense plus the tax on the conversion.

The Roth IRA has other major advantages. The Roth IRA is a tax-free account. That means you don’t have to pay tax on the earning. Also, the Roth IRA is not subject to Required Minimum Distribution so you won’t be forced to withdraw from it in your lifetime.

Pay No Tax on Roth IRA Conversion

When Mrs. RB40 retires, our earned income will drop quite a bit and it would be a good time to start our Roth IRA ladder. You pay less tax when your income is low. Here is our tax profile from 2015 after I remove Mrs. RB40’s W2. I also removed the one time Hi-Tech antitrust settlement.

Income: $32,000

• Dividend: $10,500
• Interest: $1,500
• Business Income: $36,000
• Rental: -$16,000

Adjustments: ($27,044)

• Self-employment tax: $2,544 (This is 50% of my self-employment tax liability.)
• 401K contribution: $24,500

Deductions and Exemptions: ($32,790)

• Mortgage interest: $9,177
• State and local taxes: $11,528
• Personal exemptions: $12,000

Credits: ($1,000)

• Child tax credit: $1,000

Taxes: $5,161

• Self-employment tax: $5,087

Here is an easier to read format from the tax summary page.

Now, let’s add the Roth IRA conversion to the mix. I will convert $36,000 from my traditional IRA.

Do you see the magic? Our income increases from $32,000 to $68,000, but the amount of tax owe remains the same. I just moved $36,000 from my traditional IRA to my Roth IRA. This is huge because it means I won’t have to pay tax on the conversion. We can keep doing this for 20 years and all our tax-deferred funds will be moved to our Roth IRA. I just transformed tax-deferred to NO TAX without having to pay anything! If this isn’t mind blowing, I don’t know what is.

Can this be replicated?

As I disclaimed, I am not a tax expert, but there seems to be 3 key points why this works.

• We have too much adjustment, deduction, and exemptions. In the first table, our taxable income drops to zero. We couldn’t take advantage of everything because our income would be too low. A big factor is the $24,500 contribution to my i401k.
• You can’t avoid self-employment tax (15.3%.) We have to pay self-employment tax even if our taxable income is zero. At this point, we could bring in $36,000 more and the total tax would stay the same. The $36,000 could come from any taxable sources, including part time work and IRA conversion. Actually, I’m not exactly sure why the tax isn’t increasing. If I change the conversion amount to $40,000, the tax liability would increase a little. It seems $36,000 is near some sort of threshold. I’m depending on H&R Block to get this right.
• Rental properties. Our rental income shows up as negative due to property depreciation. This decreases our taxable income.

Whew, I hope I didn’t lose too many people. Tax is a boring topic, but finding ways to pay less tax is very exciting to me. A lot of my 401k contribution came from when we were in the 25% and 28% bracket. Deferring the tax and then not having to pay tax on it is huge. Tax is one of your biggest expenses and if you can avoidit legally, you get to keep more of your hard earned money.

I admit my situation is a little unorthodox, but it could be replicated. If you plan to retire early, you should consider starting your own business and investing in rental properties. These two things will help you bridge the 5 years gap in the Roth IRA ladder and you’d pay less tax as a bonus. Of course, I prefer to make more money and pay more tax, but life is what it is. I’m happy making just enough and not paying a lot of tax as well.

Does this sound legitimate to you? If you know other unusual ways to minimize tax, please share it with us.

Disclaimer: I am not a tax accountant and there is a chance that I could be wrong about this. If you are a tax expert and see a problem, please let me know.