How I'm Accessing My IRA at 45 (Without Paying Penalties)

25:25You can do your employee contribution into Roth and then the company matches you and that goes into the pre-tax bucket, right? And then eventually you pay taxes. But what if you do all pre-tax to get all those deductions in your higher income years. And let's say this couple retires at 40 and they have$1 million between their two accounts. They got all those deductions over the years. And now let's assume that they're in a very low tax bracket. And Scott, you brought this up on the last call. I loved it, by the way. I like how you're thinking about these types of things, which is let's say these people become full-time real estate investors and they meet the real estate professional status, Right.

26:02And so now they're at a very low tax basis. They start converting from traditional to Roth. We call this converting in stages. And maybe they do it over 10 years. Right. They got a million dollars. If they convert a million dollars, that's going to put them in the highest tax bracket. Right. Because they're going to have a million dollars added to their ordinary income. But what if they convert one hundred thousand in year one, hundred thousand in year two, hundred thousand in year three, hundred thousand in year four? So we call that converting in stages. Now, what happens when they do that is layer number two starts to stack up conversions.

26:38So every year they convert 100 ,000 over. Every year, that 100 ,000 that they convert over has to season on its own for five years. So if you think about it, if they do that from 40 to 50, once they get to 55, all their conversions have seasoned, right? And really, if they needed to, they could start dipping into some of the earlier conversions. Because like we talked about, layer number two, you can take out tax and penalty free even under 59 and a half as long as that converted amount has seized in how many years? Five years. So, Scott, I'm just picking up where I think you're leaving off here on your strategy, which is get deductions in your higher income years, then retire early, start converting over in stages, and then be able to take advantage of withdrawing even prior to 59 and a half.

27:26And along the way, you're not just going to let the money sit there. You're going to invest it, hopefully in real estate and other types of private opportunities that might be able to yield a better rate of return than the traditional market. And now all that earnings continues to grow 100 % tax-free. Yeah, that's exactly it. My favorite example is the early retiree's dream is to travel the world, right? Well, in that year where you're traveling the world, you likely aren't going to generate much in the way of taxable income. That's an opportunity to do these kinds of things. It can happen in stages, right?

27:57One year in your retirement, you get that rep status, the real estate professional status. And that's the year you buy one or two properties and you do your cost segregations to have a negative taxable income bracket year. Yes, you're going to pay those taxes on the back end whenever you would realize that gain, unless you turn in 31 exchange forever. But that year, maybe you could have a$200 ,000 loss if you bought$500 ,000 to a million dollars in real estate and did a cost segregation. And then you could convert$300 ,000 from one of these pre-tax accounts into a Roth, and you're only gonna pay taxes on 100 ,000 of that gain at a fairly low marginal tax bracket for a married couple, for example.

28:35That's the power of this situation. If you just assume you're gonna be in a high-income tax bracket forever, then there's not an opportunity to do this. But if you do intend to retire early, and you really intend to not actually earn that income, or you have control over when you do realize income, this can be a very powerful strategy to take the Roth layer cake and combine it with that pre-tax account. Scott, the other thing I'll mention too, this comes up all the time, is let's say you have two spouses, right? And you have one spouse that's working and one spouse that's not working. Okay, not uncommon.

29:07And the spouse that's working, they have the earned income, right? They're supporting both spouses. Well, not only are they supporting both spouses, but they're also allowed to support both spouses from a contribution perspective. So you have to have earned income to contribute to an IRA, whether traditional or Roth IRA or 401k, but there's something called a spousal IRA contribution. So if your spouse doesn't have any earned income, but you have earned income, as long as you're married filing a joint return, you can have a contribution going into your spouse's Roth IRA. It's their own individual Roth IRA.

29:39And a lot of people don't know about this. And a lot of people are led to think that they're not allowed to contribute to a Roth IRA because when the law went into effect in 1998, January 1 is when you could set up your first Roth IRA. Didn't exist before 1998. There was tax legislation that passed in 1997 going into effect in 1998. William Roth Jr. is the senator from Delaware. He's since passed away. That was a legislative sponsor of this. That's where Roth comes from. It was a senator's name. His birthday is July 22nd. We do a big birthday celebration here. We do get cake, by the way. I'm not kidding about that.

30:17We get cake. It's the Roth layered cake. When the law was passed, they said, hey, if you make too much money, you're not allowed to contribute to a Roth IRA. Section 408A, if you make too much money, and then the IRS defines that every year based on cost of living adjustments, essentially inflation. And so then in 2010, the law went into effect that said, hey, we'll allow all income earners even the highest of income earners, to convert from traditional to Roth. And like a lot of people say, it was the best deal that Congress could give Americans. And a lot of people said, take that deal. Now, I can't tell people to take that deal.

30:53But the deal is exactly what you were saying, Scott, which is, hey, if you think tax rates are going to increase, you think your tax rates are going to increase based on your investment activities, whether it's policy or your own individual situation, guess what? You can buy out the IRS partnership. You buy out the IRS partnership by converting from traditional to Roth. And now when you distribute, you don't have to pay that silent partner. Now, do you have to pay taxes when you convert from traditional to Roth at that time? Yeah, of course you do. Again, that's buying out the silent partner at that point.

31:25You don't have to withhold from the account. That's important. So when you convert from traditional to Roth, you don't have to withhold from the account because if you withheld and you're under 59 and a half, you're going to have penalties and taxes. You can pay for that out of pocket. So you pay for that separately outside of an IRA. So you have more money in that Roth to be able to take advantage of the layered cake, take advantage of growth going forward. All right. This is our final break from paying taxes. I mean, from the podcast here, we'll be back with more after this. I'm skeptical of a lot of financial products, but life insurance isn't one of them, at least not term life.

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33:36Thanks for sticking with us. Let's jump back in. Okay, I have several clarifying questions. The three layers are contributions, conversions, and earnings. Are your backdoor and mega backdoor Roth contributions treated any differently, or are those just contributions the first layer? Great question. So layer number two, conversions. There is a subtle nuance that we need to talk about there. So that German chocolate, like I keep saying, some of it has more coconut in it than other. Okay. So there's two layers within that layer. So not to confuse everybody, we're on layer number two, conversion. We have sort of two layers within that layer.

34:17Layer number one is call it regular conversions. So I have traditional money added in there for more than a year. I have, let's say, 401k old, 401k money. I convert that over. There are these ordering rules where every time I convert, it has to season on its own for five years. So regular conversions. Below regular conversions, we have non-deductible traditional IRA contributions. So when I do a non-deductible traditional IRA contribution, that's for those out there that your income is too high and you or your spouse are contributing to a workplace plan like a 401k, you don't get a tax deduction for your traditional IRA contributions.

34:58It's called a non-deductible IRA contribution. When you convert that over to Roth, that becomes the second layer of layer number two. So layer number two as layer number one, which are regular conversions. Layer number two are these non-deductible contributions that then get converted over. And it's again, ordering rules. So we start from the top, work our way down. Contributions, then we go into conversions, converted amounts that are regular conversions. Then we start moving into our non-deductible contributions that were converted over to Roth. Simple. Simple, super simple. Yeah. Take a notepad when you're listening to this for the second time.

35:38And we know this is a complex topic. This is not a beginner strategy here. I mean, this is for the folks that are really thinking about how do I mechanically access that money in my retirement accounts who have made the decisions about 401k and Roth and are familiar with this basic jargon of these types of accounts. If that's still fresh to you, there's plenty of resources. Come back to this after kind of really grasping the philosophy about pre-tax or post-tax accounts. But these are all the exceptions around the rules, like John has said, to help folks that are working on that several million dollar portfolio in early retirement access these funds in the most tax advantaged way.

36:13So it does get complex because there's a lot of loopholes and games you got to play to contribute to these accounts in the first place if you earn above certain income levels. Yeah. And quick example, 150 ,000, like we've been using to stay consistent with that. 50 ,000 contributions. That's what we start with first. Then we move into our conversions. Let's say we have a total of 50 ,000, But 30 ,000 of that are regular conversions and 20 ,000 are non-deductible conversions. So we can take out up to that 30 ,000 and then that secondary 20 ,000, we have to wait for that to season five years so that people don't end up in a mathematical headache.

36:50Here's what you look at. Just wait for everything to season for five years. And then you don't have to give yourself the brain damage of trying to figure it out. Now, the good news is, is that's why people have accountants and CPAs and tax preparers. All of this is captured or should be captured on the appropriate documentation within your tax documentation. 8606 is when you're making non-deductible contributions. Converted amounts are also going to be included on your tax returns. And there's forms that your custodian is going to issue to you, such as 1099Rs and 5498s. So if this is all getting a little bit confusing, know that someone that understands it that is preparing tax returns professionally or you hire a good tax advisor, they can help you through this process.

37:37Okay, so back to the layer cake. The first layer is contributions. That's only the contributions that we have made. $7 ,000 is the annual contribution for 2025. So I remember years back, it was$5 ,000 or$4 ,000. Now it's$7 ,000. That's what we're talking about with contributions. Backdoor, mega backdoor are treated as conversions, not contributions. Now we're getting into 401ks, right, Mindy? No, we call them backdoor contributions, but they're actually treated as conversions for the layer cake. When you contribute to a traditional bucket or traditional account, that could be 401k, that could be just a traditional IRA, and then you convert to Roth, that's going to be included in that converted layer.

38:22Yeah, I think that in our space, we talk a lot about backdoor Roth contributions. And I want to clear up anything for anybody. Oh, so I could just contribute$100 ,000. And now that's a contribution. I could pull that out. No, it's considered a conversion for that. Do your contributions, that first layer, do those have to season for any amount of time? Or can you pull those out? No, that's why I love this, especially for, let's say, the younger generation. Let's say you got a child or grandchild or just someone that's listening that's, you know, 18, 19, 20 years old, and they're looking to set up their first IRA, their first retirement account.

39:04Roth IRA is how many years ahead of them do they have? Right. The net present value is so powerful. So they can contribute to a Roth IRA, let's say$7 ,000. And then the next year, if they want to, or even any time during that year, they can withdraw the$7 ,000. They just can't touch the earnings. So it's a nice safety net. And by the way, I know people that they have adult children that are getting their first jobs. But the problem with saving for retirement is the adult children don't have any money. Their rent is too high. Every dollar that comes in goes out the door. Even if they're savers, they just they don't have any money left.

39:38But couldn't the parent gift the child up to a certain amount? So there's gift tax exemption in the United States. The parent gifts the child X amount of dollars. The child still has to have earned income. And now the child has money to put into that Roth IRA. Let's say$7 ,000. That kickstarts their retirement. Now they're growing their Roth IRA. And they always have that safety net using the layered cake. They always have that safety net of being able to withdraw those contributions if they need to. Katie, for example, my daughter is going to have to start doing the introduction to each of these podcasts for a rate that backs into 7 ,000 divided by number of podcast episodes here.

40:15And there's so we can start maxing out a Roth. You okay with that, Mindy? I have two daughters too. So we're going to have to fight for this. And we can only pay her what we would pay somebody else. So we can't pay her$7 ,000 and she does one intro unless we're willing to pay$7 ,000 to anybody. And that's just not the going rate. Absolutely. But yes, if your kid has earned income, I have no idea, but I think it's very reasonable for me to forecast that Katie gets her first job at 14, 15, whatever that is, and she makes 5 ,000 bucks, that I give her 5 ,000 to put in her Roth IRA so she can spend the 5 ,000 that she has earned.

40:51That would be one. I don't know if I'll do that, but that would be one way I'd be thinking about setting the early habit of saving for retirement. Yes, because I think it's really kind of unfair to ask your 14-year-old child to take 100 % of the money that they just earned and put it into their Roth so that when they're 65, they can retire 59 and a half or whatever. No kid is going to say, oh, thanks, dad. That's a great idea. They're going to say, I want to spend that money. So actually, that's the plan that we're doing with our daughters is once they have any earned income, we gift them. We don't give it, Scott, it's a gift.

41:25We gift them that exact amount that they earned so that they can spend their money, but also put it into their retirement accounts because I have$1 ,000 and I can give that to them, gift that to them. John, I have one last question just for clarifying how this all works for somebody listening. Let's say I'm retired early and I have$0 in income, but I have this big 401k or traditional IRA. I want to start converting from the 401k or traditional IRA into the Roth. Is that taxed at straight income? Yes, you could say it that way. So the amount that you convert from traditional to Roth, that amount that you convert is going to in the year that you convert it.

42:11You don't have until tax filing deadline of the following year. It's in the year that you convert. Deadline is December 31. It doesn't follow the same rules as contributions. So the year that you convert, the amount that you converted is going to be added to your 1040. Think of it as ordinary income. It's going to hit that necessary line of ordinary income and it's going to be taxed accordingly. So let's say that my effective tax rate is, I'm just going to say 25%. So I convert$100 ,000 from traditional to Roth and I pay$25 ,000 in taxes. Now, this is where a lot of people get stumped. They go, oh, my gosh, twenty five thousand.

42:52They get sticker shock. Right. Which can happen. And maybe it doesn't make sense for that person to convert. But you want to do the numbers. You want to run the numbers on a spreadsheet. And the example I mentioned earlier with a couple that I know, one hundred and seventeen thousand now over two million. Would you rather pay taxes on one hundred and seventeen thousand or two million? That was an easy one. Right. Because the returns were good enough. I'm not saying that's for everybody. Right. But you want to look at, are you going to pay more in taxes on the seed or more on the crop and not just look at the sticker shock in one year?

43:24Now, that does bring up an interesting strategy that we did mention before converting in stages. I have a client that did this. He was a college professor. He retired. He had a 403B, which is basically like a 401K, about$400 ,000 in there. And he wanted to buy rental properties. He rolled over his 403B into a traditional IRA. No taxes or penalties for that rollover. He just rolled it over from pre-tax to a traditional IRA, right? And then in the first year, he converted about$100 ,000. So that was added to his ordinary income. He paid taxes. He bought a rental property, put a little bit of money into it, started renting it out for, I believe it was around$1 ,300 to$1 ,400.

44:01Instead of converting all of the money, he just converted what he needed for that particular rental property purchase. Year two, he did the same thing, converted some more money over, bought another rental property. year three, so on and so forth. He still has one rental property in his traditional, and then he has three rental properties in his Roth. His Roth is generating$33 ,000 in net tax-free cash flow every single year. There's no recaptured depreciation. There's no capital gains tax because he owns the properties free and clear. So that's all tax-free appreciation and tax-free rental income in his Roth IRA.

44:34We covered this in a previous episode, but could you please refresh me on the concept of prohibited activities or prohibited investments inside of retirement accounts or self-directed accounts that would enable real estate investing. I can't, for example, go into business with myself. I can't manage them. Can you give us the one-minute overview of that? The one-minute overview, prohibited transactions. A disqualified person cannot transact with their IRA, 401k, or other qualified account that we're talking about here, even includes HSAs. Well, who are disqualified persons to your IRA? 49.75 of the Internal Revenue Code.

45:10Just think people up and down the family tree. Your children, grandchildren, parents, grandparents, your spouse, businesses essentially that you own, control, operate. Okay? Those are disqualified persons. You can't buy, sell, lease from, exchange. You can't lend money. You can't provide services like doing physical sweat equity on those properties. What are the common ones we get? If I own a property now, I can't get that into my IRA tax-free. I can't get into my IRA at all or 401k. It'd be a prohibited transaction. I can't lend money to my IRA. My IRA can't lend money to myself, can't lend money to my house flipping business, can't lend money to my spouse, my children, my parents.

45:48So those are considered prohibited transactions and the consequences can be severe. It could be the entire distribution of all of the assets and cash of that account on January 1 in the year in which that transaction occurred. So there's a lot more transactions that you can do than you can't do. When the law was passed back in 1974, the law was exclusive. Congress wrote the law to be exclusive rather than inclusive. So the law tells us what we can't do, not what we can do, which is a good thing. For these real estate investments, just a reminder to everybody that if you're thinking about using these, you can't.

46:22I mean, this means you should not be swinging a hammer and fixing up these properties. You're not selecting the tenants or you're hiring a property manager to manage those things. These are not assets that you are regularly physically visiting or managing directly in there. We had a whole other great discussion about this with John back on a previous BiggerPocketsMoney episode here. It's a very powerful tool, the self-directed IRA. But just know before you go into those avenues that you need to have your eyes open and deal with a professional. That can help you set that up and make sure you're on the right side of the rulebook.

46:51Assuming you're selling stocks that are in your 401k in order to generate the funds that are doing these conversions, Are you paying capital gains taxes on those or is that all part of the income tax like wrapped up into this? I just want to clarify for people that are thinking about this. You're not double taxed on that, are you? You aren't. That's a great question, Mindy, and a very common question. If I have my traditional IRA and let's say I have stocks, mutual funds, maybe even real estate, I don't have to liquidate those assets to convert over to the Roth. I can convert the assets, what we call in kind.

47:26We take the current value, it gets converted over, and that value, just like cash, is reported to the IRS for the purposes of how much you're going to pay in taxes. So you don't have to liquidate. There's no capital gains tax. Your IRA is a tax-exempt entity. So when you're selling stocks, mutual funds, real estate, there's no taxes. It's all tax-exempt in the account. And when you convert an asset over from traditional to Roth, that asset just gets converted over at its value and it's reported to the IRS as such. Now, if you have properties, notes, other alternative investments, you do have to work with your custodian to submit a valuation update so that you can properly convert that asset over.

48:08And we do see that. Now, Mindy, you did bring up something that I have to mention because it's an interesting concept. And we see this happen when the stock market plummets in a very severe manner for, let's say, a short period of time. You can't time these things up. But we see this happen in financial services and have for years. Let's say the stock market plummets. Your portfolio balance plummets 20 percent. You convert when the value is much lower from traditional to raw. Now, of course, you wouldn't want to advertise, right, purposely allowing assets to decline in value just to do this. because what if they didn't go back up in value, right?

48:45So don't allow the tax tail to wag the economic dog is what we always say. But that's an interesting concept. There's also people who invest in like real estate syndications or private equity type opportunities and working with their CPA or tax advisor, they might be able to argue that the value of their investment in that real estate syndication or private equity opportunity is not what they actually invested. For example, maybe they invest$100 ,000, but because of their lack of liquidity, lack of marketability, and lack of control of the investment, their CPA might be able to argue that the value of that investment isn't$100 ,000, but maybe it's$55 ,000.

49:25And then they convert at that lower value, thus saving on taxes. You have to be very careful when you do things like that. You have to work with the right tax advisor, equity trusts. We provide education and information. We don't advise one to do that. I mentioned that because there's a recent Forbes article that's out there that talks about this, and I get a lot of questions about it. And so I thought it was appropriate timing to bring that up. Absolutely. We've kind of used the premise of just the high-level tax strategy. But again, this is where the games begin, and they go really deep down this rabbit hole here.

49:58Yes, can you manufacture a loss, manufacture a loss by buying real estate, for example, as a real estate professional and having enough depreciation to offset any income in that year? That's one strategy that's a very basic one inside of the context of real estate professional status. But when you get into the self-directed component of these IRAs, that's when a whole host of other opportunities begins to line up, right? I mean, you take that with a syndication, you can take it with a private business opportunity as well. that you're a partner in, as long as it's not one that you control or own directly, for example.

50:33And those assets, the valuations of these things are gonna be, you need to be fair with it and accurate, but man, there's a ton of opportunities in this space. John, thank you so much for your time today. Thank you for sharing all of your knowledge about this and for answering all of the questions that I had because I know enough to be dangerous and now I know a whole lot more. So thank you very much for your time and we will talk to you soon. Thank you guys both. and it's great working with bigger pockets in the community. So on behalf of Equity Trust, we're so excited about everything that we're doing together.

51:05You guys do so much for the real estate investor community. I've grown up around bigger pockets. A lot of people that I've known have grown up around bigger pockets. So can't thank you guys enough for everything you do and ultimately how you're really making an impact on the everyday real estate investor to the really experienced real estate investor. So thank you again and we'll see you guys soon. Thank you, John. And for everyone listening, As you know, we have a great partnership with Equity Trust. You can go check them out right there on biggerpockets.com. Go check it out. They will help you set up a self-directed IRA or universal IRA that will help you invest both traditional and Roth IRAs in alternative assets in addition to things like the stock market funds that may be available in your current IRA.

51:47They'll also help you with a 1031 exchange if you're looking to do that on the real estate side. And you can find that link on biggerpockets.com. Just click on 1031 Exchange right there in the navigation bar. All right, Scott. That was John from Equity Trust with yet another giant amount of information. This is a very interesting idea. And I know that we kind of rattled off a lot of really complex topics here and a lot of complex nuances. I would encourage anybody who is intrigued by this to go back and listen when they can sit down with a pen and paper or their computer up to take notes to really start looking at how they can piece this together with a 72T, without a 72T.

52:30How can they make the Roth layer cake work within their retirement strategy? I just think that the more you know, do you remember those from the Saturday morning cartoon, Scott? The more you know. This is maybe not some information you need right now, but it's a great topic to dive deep into so that you can apply it when the time is right. I think it's super complex and there's so much jargon involved in this and it's very difficult to really parse out. It's very simple after a certain number of repetitions to kind of think through the basics of this, especially the way that John explains it. But you're going to have to probably listen to this two or three times, both of these episodes on the substantially equal periodic payments and this one.

53:08And you're going to have to tie that into a philosophy about long-term bets on marginal tax rates into the future. There's a complexity to it, but you must to do it because most of the people listening to this, most people that we talk to on Bigger Pockets Money put most of their wealth into these types of accounts and they really don't have a plan for the most part to access them. They just keep contributing in perpetuity and that's fine. You're going to be wealthy. You're going to have a retirement in 30 years if you want to do that, but that's not why you listen to Bigger Pockets Money. The whole point of Bigger Pockets Money is your 30s, 40s, or 50s and accessing money and enjoying the wealth that you've built in that stage of life.

53:47And to do that, most people, most people are gonna have to have a very good mental grasp about how to use these accounts, even if they don't in practice actually withdraw from them early. And that's why we're doing this, Scott. All right, Scott, should we get out of here? Let's do it. That wraps up this episode of the Bigger Pockets Money Podcast. He is Scott Trench. I am Mindy Jensen saying, gotta shake chocolate cake.