Roth conversion ladder: How to fund your early retirement (with NO penalties)

Though financial independence and early retirement (FIRE) can offer many people a sense of freedom, it comes with a host of questions — chief among them: How the heck am I going to sustain myself when I retire?

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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The problem with regular retirement accounts

We LOVE Roth IRAs and 401ks here at IWT.

Check out this incredibly cool and artistic chart we made that breaks down the accounts.

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

Roth IRAs are a great way to save for retirement by leveraging your after-tax income to accumulate compounded interest on your investments over time. And you pay no taxes when you withdraw it at retirement age.

With 401ks, you contribute pre-tax income (with an employer match) and pay no taxes on it until you withdraw it at retirement age.

Therein lies the catch though: You can only withdraw your money from those accounts at retirement age (i.e., 59 ½ years old), otherwise you incur a penalty of 10% on your investments.

That means if your goal is to achieve financial independence and retire early, you won’t be able to touch your money until decades AFTER you actually intend to retire.

401ks have the same issue. If you want to take the money out of the account before your 59 ½ birthday, expect to be penalized 10%.

BUT there is hope. You’ll be able to access money from both your 401k and Roth IRA without incurring a stiff penalty with a Roth conversion ladder.

How to build a Roth conversion ladder

Build a roth conversion ladder workshop
Weird kids only.

A Roth conversion ladder works in four steps:

  1. First, rollover your 401k into a Traditional IRA. This will happen when you quit your job.
  2. Second, transfer the funds from your Traditional IRA into a Roth IRA. Be sure to convert the amount you’ll want to access in five years.
  3. Third, wait five years. This is also known as the Five Year Rule — an investor can only take converted money out of their Roth IRA after a five year waiting period.
  4. Fourth, withdraw the money you converted. And greet it like an old friend you haven’t seen in five years because that’s exactly what happened.

KEEP IN MIND: One way or or another, Uncle Sam gets his cut. You will be taxed on the amount you convert from your Traditional IRA to your Roth IRA if it hasn’t already been taxed. So make sure you’re in a lower tax bracket when you make this conversion. If you earn less than $10,400 a year, however, you won’t have to pay taxes at all since you don’t meet the minimum required income to do so.

The beauty of the Roth conversion ladder is that the amount you convert is growing and accruing compounded interest during the five years. So by the time your 59 ½ birthday rolls around, you’ll have all that more to enjoy.

You might be asking yourself, “Where does the laddering come in?”

To take full advantage of the Roth IRA conversion, you’ll want to contribute to it each tax year. That way you’ll be able to access your money each year until you retire.

For example, let’s say you initially contribute $25,000 to a Roth conversion ladder in 2018. Once that year is over, and the 2019 tax year hits, you’ll contribute another $25,000. Then in 2021 you can withdraw the first $25,000. In 2022, the second $25,000. And so on and so on.

If you plan on retiring when you turn 40, for example, you should plan on converting once a year for a total of 20 times so that you cover each year until you turn 59 ½. This will give you a solid well of money to draw upon until then while also allowing your earnings to grow and compound.

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.

How to Open Retirement Accounts

Opening the accounts depends on a few things.

To get a 401k, your employer needs to offer one. If they do, contribute AT LEAST enough money to get the employer match.

For an IRA, you’ll have to do much of the legwork on your own. Check out our article on the best IRAs to open today. Ramit gives his recommendations for some of his favorite IRAs.

Second, follow the steps below to open up an IRA today.

  • Step 1: Go to the website for the brokerage of your choice.
  • Step 2: Click on the “Open an account” button. Each of the above websites has one.
  • Step 3: Start an application for an “Individual brokerage account.”
  • Step 4: Enter information about yourself — name, address, birth date, employer info, Social Security.
  • Step 5: Set up an initial deposit by entering in your bank information. Some brokers require you to make a minimum deposit so use a separate bank account in order to deposit money into the brokerage account.
  • Step 6: Wait. The initial transfer will take anywhere from three to seven days to complete. After that, you’ll get a notification via email or phone call telling you you’re ready to invest.
  • Step 7: Log into your brokerage account and start investing!

NOTE: You should have basic information such as your Social Security number and employer ID handy. These applications will require you submit it.

When going through this process, the broker will give you the option to open either a Traditional or Roth IRA. Do both if you want to build a Roth conversion ladder.

A few things to keep in mind…

A Roth conversion ladder might seem like a great way to withdraw money from your 401k and Roth IRA early — but there are some snags that can get in the way.

For one, you won’t have access to any of the money you convert for five years. So if you’re planning on living off of this money, you’re going to have to find a way to supplement your income while you wait.

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

Another issue with this method is inflation. Yearly inflation amounts to roughly 3.7%. That means that the buying power of the money you convert will lessen by that much over time.

Of course, you can get around this by converting a little bit more each year. For example, if you wanted to initially convert $25,000 from a Traditional to Roth IRA, you might want to contribute $26,000 (4% more) instead.

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 doing that is finding out exactly how much you need for retirement.

How much do you need to retire?

The amount you need to save depends on how much you intend to spend (wow, I’m a real poet).

And you’ll need to look at three numbers in order to figure this out:

  1. Income. How much you make a year after tax.
  2. Expenses. How much you spend each year. This includes everything that you might possibly spend money on in the year including rent, utilities, groceries, clothes, insurance, gas, etc.
  3. When you want to retire. What is “early” for you? This is the timeline for your early retirement plans. How are you going to know how much to save each month if you don’t know exactly when you plan on retiring?

Remember: These numbers are all subject to change. It’s important to remain flexible when planning for the future. After all, we have no idea what life might throw at us.

With all of these numbers in mind, you’ll be able to come up with a monthly savings rate — or the precise amount of money you’ll be saving every month for retirement.

Here’s a great calculator that does this for you. It utilizes the 4% Rule (safe withdrawal rate) to help you find out how much you need to retire. This rule allows you to withdraw 4% of your savings without touching the principal.

Here’s how you can figure out your 4% Rule number:

  1. Find out how much you spend yearly. This includes everything that you might possibly spend in a year including rent, utilities, groceries, gas, etc.
  2. Multiply it by 25. Or however many years you anticipate being retired. If you plan on retiring early, this number will be much higher.
$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

Those numbers might seem big — but if you’re willing to put in the effort to make more and save more, you can easily reach them with time.

That’s why we created something for you that we think you’ll really like: The Ultimate Guide to Making Money. 

In it, we’ve included our best strategies to:

  • Create multiple income streams so you always have a consistent source of revenue.
  • Start your own business and escape the 9-to-5 for good.
  • Increase your income by thousands of dollars a year through side hustles like freelancing.

Download a FREE copy of the Ultimate Guide today by entering your name and email below — and get on your way to early retirement.

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