Financial Literacy

Retire Early with NO Penalties

Many of us have dreamed of the potential of early retirement or FIRE, but it can be overwhelming to figure out how you might sustain yourself as you move into this new phase of your life.

Luckily, there are many options. Aside from saving the amount you need to retire, you can also leverage several tax loopholes in order to acquire funds in your tax-advantaged investment accounts.

One loophole: Build a Roth conversion ladder.

A Roth conversion ladder works by converting money from a 401k to a Traditional IRA to a Roth IRA, and withdrawing the principal amount after five years without any penalties.

This means you’ll be able to withdraw money from your 401k and Roth IRA earlier — allowing you to use your money faster and retire sooner (if that’s your thing).

There is a bit more to it than that though. To fully understand how it works, we need to take a look at the issues with a Roth IRA on its own.

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Roth IRAs and early retirement

When considering early retirement, traditional IRAs and 401ks can seem to put you in an impossible situation. Don’t get us wrong. We love both of these forms of retirement savings, and they absolutely have their place on the journey of smart investing for retirement.

Both of these accounts enable you to save for retirement in a highly productive way. A traditional IRA leverages your after-tax income to compound interest on your investments over time. You also don’t have to pay any taxes on it until after you withdraw it.

The drawback? You can only withdraw your money once you reach retirement age. That means when you turn 59 1/2, you can finally get access to all that money, likely years after you would like if you are planning to retire early.

Traditional IRA

  • Uses after-tax income
  • Pay no taxes when you withdraw at age 59 ½
  • 10% penalty if you withdraw early

401k

  • Uses pre-tax income
  • Employer match
  • No taxes on it until you withdraw at age 59 ½
  • 10% penalty if you withdraw early

A 401k offers you similar gains and drawbacks to an IRA, giving you the chance to contribute pre-tax income this time which an employer can match. You still pay no taxes until you withdraw it at retirement age, but you also incur a penalty of 10% if you withdraw it before that age.

This information can make some people feel like they are stuck between a rock and a hard place. But, luckily for you, this is where the Roth conversion ladder comes into play whether you have an IRA or a 401k.

Bonus: Unsure what the difference between a 401k and a Roth IRA is? Check out my Ultimate Guide to Personal Finance where I explain everything you need to know about retirement accounts.

What is a Roth Conversion Ladder?

Simply put, a Roth conversion ladder is the loophole you have to withdraw a large pool of money from your retirement funds, both tax and penalty-free. Without this technique, anyone in the FIRE community will end up getting an early withdrawal penalty of up to 10%, taking quite a chunk out of those hard-earned savings.

Most of those seeking early retirement do so because they have amassed a large amount of net worth. Their retirement investment accounts, such as a 401k or traditional IRA, will reflect this worth. For most of them, they plan to live on these investments for the rest of their life. The Roth conversion ladder allows them to access the accounts early in order to do that.

The Roth conversion ladder essentially involves moving your money from your restrictive retirement accounts to more of an open system. Keep reading to figure out exactly how we recommend doing this.

Who should use a Roth Conversion Ladder?

A Roth conversion ladder is specifically useful for people who want to retire early. For example, if you plan to retire after you are 59 1/2, you will only lose out by transferring your money into a Roth IRA since it is no longer tax-protected. The positive aspect of the Roth conversion ladder is that it allows you to withdraw money to live in during early retirement. 

You should NOT use this method to supplement your income to achieve a lifestyle you can’t otherwise afford. Instead, the money should realistically stay in your retirement accounts to accrue as much tax-free interest for as many years as possible, or you will find retirement quite a challenge.

How to set up your Roth Conversion Ladder

Utilizing a loophole to the penalty system in place around retirement funds might sound complicated. However, building an effective Roth conversion ladder is simply a matter of moving your money around and patience until it becomes usable. Start your Roth conversion ladder in just four steps.

  1. Start by rolling over your 401k into a Traditional IRA. You should do this once you quit your job. From the time you quit any job, you are free to move your 401k money from that job into an IRA. Also, be aware you aren’t obliged to keep it with the same company that was holding your original 401k. Make the choice that is best for you after considering the options.
  2. The next step is to transfer some funds from the traditional IRA account into a Roth IRATransfer the annual amount you want to access in five years. Do you already have some income from Roth investments you made while working? Then, we suggest only transferring the amount to bring this up to the amount of your annual expenses instead of transferring the entire sum of annual expenses. You will lose less money on taxes doing this in the end.
  3. Next comes patience. Wait five years. The “Five Year Rule” applies to any investments in an account like a Roth IRA. It means that the investor can only take out the invested money after a five-year waiting period.
  4. Finally, withdraw the money you converted like an old friend you haven’t seen for five years.

The “ladder” part of the strategy comes into it when you use the technique on a recurring annual basis. As you move toward retirement, you continue to use the ladder to supplement your annual funds until you have reached five years before 59 1/2 when the funds become available.

Why not just contribute annually to a Roth IRA?

You take money out of a tax-protected account when you transfer money from a traditional IRA into a Roth IRA. That means you need to be ready to pay taxes on any money you transfer from a 401k or IRA into a Roth IRA. This is because contributions to a Roth IRA don’t lower your adjusted gross income, whereas you can get tax breaks when you make contributions to your 401k or traditional IRA. Instead, the money you transfer becomes taxable income for the year.

Another reason you should avoid contributing to a Roth IRA annually is if you are getting anywhere close to emptying your retirement accounts before retirement age. You need to have enough saved to keep up your preferred lifestyle for as long as you plan to be in retirement.

Additionally, you can only take money out of a Roth IRA five years after initially transferring the money into the account. You need to find some money to live on until then. You might already have this covered from 

There are plenty of ways to do that, though. Here are a few we at IWT love:

Don’t forget about standard retirement accounts for early retirement

Since your Roth conversion ladder only provides you money until you reach 59 ½ years old, you need to have a retirement savings plan for the years beyond that. The first step to finding out exactly how much you need for retirement, which you can do following the steps in the next section. However, when it comes to investing the money you save annually, you need to know what kinds of standard retirement accounts you should keep to make the most out of your money for early retirement?

You will likely be saving a significant portion of your income each year for retirement, particularly if your goal is to do this early. However, it would be best to maximize your retirement accounts to make the journey faster. Although it will look different for anyone on the road to financial independence, the common accounts you can build while you are still working include:

Each of these works slightly differently and has various potentials of effectiveness for your retirement funds. So what do we mean by maxing these accounts out each month or year? 

All three of these accounts are tax-protected. The government caps the amount of investment in these so that those in a higher wage bracket don’t benefit more from tax breaks than most lower earners. 

Reaching these caps is your goal.

From the time you build your net worth to your retirement goal, you are then ready to retire early and reap the rewards of these accounts using the Roth ladder strategy.

Commonly asked questions about a Roth conversion ladder

How much money should I convert each year?

The amount you should convert each year you employ the Roth ladder strategy depends on how much you have saved and how much you intend to spend each year. As long as you have enough saved for retirement, you should be able to send over the intended amount you will spend annually. So the real question is, how much should you save for retirement?

You’ll need to look at three numbers to figure this out:

  1. Your income, meaning the amount you make a year after tax.
  2. The amount you spend each year, or your expenses. These include absolutely everything you spend money on during the year, including utilities, groceries, rent, clothes, vacations, insurance, gas, etc. 
  3. Your intended retirement date. Once you start considering “early” retirement, you get into a pretty subjective area. You need to set out a timeline for your early retirement plans to be truly prepared to be financially independent for the rest of your life.

You might figure all these numbers out and then, six years later, experience a significant life change. Remember to be flexible with all of these, whether they go up or down. You never know what life has in store for you.

Once you have calculated these numbers, you can come up with an annual savings rate for the precise amount you should be saving each month for your retirement.

You can use this convenient calculator to figure it out. It utilizes the 4% Rule of a safe withdrawal rate. Do you not want the calculator to do the work for you? You can figure out your own 4% Rule number by:

  1. Figuring out your yearly expenses.
  2. Multiply this by the number of years you anticipate being retired. For typical retirees, this will be estimated at 25. For early retirees, add the assumed amount of years.

The estimates below are all based on the expenses being multiplied by the typical 25 years assumed for a retiree.

ANNUAL EXPENSES HOW MUCH YOU NEED TO SAVE
$20,000 $500,000
$30,000 $750,000
$40,000 $1,000,000
$50,000 $1,250,000
$60,000 $1,500,000
$70,000 $1,750,000
$80,000 $2,000,000

Although the numbers might seem quite large, we are talking about what you need to save across a diversified portfolio of accounts over quite a few years. As long as you are willing to put the effort in and realize that the more you save, the earlier you can reach your retirement goals, you won’t have an issue hitting your goal numbers.

How much should I expect to pay in taxes on a Roth IRA conversion?

The exact number depends on the exact amount you transfer each year, tax percentages the year you transfer and inflation rates as time moves forward. However, the amount isn’t quite as important as the method you will use to pay that amount. Once you have figured out exactly how much you should expect to pay each time you move money from your 401k or IRA to a Roth, you need to be prepared to pay it.

However, you shouldn’t have to worry too much about this since you will likely be living off the Roth contributions you made while working with a supplement of the money from your retirement funds. Moreover, since Roth contributions are already taxed, your tax bracket will only account for the yearly transfers and thus should be very low.

Is there a limit I can convert into a Roth IRA?

There is no limit to how much you can convert from your various retirement accounts into a Roth IRA. However, keep two things in mind. 

First, once that money leaves the tax-protected accounts, you will have to be ready to deal with the annual taxes. 

The second thing to remember is that a Roth ladder strategy only works as it should if you don’t run out of money. Therefore, it is essential to evaluate the long term to ensure you will still have the funds to continue supporting your lifestyle even after turning 59 1/2. 

What is the best time to start a Roth conversion ladder?

When implementing a Roth conversion ladder, you should start your first Roth conversion the year you plan on retiring. After that, you should continue to make conversions for the annual amount you require to live each year, with conversion continuing up to 5 years before you turn 59 1/2. That way, the only financial “gap” you will have from your Roth conversion will be in the first five years of retirement. Once you reach 59 1/2, you can freely withdraw money from any of your retirement accounts.

You can also do a Roth conversion after you have reached 59 1/2 years old. However, this kind of conversion always comes with a tax bill. While this is acceptable when the alternative is taking a 10% penalty fee that would come from withdrawing from your retirement accounts early, it isn’t necessary after you have reached retirement age.

Additionally, when you move the funds out of your 401k or a traditional IRA, it means you will miss out on any tax-free growth you could have had.

Playing your cards right during your working years can seem worthless if you have to take penalty fee after penalty fee to access your money. However, using a Roth conversion ladder gives you a way to join the FIRE community, enjoying early retirement without a 10% fee for it. If you are wondering how you might jump on this bandwagon of financial independence, check out our Ultimate Guide to Making Money so that you can start your own path to join the FIRE community.

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