BiggerPockets Money Podcast - How I'm Accessing My IRA at 45 (Without Paying Penalties)

Episode Date: July 4, 2025

Want to access your IRA before turning 59½ without paying the brutal 10% early withdrawal penalty? You're not alone, and there are completely legal ways to do it that most people never learn about. In this comprehensive guide, John Bowens from Equity Trust will walk us through the exact strategies that allow you to tap into your IRA funds for early retirement, major expenses, or financial emergencies while staying on the right side of the IRS. This episode delves into the serious considerations and potential consequences of accessing IRA funds before retirement age. It highlights the penalties and tax implications of early withdrawals, emphasizing the disruption to the growth of retirement savings. The discussion includes valid exceptions for penalty-free withdrawals, such as higher education expenses and first-time home purchases, while stressing the importance of evaluating all options and consulting with a financial advisor. Listeners are encouraged to weigh the immediate need against long-term financial health to make informed decisions. What You'll Learn in This Episode: Legal penalty-free withdrawal strategies that bypass the 10% early withdrawal penalty IRS-approved exceptions including first-time home purchases, higher education costs, and medical expenses Tax implications of early IRA withdrawals and how they affect your overall financial picture Long-term impact analysis of early withdrawals on your retirement savings growth Alternative funding sources to consider before tapping into your IRA When to consult a financial advisor and what questions to ask Step-by-step evaluation process for weighing immediate needs against future financial security Documentation requirements and proper procedures for penalty-free withdrawals And SO much more! Learn more about your ad choices. Visit megaphone.fm/adchoices

On episode 649, we talked to John from Equity Trust about 72 Ts. In the middle of that episode, he casually mentioned the Roth Layer Cake. So guess what we're talking about today? The Roth Layer Cake, woohoo! Similar to the 72T strategy, it's a great option for those looking to tap into their retirement accounts before age 59 and a half. I cannot wait to have John back on. And welcome to the Bigger Pockets Money podcast. My name is Mindy Jensen. And with me as always is my Bakery Fresh co-host Scott Trench. Thanks, Mindy. After today's episode, everyone listening is going to be rolling in the dough.

Bigger Pockets has a goal of creating one million millionaires. You're in the right place if you want to get your financial house in order because we truly believe financial freedom is attainable for everyone, no matter when or where you're starting. And especially if you have a ton of money in a pre-tax account like a 401k or traditional IRA and want to move it into the holy grail of retirement planning, which is the Roth account. So we are so excited to bring on an expert on this topic,

Mr. John Bowens, you've been on a couple times now on Bigger Pockets Money. Welcome back to the Bigger Pockets Money podcast. Yeah, thank you, Scott and Mindy. Always happy to be here. It's especially excited for today's topic, the Roth IRA-layered cake, which is certainly one of my favorite. Awesome. And just to set the stage here, we just came off a discussion again that was episode 649 of the Bigger Pockets Money podcast, where we discussed at length the concept of the substantially equal periodic payment, also known as a SEP or 72T strategy. And the whole premise of that is if you have a lot of money in a traditional account like a 401k or a traditional IRA, you can use these strategies to access those funds early

and use them to spend on whatever you like. That's great. If you want to do that, go listen to that episode. What we think might be better, or from the strategic lens, the ideal outcome for retirement planning and building tax-advantaged wealth is moving that money in the 401K or traditional IRA, the money that you deferred paying taxes on, into a Roth account using tax strategy and rollover strategies in an artful way, that is incredibly powerful because you can take this money that you've deferred at a high income tax bracket and move it into a account

where it will grow tax-free in perpetuity. And that's what we're going to learn about today. And I think this is the really powerful wealth building tool, not that the 72T isn't also great. I would agree with that, Scott. And you have the 72T substantially, periodic payment distribution strategy for your traditional accounts, your pre-tax accounts. And then totally separate from that, you have this concept of a Roth IRA and the ability to be able to convert money from traditional to Roth, the ability to make contributions to Roth, the ability to be able to invest in real estate and other alternative assets with the Roth, and then be able to actually enjoy some of the fruits of your own labor prior to the age of 59.5.

And for some people, they might be doing bold. They might be utilizing the SEPP distribution strategy and utilizing this Roth IRA layered cake strategies. So I look at it as a Venn diagram, not necessarily a one or the other. Okay. You said Roth IRA layer cake. Does this only apply to Roth IRAs or does it apply to other Roth type accounts like a Roth 401K? So it would still apply to, let's say, a Roth 401K.

but in a slightly different context because we need to navigate the rules associated with a 401K, which are different than a Roth IRA. Now, there are instances where folks have a Roth 401K. That could be with a W2 job or maybe a, let's say, solo 401K, Roth component to that. And what they might do is roll that over into a Roth IRA and then utilize this Roth IRA layered cake strategy. And I should mention for all of our viewers out there, if you look at publication 590, if anyone goes there after this or IRC 408, 408A, you're not going to find Roth IRA layered cake, but you are going to find something called ordering rules. And the ordering rules associated with how you put money into a Roth account is what makes this Roth layered cake happen. We've now mentioned the phrase Roth layer cake probably seven or eight times, and it sounds very silly without any context.

So could you please bring us in with what Roth layer cake means and just give us the idea at a 10,000 foot view so that we can spend the rest of the episode figuring out how to actually achieve this? Absolutely. So we all know now that a Roth IRA layered cake strategy is to be able to withdraw money from this Roth IRA prior to 59 and a half and not pay taxes or penalties. Like we talked about with the substantially equal periodic payments, SEPP 72T distributions, that is to prevent the 10% premature withdrawal penalty. But as we talked about in that episode, there are limitations to that. There are requirements to once you start taking distributions, you can't stop until you're 59.5. Right. Well, guess what?

With this Roth IRA distribution strategy we're talking about, you can distribute some money in one year and not in the other year. It's less restrictive. Now, all that being said, you will find that there's one layer that you will not be able to distribute until you're 59.5. So let's break it down. How do you get money into a Roth IRA? There are really three ways, hence three layers here. Number one is contributions, making direct contributions into a Roth IRA. How much can you contribute to a Roth IRA in the year 2025, for example?

$7,000 when you're under 50, $8,000 when you're 50 and over. They call that a catch-up contribution. In addition to that, there are ways that one could have a Roth 401K and contribution limits could be much higher. So we first look at contributions that are going into the Roth IRA. For those out there that say, hey, I've always been told that I'm not allowed to contribute to a Roth IRA because my modified adjusted gross income is too high. Their income is too high. They're not allowed to contribute directly to a Roth IRA. Well, in those cases, those individuals would utilize what we call a backdoor contribution,

which is contributing to a traditional and then converting over to a Roth, which leads us to layer number two. So layer number one is contributions. layer number two is conversions. What's a conversion? It's exactly what you mentioned at the beginning, Scott. If you have traditional IRA money, SEP IRA money, simple IRA money, if you have 401K money from an old job, you roll it over into a traditional IRA,

and then you can convert it to a Roth IRA. Now, why would one convert from traditional to Roth paying the taxes right now, paying the taxes in the year that they convert? And that could potentially be a law. tax consequence. Well, I don't always look at it as a consequence because we need to do a net present value calculation. We need to look at what's our return on investment going to be over how many years that we're investing. And remember, it's an exponential equation. When we punch this into our time value money calculator, if our returns are substantial enough. For example,

we work with some real estate investors here that are very good at controlling their retirement accounts, making decisions for their own retirement account, not relying on someone else to advise them, and they're doing substantially well. And so it makes sense for them to convert now from their traditional to their Roth. Pay the taxes on the seeds so they don't pay it on the crop. So layer number two is conversions from traditional to Roth. Layer number three is earnings, growth. So as the Roth IRA is being invested, maybe an individual's investing in real estate like a single family rental property, maybe it's a fix and flip transaction, maybe it's a real estate syndication or real estate partnership, multifamily apartment building, cryptocurrency, maybe even just stocks and mutual funds, right?

Traditional investments. Whether traditional or alternative investments, any growth within that account grows tax-free in the Roth IRA. When you take the money out of the Roth IRA, providing that you follow all of these rules that we're talking about, you pay zero percent tax. So in recap, the three layers are what? contributions, conversions, and then earnings. Now, this is where we get to the fun part, which are the rules, okay? The general rule, like we talked about in the 72T episode, is what? The qualified retirement age is 59.5. But there are exceptions to the rule of paying a premature withdrawal

penalty. See, if you take money out of your account prior to 59.5, as we learned about in that last episode, 10% penalty. But there are exceptions to the rule, like we talked about. That's the fun part of the tax code are the exceptions. So when we look at the ordering rules, as I call it, the Roth IRA layered cake, guess what? We go to layer number one, contributions. When we contribute to our Roth IRA, any time that we want, even prior to 59.5, we can take out whatever we contributed to the Roth IRA. So contributions can be taken out anytime tax and penalty free. we then move on to layer number two, conversions. As long as the amount converted has seasoned for five years, called a five year seasoning period, as long as it's seasoned for five years, we can take that money out without any taxes or penalties, even under the age of 59.5.

Now, layer number three, our earnings are growth that must stay in there until we're 59.5. Once we're 59.5 or older, we can take everything out, and we don't have to worry about a single dime of tax. or penalty. Layer number one and layer number two. Layer number one, we can always take out. Layer number two has to season for five years. Layer number three, we have to wait till we're 59 a half. So let's give a quick example for everyone out there, especially those that might be driving or working out right now. Let's say we have $150,000 in our Roth IRA. And let's say we look at

our layered cake. And our first layer, I don't know, Mindy or Scott, what do you guys like on the top of your cake? $50,000. You like 50,000, okay. Oh, you mean, yeah, yeah. The type of flavor. Vanilla buttercream. Vanilla butter cream. So Mindy likes vanilla butter cream, layer number one.

That's our contributions. We got 50,000. Layer number two, we have conversions. I like the German chocolate. Yeah, me too. Layer number two, we're going to say German chocolate, 50,000. That's our conversion, converted amounts. Then layer number three is going to be our earnings.

I don't know. We just call it maybe crumbly Oreo crust. So layer number one are, what was that again, Mindy? Vanilla buttercream. Vanilla buttercream. So layer number one, 50,000. The ordering rules say that we start distributing first in, first out from our contributions. So we got 50,000, 50,000, 50,000.

So we know at any time, even under 59.5, we can take that 50,000. We still have 100,000, layer number two and layer number three. If we want, we don't have to, we can start distributing from our conveyor. amount, our German chocolate, we can start converting from those amounts as long as the converted amounts have seasoned for five years. And then our 50,000 earnings, we have to wait till we're 59. So let's assume that our converted amounts have seasoned for five years. We got 150,000 in this Roth. That means I can take out up to $100,000 from that Roth, 100% tax and penalty free. And my 50,000 in earnings can continue to grow tax free. And then once I turn 59,

or older, I can start distributing from the account and pay zero percent tax. Now, there of course are some exceptions even beyond this. One is higher education. This is an interesting one. I can distribute from my earnings, even under 59.5. As long as I use it for higher education for myself or a child, let's say, I don't pay a 10% premature withdrawal penalty. I do have to pay taxes because I'm not 59. and a half yet, but I avoid the 10% penalty. So there are even some other interesting exceptions that go beyond this. But I think to make it really simple for folks, it's good to know they have that safety net in the Roth, that any amounts they contributed, any amounts that they can convert or have converted, they can take that amount out anytime they want tax and penalty free as long as

they've met those rules that I mentioned. And then their earnings just continue to grow tax free until they're 59.5 or older. And then they could start taking withdrawals. Before we take a quick, If you are enjoying this episode, we would love it if you would share the word. Please leave us a review on Spotify or Apple or wherever you get your podcasts. If you're looking for even more content, feel free to hop on over to our YouTube channel, which is YouTube.com slash bigger pockets money. Tax season is one of the only times all year when most people actually look at their full financial picture, including income, spending, savings, investments, the whole thing.

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Join thousands of small business owners who have streamlined their finances with Found. Audible has been a core part of my routine for more than a decade. I started listening years ago to make better use of drive time and workouts, and it stuck. At this point, I've logged over 229 audiobook completions on Audible alone, and I still regularly re-listen to the highest impact titles. Lately, I've been listening to Bigger Leen or Stronger for Fitness, the Anxious Generation for Parenting Perspective, and several Arthur Brooks' audiobooks that have been excellent for mental well-being. What makes Audible so powerful is its breadth. Beyond audiobooks, you also get Audible Originals, podcasts, and a massive

back catalog across business, health, parenting, and more, all accessible in one app. If you're looking to turn everyday moments into real progress, Audible has been indispensable for me over over 10 years. Kickstart your well-being journey with your first audiobook free when you sign up for a free 30-day trial at audible.com slash BP Money. Welcome back. I believe you can take out of all three layers for a home purchase, right? So you're looking at the exception and the way we would look at this is we always have to follow the ordering rules, okay, no matter what, even if we're using one of those exceptions, like higher education, first time home buyer, hardship withdrawals, we always follow the ordering rules. So we're always going to start with our

contributions, and then we're going to dip into our converted amounts that have seasoned for five years, and then we dip into our earnings. So the idea is, is we hope that whatever we desperately need whatever we're doing for. We want to hope that we can take that just from layer one and layer two and not dip into layer three. We don't want to dip into layer three. Could you remind me what the rule is? Because one of the questions I think somebody who's very young might be asking is, should I be putting my money in a Roth IRA and saving up? Or should I be saving up for that first house hack or home purchase instead? And with the Roth, you don't have to choose. You can at least take out the contributions for that purpose. And what is the rule for earnings growth if you're using

that for the first time home purchase down payment? On the earnings, you avoid the 10% penalty, but you still have taxes. And that's the same with a hardship withdrawal or the same for a, let's say, higher education expenses like I mentioned before for the taxpayer or their children, let's say, you avoid the 10% penalty. So now it sort of is like a kind of like a 72T withdrawal. But you know what's interesting is under the substantial equal periodic payments, 72T withdrawals, Like we talked about and was mentioned before, but just to make sure everybody's clear on this, once you start, you can't stop. The great thing about this Roth layered cake is let's say one year I need to take some money out of my Roth, and the next year I don't. Well, that's fine. I don't have to keep taking money out of the Roth if I don't want to.

Let's go into a little bit, another layer of complexity here. Many people who are listening to this who have a large amount of wealth in retirement accounts prior to the age of 59.5, such that they're interested in accessing those funds. early. These folks are going to broadly, not always, but broadly fit a bucket of fairly high income earners who have likely taken advantage of deferring taxes in the pre-tax retirement account. If all of your money is in a Roth and you have no pre-tax retirement accounts, congratulations, you don't have to deal with very much complexity here. You're going to be able to withdraw the contributions, tax and penalty-free. You have no conversions, and you will not pay tax on the earnings as long as you don't withdraw those earnings before age 59 and a half.

But for the rest of us, there is likely to be at least some hybrid accountability. And for many, I would say the norm in my experience is to see, you know, two to three times, maybe much more, maybe all of the wealth in a pre-tax retirement account like a 401k, necessitating the need for some strategy or the desire for some strategy to move that money from the pre-tax account to the And so in that context, do you have any strategies or observations or thought processes about how best to plan ahead for that rollover strategy? Starting with traditional contributions, those could be into a 401k, getting a deduction or traditional IRA. You, of course, have the benefit of a tax deduction. And you defer any gains growth until you start taking money out at 59.5 or older during your retirement.

or maybe you do the 72T distributions like we talked about. The other option is convert to Roth. And I think that's the premise of the question in our discussion here, Scott, is should I contribute to traditional? Should I contribute to Roth? Should I, instead of contributing to Roth, instead save up my money for my first house hack? I think that's the discussion point here. How do we make those decisions?

It's difficult to help someone make that decision for them, particularly in my capacity, at Equity Trust, we can't give advice or recommendations. But I can certainly educate people and create some thoughts and framework around this. So let's talk about some frameworks for a moment. So first, should I put my money into traditional or put my money into Roth? Here's the way I look at it. It all comes down to a net present value calculation. And you can do this very simply on a spreadsheet. The equation is an overly complex. The first variable of the equation is what do you expect your return on investment to be over the next how many years that you're going to invest. And that's variable number two. So it's a very simple exponential equation, net present value

calculation, which is, again, your return on investment and the number of years. So the younger you are, the more years you have ahead of you. So if you apply, let's say a 7.25% compounding return, that's going to look a lot different than if you're making 14% return on your rental properties. as an example. You would run that calculation out. Now, what I will tell you is looking at this and modeling this out, the Roth IRA, just think about it on its surface. You eliminate the variable of ever paying taxes again. So all of your growth compounds tax free and all of your distributions are 100% tax free. And when you distribute from the Roth IRA, as long as you wait until you're 59 and a half for the earnings, but again, your contributions and your conversions that

of season for five years, using our layered cake analogy, those we can take out any time. The way I look at it, Scott, the Roth IRA has superior features, superior characteristics that you cannot get with a traditional account. And you cannot get with just keeping your money in a brokerage account, savings account, or investing in assets in a non-taxempt environment. And it goes beyond just some of the things we're talking about here. You can also look at Roth IRAs, if you think about it when you distribute. The amount's not added to your ordinary income. Well, when you have ordinary income added to your 1040, that impacts a lot of things. That can push you into net investment income tax on your investment income. That can impact Irma when you get older.

There's all sorts of things that that can impact. But a Roth IRA, all the distributions are tax free. Number two on that is no requirement of distributions. Roth IRAs, once you turn 73, a lot of people on this call. It'll be 2033. It'll be 75 years of age. With a traditional account, you have to start taking required minimum distributions. With a Roth, no RMDs. And oh, by the way, a state and legacy planning, you don't have to pay taxes when you leave it to your children or grandchildren, or rather, they don't pay taxes when they distribute from the Roth account. That's really powerful. And you give you a quick, one quick example of that. I have a husband and wife couple. They converted about 170, $11,000,000, $11, 2012, $17,000 from pre-tax to Roth. They've grown those Roth IRAs through

real estate investing to over $2 million in property value. And they've had a lot of appreciation over the years. They have 14 cash flowing properties in their Roth IRAs across both their Roth IRAs. They're generating over $200,000 in net tax-free cash flow every single year. They're also private money lenders. They lend money on house flips to other investors. Over $200,000 is coming into their Roths every single year. And if they want to distribute that money, they pay zero percent tax. So that's a quick example of sort of that present value calculation and why that's so powerful. Hopefully that started to answer the question, maybe not answered exactly, but give people some framework. I think that there's no question that dollar for dollar, the Roth is better.

It is this superpower retirement account. All these advantages are there. And I'll go further and say, I am willing to bet, and I do bet heavily with my personal portfolio and decision making, that Uncle Sam is going to raise taxes. And he's going to raise those taxes, particularly on the owners of capital and the recipients of dividend and other investment income over the duration of my life. That is a bet. People can disagree with it. But in my mind, it's almost certainty and it's foolish not to plan on it.

In the event that doesn't happen, then great, I'll be even better off on there. But I'm going to plan on that. For the Roth to begin getting taxed, at least in the generation for the individual who's building that Roth account for that to be taxed, it would be the government reneging absolutely on the conditions of that account in there. And I think it's just much less likely than ordinary income rates being raised, which will absolutely directly affect distributions from a 401k. So I'll see your recommendation for the Roth and raise it to that level. That said, the question really is, what's the most efficient way to get large amounts of money into a Roth?

in the context of an early retirees journey. And if we frame the discussion that way, the most efficient way to get money into a Roth for, let's say, someone who's earning a high income towards the end of their financial independence journey, might be to max out theirs and their spouses 401k or other pre-tax retirement account vehicle, and then convert it to a Roth in the low-income early years, first years of early retirement. That's where the problem gets in is it may not be efficient for. those folks to just pay ordinary income tax rates and then max out the Roth. It may be much more

efficient for them to max out their pre-tax accounts. Do you agree with that premise, John? You're bringing up an interesting strategy here. Let's say someone retires at the age of 40. Let's say their income is really high from 30 to 40, and they want to retire at 40. And so along the way from 30 to 40, they max out their 401ks. Let's say it's two spouses, right? They max out their 401ks every year, all pre-tax, they don't put it into Roth. Because yes, most 401k support a Roth contribution. You 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 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? And 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 100,000 in year one, 100,000 in year two, 100,000 in year three,

100,000 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. So 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 59.5. As long as that converted amount has seasoned 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 59.5. And 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 retirees 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? One 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 go to realize that gain, unless you turn in 30, in exchange forever. But that year, maybe you could have a $200,000 loss if you bought, you know, $500,000 to a million 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 going to pay taxes on $100,000 that gain at a fairly low marginal tax bracket for a married couple, for example. That's the power

of this situation. If you just assume you're going to 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. And 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. And a lot of people don't know what.

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 to 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. We 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 afflation. 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. But 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. You 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 withhold and you're under 59.5, 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. Tax season is one of the only times all year when most people actually look at their full financial picture, including income, spending, savings, investments, the whole thing. And if you're like most folks, it can be a little eye-opening. That's why I like Monarch. It helps you see exactly where your money is going, and more importantly, where your taxed refund can make the biggest impact. Because the goal isn't just to look backward, it's to actually make progress. Simplify your finances with Monarch. Monarch is the all-in-one personal finance tool designed to make your life easier.

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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. Layer 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. It'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. So layer number, number two as layer number one, which are regular conversions, layer number two are these non-ded attributable 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. Simple. Super simple. Yeah. Take a notepad when you're listening to this for the second time. And 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. So it does get complex because there's a lot of loopholes and games you got to play to contribute to these counts in the first place if you earn above certain income levels. Yeah, and quick example, 150,000 like we've been using to say 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 conversion. 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. Here'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 that's why people have accountants in 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-ded 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. Okay. 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 treat it 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. Yeah, 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, and 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, Roth IRA. Because 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, they, they just they don't have any money left. But 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 kick starts 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 a number of podcast episodes here. And there so we can start maxing out of 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, you know, $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 that I give her $5,000 to put in her Roth IRA so she can spend the $5,000 that she has earned. That 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 they're 65, they can retire, 59 and a half or whatever. Like, 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. We 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 am retired early and I have zero dollars 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, you 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, 25,000, they 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 the couple that I know, $117,000, now over $2 million, would you rather pay taxes on $117,000 or $2 million? That was an easy one, right? Because their returns were good enough. I'm not saying that's for everybody, right? But you want to look at, you know, 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? Now, that does bring up an interesting strategy that we did mentioned 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 1400. Instead 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, but 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 recapture depreciation. 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. We covered this on 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? 4975 of the Internal Revenue Code. Just 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. So 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, I mean, this means you should not be swinging a hammer

and fixing up these properties. You're not, you're not selecting the tenants or you're at your private, 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 Bigger Pockets Money episode here. It's a very powerful tool to self-directed IRA, but just know before you go into those, those avenues that you need to have your eyes open and deal with a professional that can help you set that as up and make sure you're on the right side of the rulebook. Assuming 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, in 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. We 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 and 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 bounds plummets 20%. You convert when the value is much lower from traditional to rot. 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? So 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. thousand, 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. And 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 trust, 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 an 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. Yes, can you manufacture a loss? Manufacture a loss by buying real estate, for example, is 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. And those assets, the valuations of these things are going to 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. You guys do so much for the real estate investor community. I've grown up around bigger pockets. A lot of people that.

that I've known of grown up around Bigger Pocket. 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 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. They'll also help you with a 1031 exchange if you're looking to do that on the real estate side. And that 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, you know, 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. Like how can they make the Roth layer cake work within their retirement strategy? I just think that, you know, the more you know, do you remember those from the Saturday morning cartoon, Scott? the more you know. This is maybe not something, 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 it's, 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. And 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 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. And to do that, most people, most people are going to 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 got to shake chocolate cake.

Thank you.