503 | Deep Dive: Roth IRA Conversion Ladder

25:42You're not leaving necessarily the money at an old employer. You'd rather have control over it. So you need to do that for the strategy, but that's pretty typical anyway. So I guess my first question to you is, and I think in your scenario, they have$2 million saved up. I know I use the erroneous million, but I think 2 million is what you started with. Yeah. We'll make them a little fat fire today. Yeah. Since we're saying that they spend a hundred grand. So they have$2 million sitting in a traditional IRA. The question just very simply is, what is that first conversion amount that they would consider?

26:16How do they think about that first conversion? Yeah. I think before even thinking about the conversion amount, you have to think about what are the actual expenses that I'm trying to meet in five years or even this year, right? So we talked about beginning with an end in mind. I think first, before you even retire and do this, you have to think, okay, if I need five years of expenses, what defines expenses, right? I think a lot of us think like living expenses, right? Or after tax living expenses, but expenses might include things like inflation adjustments. You might say, if this family spends a hundred thousand today, like when they retire early, you know, will that be inflation adjusted?

26:51Might they spend more in the early parts of early retirement than they do now? So I think it's really thoughtful. Again, you'll never get the number right. All we know is the numbers are wrong, but conceptually you have to think ahead, what might my life look like when I retire early and how might my investments become income to support those expenses? So inflation adjustments, early retirement lifestyle. So how might your lifestyle be different versus while you're working? And also a lot of us have an emergency fund on the path to FI, but it could still make sense to have an emergency fund through FI.

27:22And that might be your deductibles for your homeowner's insurance. Things that insurance doesn't cover, for example, my sewage pipe broke and I had to spend$12 ,000 that they didn't cover. Emergencies will still happen even if you're financially independent. Of course, once you have an emergency fund set up, I start to call it an inconvenience fund because it's no longer an emergency. But you do have to think, wait a minute, if I only have five years of expenses saved up and an emergency happens, uh-oh, now I don't have enough to make it through the five years. So starting off with this idea, maybe your rule of thumb says, hey, instead of five years of expenses, maybe we buffer that and make it six years instead, just so that if the unexpected does happen, we'll not only be ready, but we won't be as anxious about it when it does happen.

28:05I like that. I like that a lot. And yeah, saying six years is as arbitrary in essence as saying, set aside an extra emergency fund. But I like the six years is just kind of a heuristic to use. Yeah, a 20 % buffer per year for the five years. beautiful. I like that. And right, like you said, think about with the end in mind. So I think a lot of us just very simply say, oh, our expenses are X today. That's what it's going to be five years from now or 10 years from now. Well, realistically, that's not the way life works. Like you said, Cody, sometimes people spend a little bit more in early retirement.

28:41Frankly, sometimes people spend less because some job expenses, commuting expenses went down, Maybe they go to one car. So it's important to take a close look at realistically what this looks like. And like you said, you have to factor in. I don't think most of us necessarily factor in inflation. And I also don't think most of us basically gross up the amount for the taxes that we have to pay to get down to the amount that we need to quote unquote spend because we're not thinking about taxes as part of this. So I think that's something that's important to really, really slow down on. Yeah. And let's talk about, I think that's the biggest missing piece when people talk about Roth IRA conversion ladders is they say, I need five years of expenses, but they don't think about the tax liability that they'll have to pay to actually implement the conversions themselves.

29:32Right. The tax liability on the conversion that they made. Right. And this is a really important point to make. A lot of people think that when they do the Roth conversions, they'll withhold the tax from the conversion itself. But if you do that before 59 and a half, even though the conversion will not be subject to the 10 % penalty, the withholding will. So it's actually important that the five years of expenses that you have set aside in taxable brokerage, including checking and savings accounts, includes not only your living expenses, your inflation adjusted and all those things, but also includes the estimated tax payments that you're going to have to make to pay for those Roth conversions.

30:09Yeah, that is interesting. In fairness, I think a lot of us haven't considered the taxable side because we're coming at it from the ultra frugality, FI side of saying, hey, look, if I have a mortgage paid off and my life costs$40 ,000, I'm going to be paying virtually zero in tax or very, very minimal. Even just back of the envelope with the$29 ,200 standard deduction for married filing joint, you're at$10 ,800 in taxable income. you're in the 10 % rate, right? So like you're talking a thousand bucks in tax at that point. So that's small enough that it's a rounding error. And I don't think a lot of people consider it.

30:49Like in the$100 ,000 environment, you really will. Yeah, you have to think ahead. And when I say the six years instead of five years, that buffer included the Roth conversion taxes, at least federally. And I also looked at some states, but that buffer that I mentioned before of six instead of five years includes the buffer on the tax liability as well. Got it. Got it. Got it. Got it. Okay. And right. Just for clarity's sake, that five or six years that Cody's talking about, that's the amount that you need in your taxable brokerage accounts to basically get you from your zero to when you can start actually pulling out this money that you've converted in this ladder effect.

31:27So really it's like a multi-pronged thing. You're making the conversions and then paying the tax each year along the way, but you can't access that money for five years. And then the next year, year one is six years, et cetera. But those first five years, you need money to pay for your life, obviously. So that's why it's both the actual strategy of doing the conversion and getting that right, but having enough money to bridge those first five years. So actually to add a prog to that, because we like to go a little bit into the weeds, today's episode, maybe next episode, we'll get back into 50 ,000 foot view.

32:02We like the weeds. We like the weeds. But I want to talk about too, that one of the expenses, one of those five years of expenses that we have to think about is the cost of health insurance. And keep in mind, a lot of people say, well, in early retirement, my income will be at a level, I'll probably will get a fully subsidized healthcare with the premium tax credit. But keep in mind to receive the premium tax credit, which is that subsidy through the health insurance marketplace, your income actually has a floor that it has to hit, not just a ceiling. So when you're doing these Roth conversions, not only are you thinking about setting up enough conversions to take out in five years for living expenses, but you also want to make sure those conversions are thoughtful and how they increase your modified adjusted gross income for calculating your premium tax credit.

32:46So if you're a family with lots of kids, sometimes you might actually have to convert a little bit more to actually be able to get those premium tax credits to begin with so that you can have either a low cost or no cost health plan. Right. So yeah, there is this interesting interplay between the Roth IRA conversion, the amount that you convert as a taxable event, and the subsidies that you get when you buy one of these ACA plans, I guess, ultimately through healthcare.gov. So right, in your example, when this married couple with no kids is pulling out and having that taxable event of$100 ,000 each year, just off the top of my head.

33:26That sounds like way too significant of an income to get fully subsidized. I know you dove into this, right? Yeah. So yeah, diving into that, like this family distributing$100 ,000 as a conversion, not as a normal distribution. In this case, they're actually going to have to pay$6650 for the year of health insurance, which again, maybe$500,$600 a month might not be too bad. But that's after receiving a premium tax credit of 7 ,600. So over half of their health insurance was covered by a subsidy, but they had had to be thoughtful about the amount they convert to even get into the place of getting a tax credit to begin with.

34:02Right. So, right. That's, again, start with the end in mind, depending on what your life situation is now, assuming this example couple, they might be getting heavily subsidized health insurance from their current company or companies. And while Well, that's more than a 50 % discount off of the rack rate, which unfortunately is over$14 ,000. It still is$66.50, like you said, that they have to pay out of pocket just for the insurance premium. So for someone starting with the end in mind, can they go to healthcare.gov and mock up what a premium might be? Absolutely. I mean, without going too much into detail, if you go to measurtwicemoney.com forward slash choose fi.

34:48There's actually a video that literally goes step by step on how to do this. So based on your household income, size, location, and age, regardless of what time of the year it is, you can go ahead and actually kind of search around for plans to figure out what those subsidies might be and the plan cost. And also, like you mentioned, it's really thoughtful to say, hey, if we're going to retire in 10 years, how old will our kids be then? Because maybe they're actually at an age where they will no longer be on our health plan, which might actually decrease the amount we can get in subsidy because there's fewer people in the household.

35:18So I'll have a landing page ready for you. And Brad will put in the show notes to make sure that you can watch additional videos on some of these strategies that are more detailed, including visuals for people who like to go beyond the audio. Love it. And that's measuretwicemoney.com slash choose FI. And we will have that in the show notes. Thanks for listening to choose FI and for all your support of our mission here. The absolute best way to support Chooseify is when you sign up for your next rewards credit card to use our cards page at chooseify.com slash cards. I keep this page constantly updated, so it should always be the top resource for you.

35:53Thanks for being part of our community and for your support. So we talked about this 10 % penalty that is an exception that we're trying to avoid here with this Roth IRA conversion ladder. But also keep in mind, first of all, you could just take a normal distribution and be hit with that 10 % penalty as a last resort, right? You still have access to that money, just pay a penalty. But I'm also going to quickly mention some other penalty exceptions that we might not have thought through. So again, before you dive into the Roth IRA conversion ladder, understand that there are some exceptions that we can consider.

36:24First of all, of course, once you're 59 and a half, you don't have to worry about that 10 % penalty. A second one that's very popular within the FI community is called the Rule of 55. which means if you separate from service, so if you terminate employment in or after the year, you reach age 55, that's age 50 if you're a qualified public safety worker, by the way, that you can actually take normal distributions from that workplace retirement plan, right, that 401k or that 403b without the 10 % penalty. With that said, there's a little caveat here that kind of drives me nuts, which is that when you distribute income, when you take a normal distribution from a workplace retirement plan, 401k, 403b, there's actually a mandatory 20 % federal tax withholding on the amount you distribute.

37:11That doesn't mean that you'll pay, that you'll owe 20 % taxes, but it's going to require 20 % withholding, which if you think about this from this perspective, let's say I need 100 ,000, right? If I need 100 ,000 out of my 401k, you know, using the rule of 55, that means that I'm going to have to actually distribute$125 ,000 So even though I'm paying taxes of$8 ,000, I just was forced to withhold$25 ,000 of taxes. That's incredible. And right, it is that important distinction. Since this is advanced five, most people probably know this, but withholding is not liability. It's just held on account by the IRS.

37:50And that will then be put on as a payment on your tax return. And you can request the refund at that point. But nevertheless, like Cody just said, if you're doing this very specifically to cover a certain amount of expenses, to have to then gross that up for the tax that's annoyingly being withheld, essentially like against your will, that's really less than ideal. Right, right. So the rule of 55 is great. I mean, a lot of people take advantage, just keep in mind that mandatory withholding. Another penalty exception is up to$10 ,000 from a traditional or a Roth IRA, including the Roth IRA earnings to buy, build or rebuild a first home.

38:29And by first home, that's actually a home that if you have not owned a home within the past two years. So again, even though you see the phrase first home, it's really the first in the last two years. So again, that's pretty uncommon. But if let's say in early retirement, you want to buy, build or rebuild a first home, quote unquote, you can take up to$10 ,000. That's not going to be subject to a 10 % penalty if you take it as a normal distribution. After that, there's medical expenses that exceed 7.5 % of your AGI, medical insurance due to unemployment, which when you retire early, we can't consider that unemployment even though you're technically unemployed.

39:04How loose is the definition of unemployment? Exactly. I am voluntarily unemployed for the next 40 years. Also, total disability and also inherited IRAs. So if you inherit an IRA from, let's say, your parents, for example, that will not be subject to a 10 % penalty, even if you take money out of that before you're 59.5%. And also, of course, inherited IRAs, they do have their own inheritance rules, whether it's a 10 year rule or stretch throughout your life. Just keep in mind that there's no penalty if you're taking money out of inherited traditional or Roth IRA. And then the last exception here I want to mention, it's actually my favorite, but it does have some inflexibility to it.

39:41We've mentioned before on the podcast called Substantially Equal Periodic Payments, also known as SEPP. And that comes from tax code 72T. So if you hear somebody say 72T or SEPP, they're talking about the substantial equal periodic payments, which effectively... So the IRS designed retirement accounts. They wanted to make sure they added some friction with that 10 % penalty. What they didn't want is people taking money out of the retirement accounts before they actually retired. And the IRS doesn't know, right? So if you retire early at age 50, there's no test you can take to prove to the IRS that you're retired.

40:17and they're going to go, okay, the 10 % penalty doesn't apply to you. You've proved that you're actually retirement ready. I wish they had a retirement ready quiz that you took to avoid the penalty. But instead, rather than having a retirement ready quiz that they force you to take, there's a strategy or method called SCPP to prove to the IRS that you're actually using it for retirement. You're taking a substantially equal periodic payment. So typically an annual payment out of your retirement account for the longer of five years or until age 59 and a half. So this is very important. It's the longer of five years or until age 59 and a half.

40:55So if you're age 50 and you start periodic payments, you have to continue them at least for the 10 years, right? So you have to go beyond the five years because 59 and a half is a longer period. Got it. No, that makes perfect sense. And yeah, Sean, that was an eye-opening thing for me when he talked about that on 475, that I think a lot of us had heard about 72T for years, but for a multitude of reasons, it did not seem like a really viable strategy. And evidently, I think it was in 2022, something changed fairly dramatically to make it much more viable. And that again, was a total eye-opener that I think most of us just said, okay, 72T exists, but it's not real in essence.

41:40So Sean imparted that. And he also talked about an interesting thing where you can split your IRA into essentially as many sub IRAs as you want. And when you split it, then you can put it very like granularly decide how much money you get by running that 72T on that precise amount. And then you can always do more if you want by splitting the rest of the main money into another IRA. So Cody, like I said, it was just a really cool thing that I had never considered before. Yeah. And SEPP became more popular when, like you mentioned, they actually raised, you have to reference what called the federal midterm rate to figure out how much you can take, what's the maximum amount you can take out of that retirement account using this strategy.

42:25And they actually let you use the higher of the midterm rate or 5%. And that was a big deal when they increased it to five. What's funny now is with the interest rates going back up, the 120 % midterm rate that's used is actually higher than 5 % now. Oh, wow. So it's actually kind of back to where the new normal, right? With that in mind, again, there's a lot more detail here, but I want to mention to you, some people worry about the amount that they can take out. They're worried that they might not be able to take out enough using this strategy, but based on the current midterm rate using what's called the amortization distribution method, which is really the only one to consider, by the way, if you look at the three methods, it allows you to take the most amount of money out of the smallest account.

43:06So take the most amount of annual payments out of the smallest account balance-wise, which I looked at from age 35 to 58 right now, based on when we record this in July 2024, that's up to around a 6 % to 7 % annual distribution rate. And with the amortization distribution method, what's really nice about it is the amount every year is the same. So you don't have to worry about like, oh no, did I take about the right amount this year? Just get the first year right and then keep taking out that amount moving forward. And yeah, that was also another one of the aspects that dissuaded people was it was said that the calculation is really difficult and blah, blah, blah.

43:43But I don't have to do it once. Yeah, you only have to do it once. And I think that was severely overblown. I think frankly, just like since people didn't really consider it viable, nobody really dove into just how difficult or not difficult it was. So anyway, I'm glad we stopped on that because again, this is an advanced episode. So while that isn't exactly germane or pertinent to like the specific Roth IRA conversion, it is very important for this holistic picture of, hey, look, I've got all this money sitting here. What are the different ways that I can approach this? And it's nice to know that we have multiple ways now, which is really cool.

44:16Right. And in that link I mentioned previously, you know, for more viewing, I actually have a video that actually shows all of those early distribution strategies in more detail in video. And lastly, I just want to mention the last two penalty exceptions to avoid the 10 % penalty are actually qualified higher education expenses for you, right? Parents, kids, there's special rules there for higher education expenses, and also qualified birth or adoption distributions, but it's only up to$5 ,000 per taxpayer. So just keep in mind, if there's like a unique thing you're using this money for outside of just normal living expenses, go ahead and check out the exceptions.

44:52If you want to look at the penalty exceptions in more detail, publication 590B is the IRS publication for more information. Nice. That is very, very helpful. So let's get back to the actual conversion ladder. So I think we have painted the picture of you start with the end in mind. So you have to have a sense of, okay, what am I actually trying to cover here? And now we have all of our retirement money in IRAs, in traditional IRAs. So that's the mechanism where we make this conversion each year. So we're doing that each year. Is there a recommendation in terms of, do you do it on January 1st? Does it matter?

45:35How do you think about that? Yeah, it's actually great that it's a tax year thing. So keep in mind that to take normal distributions, you know, I mentioned 59 and a half. That's actually based on the day you turn 59 and a half. Whereas what's nice about conversion ladders is you can do a Roth conversion on December 31st and your five-year clock actually starts the January 1st earlier of that year. So it's a tax year conversion date. So even if you do a conversion at the end of the year, it's actually dated the first of that year. So technically it could almost be like a four-year and 364 day holding period.

46:11That is a great piece of information. So, okay, right. In that first year that you do it, it essentially doesn't matter when you make the conversion, I guess, same for subsequent years. But in essence, you could do it on December 31st of 2024 and then January 1st of 2025. And the one that you made on December 31st of 24 would be backdated, whatever, or 364 or five days earlier to January 1st, 2024. This is a leap year, so I guess it's 365. So January 1st, 2024. Now, is it five years from that exact date? So would it be January 1st, 2029 that that seasoning period is over at that point? Would you wait until January 2nd just to be safe or how do we think about that?

46:59Yeah, it's per tax here. So if you did one December 31st of this year of 2024, It would be backdated technically to January 1st is when your baking period starts, your holding period. So all of 2024, that's year one, right? 2025, 2026, 2027, 2028. So January of 2029 is when you can access your first conversion if you did one in 2024. Okay. That is really great. So right, you're making this conversion every year. And I guess there's an interplay now between how old you are and what you need to bridge to. correct? Right. So first of all, you have to have five years ready, but let's say that you're age 50, which means you actually have to make it 10 years.

47:42So you have to have five years to start, but you might have to continue doing conversions for longer than five years. Right. So, okay. When you say five years ready, that means you need five years of money in regular taxable brokerage accounts to bridge you. But in that case, you're making the conversions every year for 10 years, basically, right? Right. Until 59 and a half when that 10 % penalty exception goes away. Right. Or when the 10 % penalty goes away. Right. Because then at that point, you don't need to bridge anymore. It's just the amount that you pull out, you can utilize immediately then.

48:21Okay. So that makes sense. So I may have misspoken there and we may have gotten, it's hard sometimes thinking about in terms of how many years do you actually need to do this? Because right, there's always that for, but I think it's, everyone can look at their own life and say, okay, I'm X age. The finish line is 59 and a half. I know I need the five years of taxable amount. And then how many years of these conversions do I need to make ahead of time? And then once I'm 59 and a half, it becomes a lot easier. But you actually added a really cool piece of nuance to a lot of people, because one of the big points of consternation, let's say is, okay, but how the heck, if I've been funneling all this money all this time into pre-tax accounts, how the heck do I have five years worth of expenses?

49:08And really you've now made that more like six years, even though again, you're just saying 20 % extra. So six years is a cute way of thinking about it, but that might be hard for a lot of people. But you actually effectively taken a year out of that. If you really think about it, Because if somebody might now hear this and say, oh, you mean I can start this? I can stop my job in December. And then I actually only really need four years and a tiny little bit of amount to bridge. Because again, it backdates all the way back to January 1st of that year. So that might actually inform in a weird kind of way.

49:45And I'm thinking about this off the top of my head, Cody, because this has never crossed my plate or frankly, anyone's plate in the FI community. This actually does change it from potentially five years to if we're really being strategic and that's a concern, right? That's the most important caveat. And it's a concern. Well, you might actually only need four years, four years in a tiny little bit, plus your gross up, obviously. Well, I think there's a caveat there though, that typically the year you retire, you wouldn't want to add more taxable income. Right, you have taxable income. And you get your PTO and all this stuff that, yes, it's typically your first Roth conversion will be the year after you retire, unless you retired early in the year.

50:25Yeah, that is very, very interesting. And of course, I think you're absolutely right. But again, also, and why I think it's important to leave that in because again, this is not edit something like that out because it wasn't a mistake. This is a brainstorm. And I think that's what's cool about this, Cody, is okay, depending on what their exact situation is, maybe their expenses are dramatically lower than our$100 ,000 example, and maybe they have a whole lot more space in the 12 % bracket. Well, maybe they do consider that then. There's always nuance. And I think whether this is a good idea or a bad idea, I think just having that as part of open the aperture to, okay, this is yet another consideration.

51:10It might not be a smart consideration, frankly, but I think it's an extra little piece of nuance that could be helpful for someone out there. Anyway, we'll put a bow on that and move on. I was painting the picture again of, all right, this is the holistic picture of you're making those conversions every year. You had the amount in your taxable accounts, but let's stop on that. I want your expertise on that. A lot of people, the amount in their quote unquote taxable brokerage accounts, these are in, let's say, a Vanguard VTI, or it might be in Berkshire Hathaway or something like there are potential tax consequences of that.

51:47So let's talk through that aspect because I think it's not just cash in all likelihood that's sitting there doing nothing. Yeah, I think there's two aspects of this that are really interesting. One, of course, is the dividend interest capital gain distributions that are going to add taxable income in those years. But also, do you invest that five years of living expenses plus the money to pay the taxes on the conversions? Do you invest that for growth or do you invest it for liquidity and stability? Because if we're talking about how important it is to have at least five years, what if that five years, in terms of, let's say you invested it in 100 % equity, what if that five years turns into four years?

52:27right? And then like, what are the potential consequences of those investments going down? And I just pulled up the historical risk and return metrics of the S &P 500 index, which is very similar to the VTSAX that a lot of us chill with. Over a five-year period invested in the S &P 500 going back to 1926, there have been 12 periods of the 94 periods that experienced negative annualized returns. So if you're investing in equity over a five-year period, historically, there has been a chance of losing money over that period. I think a lot of us think that, oh, the S &P does maybe 8%, 10%. But that's over very long periods annualized.

53:04So just keep in mind that historically, there's been about a 13 % chance, again, looking back, not forward, of actually losing that bet. So my perspective is always to prioritize the ability to maintain your desired lifestyle above tax optimization. So what that means is if I had, again, this is just my own bias here that if I have five years of living expenses, I'm going to invest that for short-term stability and then keep my other investments and my other accounts growing longer term. Because my focus here is to have enough liquidity and stability to make it the five years without having to break into another strategy, especially if you're prioritizing Roth conversion ladders.

53:45Okay. I like the concept, but I want to get into when the rubber meets the road. So at what point do you start prioritizing not long-term growth with that, but stability? Because presumably, I don't believe you're saying, okay, I'm on a 20-year path to FI and on day one, any money that I have extra, I'm not putting into VTI. So I'm actually focusing now on VTI more than VTSAX. I feel like VTSAX has become like this meme. And for most people, VTI is a slightly better option. So you're not saying stick it in your Globo bank savings account because you obviously work for all that growth. So at what point do you transition?

54:30Because there has to be a transition. Yeah, that's a great follow-up. So my heuristic, again, I know that rules of thumb, again, they always say one size fits all, hardly fits anyone. With that said, I have my own heuristic here that says any money you expect to spend within the next seven years, I'm putting that and fixed income. So I start to think about adding, again, let's say somebody is 100 % equity in their portfolio. I start thinking about adding fixed income to that portfolio, starting when they're seven years out to retirement. So yeah, if you're building up your five-year ladder and you're 20 years out, don't invest it for stability from the beginning.

55:04Start de-risking that portion when you're within five to 10 years before you plan to retire. Okay. And right. At that point, that person will still be working and there might be some additional tax consequences naturally, right? Especially if there are unrealized long-term capital gains, depending on your tax bracket, there might be, and this will be another advanced episode we do, but there's a way potentially pay very little. There is a significant amount of people that might pay 0 % tax liability on long-term capital gains up to a certain amount, But even still, and this is very important, long-term capital gains get a preferential tax rate.

55:42Okay. For most people, it's going to be 15%, right? So I think this is important that a lot of people hear the terminology and they think long capital gains, capital gains. I've heard so many people vilify this as a boogeyman when I want to shake them and say, you're getting a preferential rate. You are literally being showered with benefits for this. Just because it has this weird term doesn't mean it's something negative or nefarious. You're not paying at your top marginal bracket. It's not ordinary income. You're paying at this preferential rate. But nevertheless, Cody, if you're on a 20-year path to FI and you start de-risking seven years out, depending on the particular lots of VTI that you decide to sell or the particular shares that you decide to sell, you may have bought those shares on day one and we're 13 years down the road.

56:32There might be a decent bit of unrealized long-term capital gains in there that you have to pay tax on. Now, naturally, this all kind of washes out in the sense that, okay, this is not just a math equation because realistically that person would say they'd pay the tax. It would just be part of life. They'd move on and then they'd realize, okay, maybe I need to work an extra six months. It wouldn't be this overt thing. It would just kind of wash itself out is how I think about it. But now that I brought this up, I know you're vigorously shaking your head, which I love. And any additional nuance that you have?

57:09Yeah, I think, again, it goes back to that prioritization. I have three levels of prioritization. And again, it's so important that you don't skip the line, right? So starting with number one, is my portfolio set up for me to be able to support my desired living expenses? Right. So that might mean, for example, like, hey, like not having all the money that I'm spending a year from now all invested in equity. Right. Like focusing on stability and liquidity versus growth and income at certain points in your journey. Number two in prioritization is going to be diversification. Right. Diversification to me means that your investments are going in different directions at different speeds.

57:46If all your investments are going the same direction at the same speed, if you're only invested in the S &P 500 and the total stock market index, It's like going to the grocery store and buying two bananas of different brands, right? Rather than buying an apple, a banana, a pineapple, right? Diversifying. So the ability to meet your desired lifestyle, then diversification, then tax optimization. Do not let, oh no, the capital gain jump to number one in your line. And then that's the whole idea that people mentioned of letting the tax tail wag the dog, which we're probably tired of hearing about in our community sometimes.

58:19But just it's mentioned over and over again because it's so important. Don't let potential tax consequences run your financial plan and effectively run your life into retirement. Yes. We cannot say that enough. Let's be clear. So this is really important. And one of my biggest pet peeves in the entire universe is people who make suboptimal decisions based on some bizarro thought of just not paying tax as if it's something different. They get into just oddball territory and they turn their brains off and it's really frustrating. Sometimes it's just by lack of knowledge and sometimes it's some aversion to paying tax or whatever it may be, but it's just so silly sometimes.

59:00There are people who still today say, I need a mortgage for the interest deduction so I can deduct it off my taxes. When any person who has some knowledge understands that, man, especially in this new era we're in with the massive standard deduction, most people cannot even come close to itemizing their deductions to get over, like we said, that$29 ,200 for married filing joint. And of course, Cody, we could have set this up for a single. There's no preference for married filing joint. We picked one. We could have done head of household here for this entire thing. So anybody out there who's saying, oh, but I'm single, does this apply?

59:39Of course it applies. It's the same damn thing. It's just like we can't do four of these in parallel. But that person who's saying like, oh, I need this interest deduction, right? Like even if by some miracle, you're adding all of your itemized deductions and you get over the$29 ,200, you're only getting the benefit in essence for the amount over$29 ,200. And then you multiply by your marginal rate. So it's a tiny little baby benefit that you're getting most people for something like that. And then obviously you writ large on another one of my pet peeves is like a lot of these real estate investors who are like, I can never pay tax.

1:00:17I have to roll this forward forever. I need to, like, I only have 90 days to do it, but come hell or high water, I'm going to find an investment. Step up and face this is everything. Right. It's so silly. I'm like, they make suboptimal decisions. And then you have intelligent real estate investors like Scott Trench and Chad Carson and Paula Pant, who counsel in essence the opposite of that, of just like, all right, let's let the tax tail not wag the dog and let's make the right decision financially. And obviously you don't want to be unaware of the taxes clearly in any of these cases. We're not arguing that, but for most people, you're getting a much smaller tax benefit on a lot of things than you've been led to believe.

1:00:55So rant over and I'll let it get back to you. Yeah. And a good reminder, like today, like this whole episode was focused on optimizing the top 10%, not the 90%. That's so important to get right. Get the 90 % right. The 10 % is what we're talking about. And ironically, we're talking about how to avoid the 10 % penalty. If a 10 % early withdrawal penalty will not allow you to retire, you might not be ready. Cody, I love that. That is like the quote of the century. I want to emblazon that on our website or something. That is amazing. Okay. I think we're coming in for a landing here. So let's talk about maybe other early retirement income sources, because I wonder if there's some interplay here.

1:01:35a lot of people still might have that question of those first five years. And that's the last question that I have for you as of now. And I'll let you kind of run into this other income sources. So I guess when people think about those first five years, which now we're in essence saying is six is how we should think about it. A lot of that is going to be in equities, though, like you said, maybe over that seven year prior period, you're kind of slowly getting out. Some people might have an emergency fund or might be in this day and age, might have money in a high yield savings or something like that.

1:02:06That's not unrealistic. The one consideration we brought up before was what about if you have Roth IRAs that you've been contributing to over the years, like you talked about those 10 years, you could have$59 ,500 per person. Is that a viable strategy for bridging those first five years? Yeah, that's a great point. Earlier, we talked about this five year or six year and all those strategies there. But let's say that, in retirement, maybe your withdrawal, your tax-free and penalty-free withdrawal of your direct contributions, it's not that you can choose which ones come first. Those come first.

1:02:44Those come first before you take your conversion money out. So yeah, if you and your spouse, partner have been contributing to your Roth IRA, either directly or using maybe backdoor, like those non-taxable contributions, you could have over maybe one or two of your five years covered by your Roth IRA withdrawals, which by the way, will not increase your taxable income at all. So you can actually take your money back out of the Roth IRA that you put in directly that meets your living expenses and still have the full breadth of conversions available to you so that your five years actually feels more like two or three or four years.

1:03:21Yeah, that is really, really important. So right, they're completely distinct in this case. We're talking about the contributions that you made all along the way every year if you had been contributing to your Roth IRA. So, okay, that's important. So that counts as part of this five-year bridging, but how else should we think about other early retirement income sources? Yeah, I think most people I work with, 100 plus people, to and through retirement, the Roth IRA conversion ladder usually isn't the only source of retirement income. So I'll mention a few others, including some that are kind of unique.

1:03:54One is reimbursing yourself from your HSA, right? So in the FI community, we might've been, again, a lot of us are learning about it new today, but example, like my wife and I, we have about$50 ,000 in our HSA that is invested for long-term tax-free growth for future reimbursement. Maybe if there's a year where something happens and we need a little bit more income, but we don't have to start the substantial equal periodic payments or take extra out of a different account, that's kind of like another form of emergency fund. We don't necessarily want to take it out of there, but at least the HSA is available as one of those last resorts.

1:04:29So reimbursement for prior qualified medical expenses, or of course, in the current year. Also, private or public pensions. You know, a lot of us talk about how pensions are going away, but there are still a lot of people with pensions. So just keep in mind that public and private pensions could start sometimes that you may be in your 50, kind of in your mid 50s, typically, if you do have a pension, There's an awesome account, right? 457B distributions. They do not have a 10 % early withdrawal penalty. Effectively, kind of my tinfoil hat here says the 450B includes government employees. So the government in a way kind of set themselves up for themselves, because as you imagine, a lot of people who work in government, they can't be a senator their whole life, right?

1:05:10So that's an opportunity for government and also other like nonprofit, it, they might offer a 457B, which does not have a 10 % early withdrawal penalty. With that said, do not move that 457B to an IRA because you would lose that opportunity. It has to stay in the 457B. So again, it's not my favorite, but it's still an opportunity. But just to be clear, so when you pull out of a 457B, there's not the 10 % penalty, which is wonderful, but it's still a taxable event because the money went in pre-tax, right? That's right. Yeah. So taking a normal distribution, assuming they allow partial distributions for 57B.

1:05:46Next is, of course, an inheritance, whether it's a taxable or non-taxable inheritance. So whether you inherit an IRA or just inherit taxable brokerage assets. Other would be rental real estate, right? So a lot of the listeners might have income coming their way, your net real estate income to help support their own living expenses. And also one thing we haven't talked too much about is what about an early retirement? What if you end up selling your house, right? You sell your house and either rent or buy another house. Maybe you specifically, when you sell your house, keep some of that net cash as part of your cushion to get through the five years.

1:06:20Let's say somebody sells their house two years before early retirement. They should be thinking ahead for, hey, should I hold on to some of this liquidity for that five-year period? And then lastly, not just selling your house, but maybe you sell other assets that are appreciated just to give yourself a little bit more liquidity for the first five to six years. Yeah. The selling your house is an interesting one. And I guess it depends where you are. Let's assume you still have mortgage payments, right? So I'm thinking most people do not consider their home equity as part of their 4 % role. Clearly, in my estimation, it should be part of your net worth, but if that money is just sitting there in the walls of your home, you're not able to utilize it for early retirement in essence to cover your expenses.

1:07:06But right, if you take a scenario where, okay, I've had this mortgage locked up for 20 years, but I'm still paying on it. Well, I might be able to sell that house, then take all of that equity. That might be my five years. And then even if I'm renting an apartment or a condo or whatever, or another house, it might be comparable to what my mortgage payment was previously, especially when you add in all the extra factors. Because right, I'm envisioning a scenario where someone's saying, well, look guys, that doesn't really help me because I paid off my mortgage and my expenses are predicated on having a$0 living expense in essence.

1:07:41And now you're saying, okay, I need to pay rent every month. Well, obviously then start with the end in mind. You would have to factor for that. But for most people, most people haven't been in their houses for 30 years and paid off mortgage. So that actually might be a viable strategy to bridge those years that you need. Yeah. And I'll mention all of my financial planning client meetings are actually on YouTube to watch. And there's actually a video, oh, we can put in the show notes, but there's actually a financial planning meeting with a client named Jamie. Her real name, real numbers all on YouTube for you.

1:08:13She's completely vulnerable and transparent with the numbers, but she specifically sells a house that had a mortgage and buys a new house, but it actually provided an additional $290 ,000 of liquidity for her to support her living expenses in early retirement. So again, I'll just show you one example of how you could possibly sell a house or sell a condo, relocate, whether it's renting or buying a new house, and maybe not locking up everything. And keep in mind, even with 7 % plus interest rates, just keep in mind, it might be worth, again, sometimes that liquidity might be worth the higher interest rate, at least temporarily.

1:08:46And then maybe once you get to 59 and a half, maybe you can start being more aggressive with paying off that new mortgage that you had to get in early retirement. I love that. In essence, there's always nuance, but having these different options at least gives you something to think about for your particular situation, right? We can never cover everyone's situation on a podcast like this, but I think we've done a pretty wide ranging job of explaining this in a lot of detail, Cody. So is there anything else? And I know in your document here, you have some information on tax reporting. I think that's outside the scope of what we could talk about here.

1:09:21But any final words on the Roth IRA conversion ladder or anything we haven't talked about or you want to sum it up? Yeah. So a lot of listeners might be saying, okay, to get five years ready for early retirement in my taxable brokerage account, that would mean foregoing maxing out my pre-tax workplace retirement plan, or that would be foregoing my HSA. I would actually tell you, again, like I'm not your advisor, like this is just for you, but it would be very hard for me to give up that tax deferral only for the sake of building up your funds for creating ladders. So even though we focused a lot on it, the Roth IRA conversion ladder is still to me, typically secondary to maximizing your tax deferral.

1:10:03So if you feel like I don't have extra money to put money into taxable brokerage accounts, it might still make sense for you. Again, not advice for you and your specific two ears listening, but for the most part, I'm actually finding that it would still make sense for somebody to take advantage of maxing out their pre-tax accounts. Again, assuming they're going to have a much lower effective tax rate in retirement, don't get too caught up in building up taxable brokerage if you're having to forego some tax deferral. So just keep in mind that even though we talked about these Roth IRA conversion ladders, that that isn't the only option and you don't have to, like, You can still call yourself a member of the FI community, even if you don't have a Roth conversion ladder happening for you.

1:10:42It's not a mandatory requirement to be part of the community. Oh, I love that. I hope people know by now there's no requirement to being part of the FI community. That's what's beautiful about this is there are so many different flavors of FI. I think it is just about living an intentional life and getting to a point where you are financially independent. you have a significant amount more power on your side of the court and however that works for you. Frankly, there might be many people listening to this, Cody, who never get to the definition of FI, but their lives are still dramatically better for having found the FI community, having found you, having found Choose a FI.

1:11:23And I don't want anybody to walk away feeling deflated in that sense. I think that again is what's beautiful is this is a wonderful option. And I think it's one of those things that it's like a feather in someone's cap, if they're able to pull this off and they're able to do this. And even more still, the prototypical example of I paid zero tax, right? I got the tax deduction on the front side. I paid zero tax because my life was so inexpensive. And yeah, that's cool. But I mean, out of every thousand listeners, how many people are actually doing that? One, maybe zero, one, two, three, something minimal.

1:11:57So let's put it in perspective and say, that's why Cody set this up with the example of the hundred thousand, which is this still works. And we didn't dive into all the nuance of his precise example, but just that it works with a very minimal effective tax rate, even with someone with a hundred thousand dollars of expenses. And that's a pretty cool way of looking at this. I think a lot of us are going to have dramatically lower expenses annually than that. And that just makes it easier still on both sides, right? In the sense that you're paying less tax and you need a smaller pot of money to bridge those first five years.

1:12:32So there's always this interesting thing when your expenses are lower, even along the path to FI, for every dollar less of expense that you spend every year, okay, it makes my FI number lower, but it also gives me more to put into my investments every year. So it gets me to FI quicker on both sides, which is actually a really interesting way of looking at it. So Cody, I really appreciate you. I really appreciate you taking all this time. I think we did a really, really good job here. And just like always, there's going to be additional nuance. We can always hop on another one. If anybody has feedback, undoubtedly, we left something out.

1:13:06Undoubtedly, there's additional nuance. We always take feedback, feedback at choose a fight.com. Give us something I can add it in on a future roundup. I can put it in the newsletter or Cody and I can jump back on another episode and things are always changing in the FI community, but this is really just wonderful and up to date now. So Cody, again, thank you. And where can people find you? Yeah. So, um, you know, it's funny, my, my trademark for measure twice is keep finance personal, which is really what you're talking about is everybody has a personal path to and through FI. So to find me an additional educational resources, you can go to measure twice money.com.

1:13:39I also have the measure twice money YouTube channel, which actually you can watch real financial planning with real clients. And Brad and I, again, just maybe a little hint in the future, we might be doing one of these real life case studies with video and audio for the ChooseFI community specifically. So more to come on that. Yeah, I love that you dropped that. We've been talking about that for a while. I think we are definitely going to make that happen. And that could be a really fun series and resource going forward for ChooseFI. So to be continued on that, but yeah, measure twice money and we'll have all the links that we mentioned in the show notes.

1:14:12and as always, thanks for being part of the Chooseify community and thanks for being here. Thank you for listening to today's show and for being part of the Chooseify community. If you haven't already, the best ways to get involved are first, subscribe to the podcast. So you're listening to this on a podcast player, just hit subscribe and then subscribe to my weekly newsletter. I actually sit down every Monday and write this by hand and I send it out Tuesday morning. So just head over to chooseify.com slash subscribe and it's really, really easy to get on the newsletter list right there. And I would greatly appreciate it.

1:14:47It's the best way to get in touch with me. You can actually just hit reply to any of those emails and it comes directly to my inbox. So that's the way that I keep a pulse of the community and how we keep this the ultimate crowdsourced personal finance show. And finally, if you're looking to join an in real life community, we have Chooseify local groups in 300 plus cities all around the world. So head to chooseify.com slash local, and you'll find a list of all of those cities in 20 plus countries all across the world. And if you're just getting started with FI, or you have a family member or a friend who you think would be interested, two easy ways.

1:15:24Chooseify episode 100 is kind of our welcome to the FI community. And even though it's a couple years old at this point, it still stands up. And it's a really great just starting point to get an understanding of what is financial independence? What are we doing here? Why are we looking to live a more intentional life where we save money and use it as a springboard to live a better life? And then Choose a Vi created a financial independence 101 course that's entirely free. Just head to choosefi.com slash fi101. And again, thanks for listening.

1:16:07Thank you.