Many individuals pursuing Financial Independence / Retire Early often wonder- where will my money come from if I retire before the age limit for withdrawing from retirement accounts without penalty? This age limit is 59.5 years in the USA. If you retire at 30 years old, how would you avoid the 10% early withdrawal penalty fees?

Individuals can withdraw from their 401k or IRA early without penalty if they plan 5 years in advance and incorporate the Roth IRA conversion ladder strategy. This awesome loophole allows you to get your cash out, penalty free, to live on in early retirement!

The Roth IRA conversion ladder is a fantastic tool for those that are planning an early retirement. The Roth IRA conversion ladder strategy is neat tool, knowing how it works long before you plan to retire is critical to seeing you up for success. There are also other methods of getting money our of your IRA or 401k penalty free.

Section 72(t) of the Internal Revenue Code

Since we are talking about early withdrawals from retirement accounts, I cannot leave out Internal Revenue Code section 72(t) and 72(q)!

These sections in the IRS code can provide early withdrawals PENALTY FREE – called substantially equal periodic payments (SEPP).

Why does the IRS have this blatant loophole? It is intended to be used by those that are no longer employed (retired early) to be used for expenses, such as food.

Once you start the SEPP, it cannot be stopped for 5 years or until you turn 59.5 years old, whichever is longer.

How Much Can You Withdraw Through SEPP?

The amount you can withdraw per year with SEPP is determined by the government in the form of a “reasonable interest rate”, which is 120% of the Federal Mid-Term rate which is 0.46% for October 2020.

This equates to about $2,174/year withdrawal payment per $100k in your retirement account. If you have $1M in your retirement account, that’s $21,740 per year. However, your withdrawals will be taxed as income, but will avoid the 10% early withdrawal fee.

Roth Conversion Ladder

Wait- these meat and potatoes look nothing like a Roth conversion ladder!

Now on to the meat and potatoes- the Roth conversion ladder. This is the best loophole that can be used to minimize your taxes in early retirement, outlined in the steps below.

  1. Contribute money to a Traditional 401(k) and/or a Traditional IRA.
  2. Retire early- you’re now in a lower tax bracket.
  3. Roll portions of your traditional balances periodically into a Roth IRA and let the money sit for a minimum of 5 years.
    • Roth contributions can be withdrawn penalty free after 5 years.
  4. Withdraw your principle penalty free!
  5. Rinse/Repeat

For an example, lets say you need $40k to live on each year, you would do the following:

  • 5 Years before Retirement: convert $40k of traditional accounts to a Roth IRA
  • 4 Years before Retirement: convert $40k of traditional accounts to a Roth IRA
  • 3 Years before Retirement: convert $40k of traditional accounts to a Roth IRA
  • 2 Years before Retirement: convert $40k of traditional accounts to a Roth IRA
  • 1 Years before Retirement: convert $40k of traditional accounts to a Roth IRA
  • Year 1 of early Retirement
    • Use the “5 Years before Retirement” conversion as your income (tax free!)
    • Convert $40k of traditional accounts to a Roth IRA
    • Repeat “Year 1 of early Retirement” steps for year 1, 2, 3, 4, 5….
The Roth IRA Conversion Ladder

See, this is looking like a ladder now right?

You don’t necessarily have to do the conversion 5 years before retirement- especially since you’d be hit with a tax bill for the conversion. I recommend living off of taxable accounts, SEPPs, and/or contributions you’ve made to Roth accounts your first 1-5 years of retirement.

Remember, traditional to Roth IRA conversions are taxed as ordinary income so it is best to space out your conversions appropriately to minimize your tax bill.

Why Not Just Contribute to a Roth IRA and Roth 401k in the First Place?

It’s actually quite surprising really- you can have tax free contributions, tax free growth, and tax free withdrawals by starting with Traditional accounts and then later converting to a Roth IRA!

  • You don’t pay tax on the money you contribute to a traditional IRA nor traditional 401(k)
  • When you retire early and convert your a chunk of your traditional balance to a Roth IRA, you will be in a lower tax bracket. However, you will have to pay taxes on the conversions since you didn’t when you made the contribution, right?
    • If your conversion is your sole income and it is equal to your exemptions, deductions, and credits every year, you can perform the conversion TAX FREE!!!
  • Of course, since your conversion is now a Roth IRA- you can withdraw the contribution PENALTY & TAX FREE!!!

Will You Use a Roth IRA Conversion Ladder When You Retire Early?

The Roth IRA Conversion ladder takes much fore thought and planning (5 years), but it will pay off in your early retirement.

I will be utilizing the Roth IRA Conversion Ladder when I retire early by employing the below strategy:

  • Max out Traditional 401(k), 403(b), and Traditional IRAs every year, but 1 year, from now until retirement.
  • Max out Roth 401(k), 403(b), and Roth IRAs for 1 year (this will give me a $50k base to live off tax free for my first 1-5 years in retirement)
  • Potentially utilize SEPPs through 72(t) for some supplementary income in early retirement.
  • If SEPP and Roth does not supply me with enough income in years 1-5 of early retirement, I will pull from taxable accounts – my Vanguard mutual funds and ETFs.
  • Start Roth IRA Conversion Ladder year 1 of early retirement.

How are you planning to pay yourself in early retirement?


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