How to Create a Roth IRA Conversion Ladder to Fund Early Retirement

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When I first started this blog, I was unfamiliar with the concept of FIRE.  It seemed like everybody on the blogosphere was obsessed with reaching it.  And then there was me, with no discernible concept of what FIRE was, let alone how to get there.

 

FIRE

roth ira conversion ladderNeedless to say, I quickly got up to speed when I found out that FIRE stood for Financial Independence, Retire Early.  Early retirement?  Yes please- where can I sign up?

 

I began to read just about anything related to FIRE.  I wanted to learn the secrets of these early retirees and exactly how they accomplished that feat.  For the most part though, most people provided the same basic advice.  It went something along the lines of: max out your retirement accounts and save more than you spend.  Nothing out of the ordinary, until I stumbled upon a Reddit board.  

 

That’s when I learned about the Roth IRA conversion ladder.  It was intriguing, but I was also having a really hard time following the concept.

 

Confused about the Ladder

If you Google “Roth IRA conversion ladder”, you won’t find a single brokerage or wealth management firm on the first page of search results.  It’s almost like brokerage firms want you to follow the rules and not retire until you’re 65.  By then, they should be able to draw quite a few fees on your plump retirement accounts.  Just a theory as to why they may not be sharing this information more freely.

 

If you are unfamiliar with this information as I was, let’s get into it.

 

As most of you know, reaching early retirement is not easily attainable.  Even if you save enough money to retire early, you may run into some trouble if this money is in a tax-deferred account.  If you withdraw before 59.5 years old, that would result in early withdrawal penalties.  

 

This is where we break out the secret weapon, the Roth IRA conversion ladder.  If you do this correctly, you will be able to withdraw tax-free from this plan before you reach 59.5 years old.  

 

Roth IRA

Before we get too far, let’s clarify what a Roth IRA is.  A Roth IRA is a tax-deferred retirement plan that allows you to contribute post-tax dollars into the account.  The big selling point of a Roth IRA is the ability to withdraw contributions and earnings from the plan tax-free, as long as you are 59.5 years old and have had the plan in place for at least the last five years.

 

Roth IRA Conversion

A Roth IRA conversion is when you transfer money from one retirement plan, like your 401(k), into your Roth IRA.  When you do this, you must pay income tax on the converted amount.  However, you do not have to pay the 10% early withdraw penalty.  

 

An Example

If you wanted to convert $40,000 from your Traditional IRA into your Roth IRA and you were in the 25% tax bracket, you would need to pay $10,000 in taxes in the year of conversion.  Therefore, it’s imperative that you have enough money in savings to cover these taxes, as you will not want to pay it out of the $40,000 withdrawn.  If not, you would incur a 10% penalty on top of the taxes you owe.

 

Tax-Free, Penalty-Free Using a Roth Conversion Ladder

Since you will have to wait five years after each conversion to withdraw your plan’s funds untaxed, you must estimate what you will need to live on each year.  Using the above scenario, if you needed $40,000 a year to live on, you could anticipate reaching FIRE at the age of 40.  If you anticipated retiring in 2025, you would begin to start the strategy in 2020.  

 

So how does it work?  After you convert the $40,000 in 2020, you will need to pay your taxes.  In this scenario, taxes would be $10,000 based on a 25% tax bracket.  In 2025, you can withdraw the $40,000 that you converted into the Roth IRA, penalty and interest-free.  It’s important to note that you cannot withdraw the earnings.  You can only withdraw the contribution amount that you made.

 

Continuing with this scenario, if you plan to retire at 40, starting at 35, you would need to begin making Roth IRA conversions of at least $40,000.  For simplicity purposes, I’m not going to factor inflation into these calculations.  Thus, you would need to continue doing Roth IRA conversions for the next 24 years, until you reach the age of 59.5 years old.

 

Take a look at this chart:

 

Roth IRA Conversion Ladder Chart

Year Age Roth IRA Conversion Roth IRA Withdrawal Amount Notes
2017 35 $40,000.00 $0.00  
2018 36 $40,000.00 $0.00  
2019 37 $40,000.00 $0.00  
2020 38 $40,000.00 $0.00  
2021 39 $40,000.00 $0.00  
2022 40 $40,000.00 $40,000.00 5 year conversion since 2017
2023 41 $40,000.00 $40,000.00 5 year conversion since 2018
2024 42 $40,000.00 $40,000.00 5 year conversion since 2019
2025 43 $40,000.00 $40,000.00 5 year conversion since 2020
2026 44 $40,000.00 $40,000.00 5 year conversion since 2021
2027 45 $40,000.00 $40,000.00 5 year conversion since 2022
2028 46 $40,000.00 $40,000.00 5 year conversion since 2023
2029 47 $40,000.00 $40,000.00 5 year conversion since 2024
2030 48 $40,000.00 $40,000.00 5 year conversion since 2025
2031 49 $40,000.00 $40,000.00 5 year conversion since 2026
2032 50 $40,000.00 $40,000.00 5 year conversion since 2027
2033 51 $40,000.00 $40,000.00 5 year conversion since 2028
2034 52 $40,000.00 $40,000.00 5 year conversion since 2029
2035 53 $40,000.00 $40,000.00 5 year conversion since 2030
2036 54 $40,000.00 $40,000.00 5 year conversion since 2031
2037 55 $40,000.00 $40,000.00 5 year conversion since 2032
2038 56 $40,000.00 $40,000.00 5 year conversion since 2033
2039 57 $40,000.00 $40,000.00 5 year conversion since 2034
2040 58 $40,000.00 $40,000.00 5 year conversion since 2035
2041 59 $40,000.00 $40,000.00 5 year conversion since 2036
2042 60 $40,000.00 $40,000.00 Congrats on turning 59.5!!!
You can withdraw however you want.


Using the Roth IRA Conversion to Retire Early

As you can see, the math is pretty simple behind a Roth IRA conversion.  The hardest part is making sure that you have enough in retirement to cover all of your expenses.  It’s one thing to have enough money to make it until you reach 59.5, but it’s another to have enough to live on for the rest of your life.  

 

If you’re like me and aspire to retire early, Roth IRA conversions are a great way to access your money, tax-free and legally before you reach retirement age.  Just make sure you know the rules before you begin.

 

So readers, were you already familiar with the Roth IRA conversion ladder?  If you weren’t, are you now thinking about utilizing it?  Share your thoughts below.

Mustard Seed Money

Welcome to the website. A mustard seed is a very small seed but astonishingly grows very large over time. My hope is that through your financial journey that your small investment in time, money and faith will grow beyond anything that you could ever imagine.

38 Comments

  1. Nice explanation of the ladder! I was familiar with it already, but am a ways away from implementing it still. The trick is to watch your taxes and income on the year to make sure you convert only the amount that is not taxable or does not raise your current tax bracket. If you start generating taxes due to conversion, some of the benefit is lost.

    Personally, I was planning on living off the brokerage account the first 5 years and converting over while I had $0 in income so that I could pay $0 of income tax.
    Justin @ Atypical Life recently posted…4 Critical Steps to Reduce Home Costs with Energy EfficiencyMy Profile

    • Justin – What you describe is basically what I’ve done.

      I FIREd 5 years ago and I’ve been living off after-tax savings. Every year since I FIREd, I’ve been doing a Roth IRA conversion to raise my taxable income enough so that I qualify for an ACA subsidy without slipping below the Medicaid threshold.

      It’s worked well for us!
      Mr. Freaky Frugal recently posted…Investing attitudeMy Profile

      • Thanks for sharing Mr. Freaky Frugal!!! That’s awesome that you’re implementing this strategy and had a plan in place to live off after-tax savings in the mean time. That’s amazing!!!

    • Thanks for sharing Justin!!! I too am a ways off but am excited about the possibility of implementing this strategy in the future. Hopefully taxes stay low for the foreseeable future 🙂

  2. A very interesting concept for early retirement. The Madfientist has a good post about exactly how to perform all the conversions to limit the penalties and taxes. The only issue is that this loophole has the potential of eventually being closed. Although the way our government is run, maybe that is unlikely for a while.
    Jeff @ Maximum Cents recently posted…Should You Speculate in Bitcoin?My Profile

    • Leo,
      Your observation is right on. The tax due is paid currently as the conversion amount is an addition to taxable income. Unless there is another tax offset, like capital losses (Limit $3,000) or another tax deduction, the tax due will have to come from the individual’s cash.
      If you see my post in this thread, I think a $40,000/yr conversion is unrealistic for a 35-year old to continue until age 60.
      I’m over 50 and have a high balance in my traditional IRA but I would not be able to pay the taxes due if I included large converted amounts in my taxable income.
      I hope that clears up the confusion.

    • Thanks for stopping by Leo!!! Hopefully if you’re still working you can cover the extra taxes in the five years before you retire. If not you’ll have to take some additional funds to help cover it 🙂

  3. Hmmm…$40,000 a year for 25 years, starting at age 35? I don’t know many people that have that amount in their 401(k) or traditional IRA starting at that age. That is assuming incredible returns for the maximum contribution each year.
    It’s a great concept to avoid taxes in retirement years, but don’t forget, the taxes are paid up front. Maybe it gives some comfort to know your tax due now instead of trying to guess what it might be?
    I’m currently balancing my regular contributions plus over-50 catch-up payroll deductions ($24,000) against conversions to my Roth IRA (reduce income taxes/increase income taxes). I can tap my traditional IRA to reach the $40,000 if I want to pay the taxes now, but that would really require some budgeting to handle that burden.
    If I’m not seeing this right, please comment.
    Dora recently posted…Money Learning Checklist 2 – SpendingMy Profile

    • A million dollars in your portfolio at age 35 does seem pretty daunting. I guess if you’re really disciplined and invest the max in both accounts and make some great investments it’s possible 🙂

  4. This is super helpful. I have never heard of this concept before. I also didn’t know about FIRE until I joined the PF community. It’s such a cool concept that everyone is aiming for, myself included.

    I will keep this in mind when I want to do the conversion. I definitely want to be able to withdraw funds earlier thank 59.5 just in case something happens.
    Ms. Frugal Asian Finance recently posted…How This Family Slashed Their Mortgage Payment By $700/monthMy Profile

  5. I’m just glad as a Canadian life is a little simpler. We can contribute to our RRSP account and withdraw it in early retirement without penalty, as long as you don’t withdraw too much. The only penalty will be a temporary withholding tax until you file your taxes the next year and get it back.

    As long as you combine your retirement fund withdrawals with a TFSA (not taxed), you should be able to reach financial independence and have access to all of your cash tax free.
    Money Miser @ Money-Miser.com recently posted…Why Is Everyone So Hell Bent On Spending All Their Money?My Profile

  6. I’d heard of it but never read about it to see how it works and if it could help me or not; thanks for sharing with us 🙂
    The benefit is as you said accessing your money early, but of course paying the tax man early too. It’s true that the the only losers in this scenario are probably banks and financial institutions
    SMM recently posted…What’s Your Money System?My Profile

    • Thanks for stopping by SMM!!! I definitely agree having access to your cash is wonderful, although the downside is tapping that cash when it could be growing. Although I’d rather retire early and use the cash then die and never use it 🙂

  7. Thanks for giving a great explanation of the ladder. It is an interesting approach to access money for early retirees. I am trying to work on building up substantial funds in a taxable account to cover early retirement.
    Dave recently posted…Schwab 1000 Index Fund (SNXFX)My Profile

    • Thanks for sharing Dave!!! It’s definitely something that will take me awhile to get to but I feel like I am making progress every year 🙂 Hopefully I’ll get there soon enough!!!

  8. In your example, why do you keep making conversions from age 54 to 60? You have to pay tax on the conversion in the year you convert and you are within 5 years of being able to withdraw from your 401k or IRA (assuming that is what is being converted). Instead you could just withdraw the $40 K directly from 401k or IRA in the year your turn 59.5 or older and pay the taxes 5 years later that in your example.

    • Yes, technically there’s no benefit in avoiding a 10% early withdrawal penalty by converting after age 55. I went back and forth whether to show conversions for those years, but for a lot of people it’ll make sense to continue converting to get as much into the Roth space as possible.

      • Sorry, I don’t follow. Why does it make sense “for a lot of people…to continue converting” after age 55? It seems like the same difference unless you are planning on being in a higher tax bracket in the future which is explicitly not the assumption in your example.

        • Thanks as always for your comments Dan. The assumption that I failed to share was starting at age 62 people are eligible for social security which they are required to pay taxes on it if they elect to start receiving. By converting earlier in a lower tax bracket without the social security it can be tax beneficial.

          • I understand. Following that line of logic, a more generic statement is that you should continue Roth IRA conversions until you start drawing Social Security which can be deferred to age 70.

            Some people still have defined benefit pensions which should also be taken into account. In my case, there is no added value by deferring my pension benefits beyond age 65. Even though I can defer my Social Security benefits to age 70, I’ll likely be drawing my pension at age 65 which may affect my tax bracket..

  9. I am familiar with the conversion ladder. I am interested in taking off several months or a year to travel and I wonder about converting some money from traditional to Roth then, since my income for that year will be very low. I only ever hear about people doing the conversion ladder in early retirement though.

  10. The Roth ladder is definitely a key tool in the arsenal, and it’s part of our backup plan. But we’re hoping that we never truly retire and have enough income to make it unnecessary – let the pile keep growing!
    Paul recently posted…Dances with ChickensMy Profile

  11. Thanks for explaining the Roth conversion ladder. I was just listening to a financial podcast(believe it was Stacking Benjamins) last week about this same topic. It was a confusing how it was explained on the podcast but now reading it from you it sounds more simple.
    I’m approaching my 40s soon and hope to reach early retirement in my late 40s-early 50s ranging and the IRA conversion ladder is one of the tactics that I need to know. Thanks again for this info MSM!!

    • Thanks for stopping by Kris!!! I’m so glad that you were able to follow along. I know how frustrating it can be when something isn’t explained in a manner that makes sense.

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