The FI/RE movement has grown bigger over the years, and so have incomes. With that comes the ability for employees and investors to reach a level of retirement savings that some may deem as comfortable enough to retire before reaching age 59.5. But we all know those early distributions of tax advantaged retirement accounts incur a 10% penalty if done ahead of that magical age. Enter the Roth Conversion Ladder, a way to avoid early distribution penalties by converting traditional retirement account funds into Roth IRA funds.
What is The Roth Conversion Ladder?
The Roth Conversion Ladder system is a way of converting traditional IRA or 401(k) funds into Roth IRA funds over a period of years in the amount of expected yearly income needed when disbursed.
5 Year Waiting Period
If you’re planning an early retirement and want to make use of your tax-deferred accounts before the age of 59.5, you’ll have to make sure you start converting retirement funds into your Roth account 5 years before your target retirement date in order to avoid the early distribution taxes. Once you’ve started converting, you’ll want to convert your expected annual expense amount every year until age 54. This way, when your final conversion is available, you’ll be of age to start cashing out your tax-deferred accounts the old-fashioned way.
How Do I Know if I’ve Saved Enough to Retire Early?
The easiest way to get your target retirement amount is to pick a safe withdrawal rate that you’re comfortable with (the percentage of your retirement account you’ll withdraw each year in retirement) that produces the level of yearly income you need. For example, if you expect you’ll need $40,000 per year in retirement, you would need to save up $1,000,000 (or $40,000/0.04). This will ensure that you can withdraw an amount each year that will pay for your expenses, but retain the initial balance that your retirement account(s) consisted of when you retired, effectively ensuring that you never lose all of your money. Unless of course you decide to start disbursing more than your SWR each year, which should probably start close to the end of your life expectancy.
Example
This chart below from investopedia details what a series of conversions might look like:
In this example, the early retiree starts at age 40 converting yearly expense amounts from a traditional retirement account to a Roth IRA. After year 5, or age 45, the retiree begins withdrawing the expense amount each year, penalty free. The conversions stop at age 54, because the retiree will have access to all retirement funds in all accounts at age 59 (5 years after the age 54 conversion) penalty free without waiting 5 years.
Conclusion
If you are looking to retire early, this method can be a great way of executing your vision. Just make sure to plan out your monthly/annual expenses and account for as much as possible, being as conservative as possible. There are always circumstances that may arise which bump expenses up such as children, medical situations, or college expenses. This can be a great strategy for coast FIRE or barista FIRE seekers as well, AKA those who wish to leave their traditional 9-5 and begin doing more of a passion project for money just to cover simple expenses.
All in all, if you have a plan and want to retire early, this can be one of the best ways to do it!
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