A lot of people would love nothing better than to be able to retire early. But saving for it, and actually doing it, are two entirely different endeavors. The basic problem is the way most people save, and that’s through tax-sheltered retirement plans.
But that creates an early retirement dilemma: if most of your money is sitting in retirement plans, you won’t be able to access them early without incurring a 10% early withdrawal penalty, as well as ordinary income tax.
Now you could get around this issue by making sure you have plenty of non-tax-sheltered investments. You’d be able to tap those in the early years of retirement, without having to pay either income tax or a penalty.
But that’s not as easy as it sounds, since taxable investments don’t get the benefit of tax-deductible contributions, nor of tax-deferred investment income. Many people who have huge tax-sheltered retirement portfolios, have comparatively little in the way of taxable savings and investments.
But there is another solution…
The Roth IRA Conversion Ladder
Roth IRAs have become increasingly popular in recent years. As retirement plans go, they’re unconventional. You don’t get the benefit of tax-deductible contributions. But you will get tax deferral on your investment income.
The upshot is that once you reach age 59 ½, and you have been in the plan for at least five years, you can begin making withdrawals of both contributions and investment income fully tax-free. Got that? Tax-free income in retirement–not tax-deferred.
Not surprisingly, this has led to a massive wave of Roth IRA conversions. That’s where investors move money from regular retirement accounts–401(k), 403(b), and traditional IRA plans–into Roth IRAs.
This is referred to as a Roth IRA conversion. Unlike simple rollovers of funds from one retirement plan to another, Roth IRA conversions generally have tax consequences. You will have to pay ordinary income tax–but not an early withdrawal penalty–on any retirement savings transferred into a Roth IRA in the year of conversion.
For example, if you move $40,000 from an old 401(k) plan into a Roth IRA, and you’re in the 12% tax bracket, you’ll have to pay $4,800 in federal income tax on the amount converted–$40,000 X 12%. (Non-tax deductible contributions to the 401(k) plan would not be taxable, but that’s a complicated topic we don’t have time to discuss here.)
On the surface, that may seem scary. But if you’re looking to create a stream of tax-free income in retirement, that benefit usually outweighs the current year tax liability.
Because of the tax liability, it’s most common for people to do a Roth IRA conversion over several years. That will minimize both your tax bracket and your taxes in the years of conversion.
Creating a Roth IRA Conversion “Ladder”
Since withdrawals from a Roth IRA can be taken tax-free, this creates a potential source of tax-free income even in early retirement.
There’s a loophole with Roth IRAs that pertains only to Roth IRAs, and no other retirement plans. It’s a loophole that’s made to order for early retirement.
Since Roth IRA contributions are not tax deductible, they can be withdrawn tax-free at any time. That means even before you turn 59 ½ and are in the plan for at least five years.
This has to do with IRS Ordering Rules, that allows the first withdrawals taken from your Roth IRA to be regular contributions. You can withdraw those at any time without ordinary income tax or an early withdrawal penalty.
Now the situation is a bit different with Roth IRA conversions. The IRS requires that there is a five-year waiting period after each conversion. If you withdraw the converted balance before five years, you won’t have to pay ordinary income tax, but you will have to pay the 10% early withdrawal penalty.
This is where the Roth IRA conversion ladder enters the picture.
Why a Roth IRA Conversion and Not Annual Roth IRA Contributions
Just in case you’re wondering why it’s necessary to do a conversion, and not simply make annual Roth IRA contributions, it has to do with dollar amounts.
Roth IRA contributions are limited to just $6,000 per year, or $7,000 if you’re 50 or older. It would take a very long time to accumulate a large Roth IRA account with such small contributions. As well, if you plan to use your Roth IRA for early retirement, there may not be enough years between the time you begin making contributions and you plan to retire.
Still, a third factor is that a lot of people still don’t participate in a Roth IRA plan. The lack of tax deductibility of the contributions can be an obstacle.
A Roth IRA conversion makes more sense as a source of the kind of funds that would be needed for early retirement. Since it can be potentially several hundred thousand dollars–depending upon when you want to retire–it’s more likely you have that kind of money saved in other retirement plans. This is particularly true of employer-sponsored plans, like 401(k)s, where you have both higher contribution amounts and a potential employer match.
Creating Your Own Roth IRA Conversion Ladder for Early Retirement
Can you see where we’re going with this? If you start doing Roth IRA conversions at least five years before your planned early retirement, you’ll be able to begin withdrawing those contribution balances tax-free and penalty-free by the time you early retire.
As an example, let’s say you plan to retire at 50. You decide that you need at least $40,000 in tax-free income at that age. At 45, you begin making annual Roth IRA conversions of $40,000. In each year you make the conversion, you pay the applicable tax on the amount converted.
By the time you turn 50–and your initial conversion is five years old–you’ll be able to withdraw the $40,000 conversion balance you made at age 45. If you do this for 10 years, beginning at age 45, you’ll have a steady tax-free, penalty-free income of $40,000 per year through age 59.
At age 59 ½, you can begin tapping any and all other retirement plans you have available, penalty-free, and subject only to ordinary income tax. And of course, any amounts you have remaining in your Roth IRA account can continue to be withdrawn on a tax-free basis.
We’re throwing out a lot of numbers, so let’s see how this works in the table below.
|Year||Age At The Time Of The Action||Roth IRA Conversion Amount||Roth IRA Withdrawal Amount||Source Of Funds Withdrawn|
|Totals||15 Years||$400,000 Converted||$400,000 Withdrawn|
An Important Caveat on the Roth IRA Conversion Ladder
As you can see from the table above, a Roth IRA conversion ladder can do an outstanding job of providing you with tax-free, penalty-free retirement withdrawals well before age 59 ½.
But there’s a Part B to this strategy that’s equally important. If you’re going to use a Roth IRA conversion ladder to fund your early retirement years, you have to make sure there’ll be plenty of retirement assets left by the time you reach 59 ½.
In the example above, the total amount of retirement capital used for the Roth IRA conversion ladder is $400,000. That’s a lot of capital to burn through before you even reach 60.
In order for the strategy to work, you’ll have to have enough other retirement savings to provide you with an income for the rest of your life. Exactly how much that will be will depend upon how much income you’ll need during the traditional retirement years.
Complicating this issue is the fact that you won’t be eligible for Social Security until age 62 at the earliest. And if you begin taking benefits then, it will be at a greatly reduced level. Full retirement age for Social Security purposes–the age at which you’re entitled to your full retirement benefit–doesn’t begin until age 67 for most people today.
That means you may continue to be entirely dependent on your retirement savings between the time you reach 59 ½ and you begin collecting Social Security benefits. That would take a very large retirement portfolio.
Lowering the Amount of Retirement Savings You’ll Devote to the Conversion Ladder
Two alternatives to consider include:
- Utilize SEPP withdrawals to avoid penalties.
- Expect less income from the Roth IRA conversion ladder, and rely on additional sources of income in early retirement.
The Roth IRA conversion ladder is an excellent strategy to provide income during the early retirement years. But it only makes sense if you have the kind of retirement savings that will also provide a generous income when traditional retirement arrives.