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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.
Needless 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.
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.
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|
|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.