Having enough income to sustain your lifestyle is a prerequisite for financial freedom. One often overlooked requirement for independence is how those investments are structured.
If you have every penny tied up in a 401K, your going to have a severe cash crunch pretty quickly after retiring. That, or get hit with major taxes/penalties when you start cashing it out.
To avoid this, we will utilize a Roth Conversion Ladder to slowly remove funds from our retirement accounts without penalties and minimum taxes. Also, we will use a bridge account to hold us over till the funds from the conversion ladder are available.
Our current number for retirement is $410,679 in stock/bond investments. The majority of this money will be in our 401K’s. Our main goal will be to withdraw this money penalty free and also tax free.
Roth Conversion Ladder
Once we reach financial independence, it is very likely one if not both of us will leave our current jobs. I can’t say for sure what our outlook on our current workplaces will be at that point in our lives, but if we reached financial freedom tomorrow my two week notice would be turned in. When this happens our 401K’s will be converted to traditional IRA’s. Both are pretax, and this move is penalty free.
The next step would be to slowly convert the investments in the traditional IRA to a Roth IRA. The pace at which we convert the funds will depend on our income and the tax code at the time. The conversion is a taxable event. But being able to control how fast we move cash between the accounts will allow us to pay as little in taxes as possible.
Once money has been moved to our Roth IRA it has to stay there for five years before we can remove it without penalty. The withdrawal from our Roth will be tax free as well as we paid taxes on the funds when they moved from the Traditional to the Roth.
While money in our 401K’s is accessible to us before turning 59 1/2, it is cumbersome to get to the money without penalty or a high tax rate. We will essentially need to be planning six years in advance to withdraw the funds.
As a result, we will need to have plenty of income from real estate investments or anything else we are interested in doing at the time. We will also need to have plenty of capital available in taxable investment accounts. This will make up for any shortfalls we experience and act as a bridge to when funds from our retirement accounts are available.
The main question is how much is enough in the bridge fund.
Our current budget has our estimated expenses at retirement at $32,854.32/year. Of course this will need to be adjusted in the future as inflation rises. But gives us a number to target in today’s dollars.
Six years of expenses would then mean having $197,125.92. Some of this income will come from rental property income. With seven properties, the income per year would be approximately half our budget. This would decrease six years of capital needed from the bridge fund to $98,562.96.
We went ahead and rounded this number up, putting our target for the bridge fund at $100,000. Retirement accounts would then need $310,679, with most being in our 401K’s.
With this approach, the majority of our cash will be tax sheltered as long as possible. We will still have enough liquidity to get by on, without stress. As a result, we can then move cash from pre-tax to post-tax accounts as we please. Making sure to pay the minimum in taxes as possible on our savings.