Early retirement will probably require you to access retirement savings before reaching age 59.5. Fortunately, there are several ways to do that without incurring an early-withdrawal penalty. A Roth conversion ladder is one such technique.
We are absolutely against accessing retirement funds early except in the most dire situations, and only as a last resort. Once you retire, whether at age 35 or 65, a retirement withdrawal is no longer “early” in that sense, even if the IRS thinks otherwise!
The idea behind a Roth conversion ladder is to use the Roth conversion process (whether part of, or separate from, a backdoor Roth) to access funds that currently sit in a traditional IRA before age 59.5. This process helps early retirement goals because you can withdraw your contributions to a Roth IRA at any time without taxes or penalties, but the same is not true for a traditional IRA.
After age 59.5, you can withdraw your contributions and the growth on those contributions from a Roth IRA without any taxes or penalties, assuming you have had a Roth IRA for at least five years.
Withdrawals from a traditional IRA at any time will incur regular income tax; if done prior to age 59.5, it will also trigger an early-withdrawal penalty.
If the funds you wish to access are already in a Roth account, then a Roth conversion ladder is unnecessary. You can already withdraw the contributions made to your Roth IRA. However, if you contributed to a traditional account over the years, a Roth conversion ladder can move funds in your traditional account to a Roth account to allow you to access the funds before age 59.5. As a result, the Roth conversion ladder is one of the most popular tools for early retirees with a traditional IRA or 401(k).
Converting funds from a traditional to a Roth IRA is a taxable event because your traditional IRA is funded with pre-tax money (while a Roth IRA is funded with after-tax funds). You will pay income taxes on the amount converted at your prevailing marginal tax rate when you file your tax return for the year in which the conversion took place. For instance, if you convert $10,000 this year, you will pay taxes on that $10,000 when you file your 2023 tax return sometime in 2024.
If you have a basis in your traditional IRA because of prior nondeductible contributions, a prorated portion of the amount converted is taxable. Consider a backdoor Roth if you find yourself in this situation.
Once those converted funds are in your Roth IRA, you can withdraw the amount converted five years later, regardless of your age, without owing taxes on the amount withdrawn (since you were already taxed when converting). And because there are no taxes on the amount withdrawn, there is no early-withdrawal penalty on the withdrawal either! That hypothetical $10,000 you converted in 2023 can be withdrawn in 2028 without incurring taxes or penalties.
The five-year rule that applies to conversions is separate from the five-year rule for qualified distributions that applies to contributions and growth. Each Roth conversion has its own five-year clock.
The Roth conversion ladder is simple:
Conversion in Year 1 ⇒ withdrawal in Year 6
Conversion in Year 2 ⇒ withdrawal in Year 7
Conversion in Year 3 ⇒ withdrawal in Year 8
Conversion in Year 4 ⇒ withdrawal in Year 9
Conversion in Year 5 ⇒ withdrawal in Year 10
Conversion in Year 6 ⇒ withdrawal in Year 11
Etc.
You can build the ladder for as many years as you need. Your last year will usually be the year before you reach age 59.5. The optimal starting time is at least five years before you need to access the money since the first year you can withdraw converted funds tax- and penalty-free is the sixth year of your ladder. Someone who wants to access their traditional IRA beginning in the year in which they turn age 49.5—i.e., their “age 49.5” year—would need to start building their Roth conversion ladder no later than their “age 44.5” year to meet the five-year post-contribution requirement:
Conversion in “age 44.5” year ⇒ withdrawal in “age 49.5” year
Conversion in “age 45.5” year ⇒ withdrawal in “age 50.5” year
Conversion in “age 46.5” year ⇒ withdrawal in “age 51.5” year
Conversion in “age 47.5” year ⇒ withdrawal in “age 52.5” year
Conversion in “age 48.5” year ⇒ withdrawal in “age 53.5” year
Conversion in “age 49.5” year ⇒ withdrawal in “age 54.5” year
Conversion in “age 50.5” year ⇒ withdrawal in “age 55.5” year
Conversion in “age 51.5” year ⇒ withdrawal in “age 56.5” year
Conversion in “age 52.5” year ⇒ withdrawal in “age 57.5” year
Conversion in “age 53.5” year ⇒ withdrawal in “age 58.5” year
In this example, no more conversions are needed after the “age 53.5” year. At that point, there are already converted funds accessible each year before the “age 59.5” year, when the early-withdrawal penalty will no longer apply. At age 59.5, all funds can be withdrawn penalty-free—whether contributions or growth, Roth or traditional!
The amount you should convert each year will depend on (1) how much of your traditional balance you anticipate needing to access before age 59.5 and (2) when you start building your ladder.
Here is how you can calculate how much you need to access via a Roth conversion ladder during early retirement (i.e., before reaching age 59.5):
Start with your annual expenses, a crucial requirement to compute your FI Number.
Multiply by the number of years you will enjoy early retirement.
Subtract the total amount of any pension(s) you will draw on, if any, before reaching age 59.5.
For example, if you will receive a $300/month pension beginning at age 55, your calculation is: 59.5 – 55 = 4.5 years of receiving a pension × 12 months per year = 54 months total × $300/month = $16,200 in total pension income during early retirement.
Subtract the total amount of Roth contributions that are available to withdraw during your early-retirement years.
Subtract any savings or brokerage account balances that you will be available to draw from while climbing your ladder.
Once you have the total amount you need to access via a Roth conversion ladder during early retirement, divide that by the number of contribution years in your conversion ladder. Suppose the person in the above example anticipates needing $150,000 from their Roth conversion ladder during early retirement. If they started building their Roth conversion ladder in their “age 44.5” year as illustrated, they should convert at least $150,000 ÷ 10 years = $15,000 per year.
Suppose instead that same individual started building their Roth conversion ladder at age 39.5. With fifteen years of building a Roth conversion ladder (in years twenty through six before age 59.5), they would only need to convert $150,000 ÷ 15 years = $10,000 per year. The withdrawal schedule would remain the same: $15,000 per year in each of the last ten years before age 59.5. (Five years later is the earliest you can withdraw a conversion, but you can also wait until later if you wish.)
If this seems simple, it is. Convert the amount you want to access early at least five years before you will need the funds. There are some situations where it could be more cost-effective to simply pay the penalty rather than using a Roth conversion ladder, though, so it is still a good idea to work with a trusted professional when building your ladder to get an individualized approach.
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