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Using the Roth conversion ladder to withdraw retirement funds early and without penalty is a popular strategy of the FIRE movement. While we are not calling ourselves FIRE, a lot of what we are doing benefits from the same strategies. So, in December 2022, we executed our first Roth conversion. This post will explain what it is, why to do it, and what our experience looked like.

What is a Roth Conversion Ladder?

Here is a super condensed version:

1. You have money in your traditional 401(k) (pre-tax) through your employer, where you worked and contributed for years.
2. After leaving work, you “roll over” that 401(k) balance to a traditional IRA at a brokerage of your choice. Also pre-tax, so no taxes or fees this step.
3. Since you want to access that money early, you decide to “convert” some to a Roth IRA. You perform the conversion online with your brokerage, and you will pay tax on this amount in the year you make the conversion.
4. You convert more in Year 2, Year 3, Year 4….
5. After 5 years from the first conversion, (Year 6) you can withdraw any or all of the converted amount in Year 1, tax and penalty free, no matter your age! At this point you have built a “ladder,” as in Year 7, you withdraw Year 2’s conversion, in Year 8 you withdraw Year 3, etc….

If some of this terminology is new to you, check out the Account Descriptions section at the bottom of this post!

Why perform a Roth Conversion?

What’s the play here?

As the 5 steps describe, a Roth conversion means taking pre-tax money from a traditional IRA, and “converting it” to Roth IRA, which are after-tax dollars. This means you are purposely creating a taxable event.

Since taxes = bad, you may ask why would you want to do this? Well, to set yourself up with the opportunity to access retirement funds early.

When you leave your work, your income plummets (bummer!), but so does your tax rate (hooray!) So if you plan it right, this can be a golden opportunity to build a Roth conversion ladder, and pay NO TAX or VERY LITTLE TAX on retirement funds.

What’s not seen in the income tax brackets above is the standard deduction, which in 2022 was $25,900 for married filing jointly. Most are familiar with this in that the government allows you to earn up to that amount, and pay zero federal tax. Well, it also means you can convert up to that amount! But you don’t have to stop there. As the graph shows, you may also decide to convert an additional $20,550, for example, on top of the standard deduction. If you did this, then you’d pay 10% tax, which would come to $2,055.

Continuing that example, $2,055 tax owed on a total of $46,450 converted is an effective 4.4% tax rate. By saving money in a traditional 401(k) during peak working years, sheltering it from your higher tax rate, and then converting it to a Roth IRA during a low/no income period, you’re locking in low/no taxes. This is a major win.

Our Roth Conversion – setting ourselves up to Withdraw Retirement Funds Early

Here’s how it looked for us to follow the 5 steps above.

1. Fund Your Retirement Accounts while working

Both Clari and I had access to employer-sponsored retirement plans when we worked with our companies, and both company plans happened to be with Fidelity. After our debt payoff years, we started saving as much as we could in each of our 401(k)’s (electing traditional), with the goal of maxing them out to the IRS limit. We also began to max out our IRA’s (choosing Roth). This meant $19,500 + $6,000 = $25,500 for each of us, annually, in these tax-sheltered accounts. In addition, each company 401(k) offered a “match” in the range of 3-8% of our contributions, which springboarded the savings even more.

2. Roll over your 401(k) to a traditional IRA

About a year after leaving my job, I rolled over my 401(k) in Fidelity to a “traditional IRA” that I had opened in my brokerage of choice, Vanguard. After a phone call, Fidelity cut me a check for my full account balance, and sent it to me in the mail. The check was made out to me, and included my traditional IRA and account number at Vanguard. This is super important: you don’t cash the check! It has to get deposited directly into Vanguard, which meant I, in turn, mailed the check to Vanguard. This “mail a check then mail a check”, is a bit old-fashioned, but it worked. There were no tax implications to this step, and there were no fees or penalties.

If I would have cashed it by depositing it into a bank, it would be akin to an early withdrawal – subject to a 10% penalty, along with owing income tax on the full amount. That’s already a nightmare scenario, further worsened by removing the prospect of tax-free compounding growth after that.

The money was pre-tax in your 401(k), and it’s still pre-tax in your traditional IRA. Before this roll-over, my traditional IRA was never used, so the balance had been $0.00. Now, after the roll-over, the balance was the amount that my 401(k) was. I was ready for a Roth conversion!

3. Convert some of your traditional IRA to a Roth IRA

Because this is a taxable event, we only wanted to convert a portion of the Traditional to a Roth. Since this was our first time, figuring out how much to convert took lots of planning. The conversion would incur taxes at both the Federal and State (booo, New York!) level. Since we’re not working for pay, we’re in the lowest tax bracket, so we could convert all the way up to the Standard Deduction ($25,900 in 2022 for Married Filing Jointly) and not pay any federal taxes. We could then withdraw that converted amount 5 years from now, with no taxes or penalties.

Considerations impacting our conversion amount

We would have converted up to the Standard Deduction, maybe even a bit more, if it weren’t for 2 things:

1. Clari had about 2 months of W-2 income in early 2022, before we made our transition. This income used up a portion of our standard deduction.
2. Here in New York we are enrolled in Medicaid, which has an income eligibility limit of $24,353. Because of this, if the amount we converted, plus the W-2 earned income exceeded this limit, it would disqualify us from this healthcare program. We do have other healthcare options, but for now, we decided to just keep the conversion low enough that we wouldn’t go over the limit.

Because of these limits, we had to factor in ANYTHING that would qualify as income: W-2 employment, side-work, interest payments, and dividends from taxable brokerage accounts. I even dabbled in some crypto which gave a (taxable) payout. All of this combined couldn’t exceed $24,353, lest we be booted from our health care plan. So, we came up with a figure that also left a small buffer in case of surprise income we might accidentally miss.

In the end, this meant that in December 2022, we converted $12,700.00 as our first Roth conversion. Our total reported income stayed under the Medicaid eligibility cap ($24,353), which itself is under the Standard Deduction ($25,900), so we owed no federal taxes. Because we were living in New York State at the time of the conversion, we were subject to state income tax, totaling $208.00.

4. Convert more to Roth next year

We plan to do a Roth conversion each of the next few years, as long as our living/income/tax situation remains the same, slowly building a tax-free balance in our Roth IRAs. For now, it seems like remaining eligible for Medicaid will determine the amount we convert. Theoretically, we could continue to do this until one of these two events occurs: a) we deplete the balance in our traditional IRA’s, or b) we reach the age of 59.5, at which point we no longer need to bother with the conversion.

If it weren’t for the Medicaid constraint, then we would have converted more than $12,700, and also would have increased it each year to protect against inflation. The below chart is an example of what the first 10 years of doing this would look like, if we were targeting an annual spend of $25,000 and estimated 3% for inflation. Accordingly, in Year 1 we would take the desired $25,000, add 3% compounded over 5 years (around 16%), for a conversion amount of $28,981.85. This is the same amount that would be withdrawn in Year 6.

5. Withdraw your retirement funds early!

A true conversion ladder would, after year five, offer a steady stream of tax-free income to live off. Of course, for us here in the United States, we know $12,700 is not enough for us to actually live off five years from now. That is, assuming we aren’t living out of a van and eating cat food. Either way, the Roth conversion is an outstanding opportunity to lock in never paying tax on this money, AND doing so well before retirement age, penalty-free! So, we have set up the possibility to access retirement funds early!

Account Descriptions, notes

Account Descriptions

• Traditional IRA – a pre-tax retirement account with a max annual contribution of $6,500 (in 2023). Because the money (usually) goes in before being taxed, guess what? You have to pay taxes when you withdraw the money in retirement, (age 59.9 per the IRS). I say “usually”, because there are income rules where you can’t deduct your contribution if you make a certain amount.
• Roth IRA – an after tax retirement account with a max annual contribution of $6,500 (in 2023). Because the money goes in after taxes, this means that money, and its growth, are not taxed when you withdraw later on. Additionally, your Roth IRA contributions can be withdrawn anytime, unlike the Traditional IRA. However, if your income exceeds a certain amount (married filing jointly $214,000 in 2022), you are not eligible to contribute directly to a Roth IRA. (You can still do it, just via the back door). Note that the max annual contribution applies to all IRA’s combined. So for 2023, whether you do Traditional, Roth, or a mix of both, the max an individual can save is $6,500.
• Traditional 401(k) – a pre-tax workplace retirement account with a max annual contribution of $22,500 (in 2023). Because the money goes in before being taxed, you save on taxes during the contribution years, but you have to pay tax on withdrawals at retirement. The amount of tax you pay will depend on how much you withdraw in a given year. Because many companies offer to match contributions of their employees, 401(k)’s are very popular retirement savings vehicles.
• There are other 401(k) options like Roth, and those for self-employed individuals, but we have no experience with those.

Notes

• If you have directly contributed to a Traditional IRA, and now have rolled over a 401(k) into that mix, while trying to convert some of it to a Roth, it gets more complicated. Fortunately, this was not our case.
• This strategy could work as a one-off for anyone who experiences an unexpected employment gap. Towards the end of the year, if your income is tracking less than expected, you could perform a Roth conversion. You would decide the amount to convert based on where your tax bracket is tracking. i.e. convert enough to “fill up” the rest of the bracket you’re in, without bumping up to the next one.
• This article by Root of Good was really the kickstarter to helping us understand how to access retirement funds early, and I referenced it whenever I ran into trouble.
• This article by the Mad Fientist has some snappy graphics, and runs some comparison scenarios to consider instead of the Roth conversion ladder.