I want to tell you a story about accessing tax-deferred funds in an IRA or 401k before age 59.5 without paying a penalty. But first I’m going full out White Fang on you.

A trapped animal will do just about anything to get free. When you get caught, normal rules of comportment and demeanor are sloughed off to make room for the demands of the primordial will to live. It’s all about survival. Adrenaline rushing, pumping through arteries and veins, clouding the judgment and dulling the pain, the wild animal will chew it’s own leg off to disengage itself from a trap. It’s all about survival.

What separates man from beast is consciousness and the ability to plan for the future. To plan for a tomorrow that’s better than today. We are wise enough to search for traps and avoid going down paths that might be trapped.

Travel back a few years in time to our recent military conflicts and take a journey with an infantryman across the arid desert landscape cut by wadis and pockmarked with rocks. When on patrol, the soldier avoids commonly tread footpaths because that’s where the improvised explosive devices (the dreaded IED) often lie in wait for unsuspecting soldiers. When left with no other alternative but to pass through a choke point like an alleyway between adobe mud compounds, the soldier sweeps the ground with a metal detector to check for IEDs. Feet and legs are important, and the utmost precautions are taken to prevent loss of life and limb.

A wild animal can’t think ahead like us higher order beasts. When the animal is out on patrol, a well placed trap can ensnare the unsuspecting creature. The end result is a leg caught in trap and the choice (that isn’t really a choice) to gnaw its own leg off.

A leg, from just above the knee down to the foot, is about ten percent of a human’s body weight. Ten percent is a big number when it comes to bodily integrity or the integrity of your investment portfolio. You don’t want your investment portfolio to lose a leg. Your portfolio might never walk again, and at the least it’ll need crutches or other assistance to carry you through retirement. It’s all about survival.

Early Withdrawal Penalties: How to not chop off 10% of your portfolio

Here’s one the most frequently asked questions I receive:

Hey dude, I read your awesome article on earning $150,000 per year while paying only $150 in tax. You put over $60,000 into traditional 401ks and IRAs by maxing out those accounts each year. But let me tell you, you’re so screwed because you have to pay a 10% penalty on top of ordinary income tax on every penny you withdraw now because you are in your thirties and nowhere near age 59.5.

The grammarians among us will quickly realize that’s not a question at all but rather a statement. Some of the nicer readers that aren’t trying to prove the impossibility of early retirement phrase things in a Jeopardy friendly format by asking “what is your plan to access traditional IRAs and 401ks before age 59.5 without paying a 10% penalty?“.

Like a smart soldier navigating a booby-trapped route on a battlefield, it all comes down to careful planning and execution (if you want to avoid losing that ten percent). There are two major paths that permit penalty free early withdrawals from 401ks and IRAs.

The first path, Rule 72t withdrawals (also known as Substantially Equal Periodic Payments or SEPP), will be discussed in great detail in a future post. The ten second explanation is that it allows you to withdraw around 3-4% of your tax deferred assets each year following a strict IRS formula. It requires a long term commitment to a rigid withdrawal scheme with severe penalties for messing up withdrawals. In other words, it’s very difficult to deviate from the 72t withdrawal plan before reaching age 59.5, and if you do so by accident, you’ll feel the snap of the trap and lose ten percent of your withdrawals backdated to your very first 72t withdrawal (ouch!).

The second path is the Roth IRA Conversion Ladder. It’s the plan I’m following to fund the next twenty five years of my early retirement before reaching age 59.5.

The Roth IRA Conversion Ladder

By cleverly maxing out our tax deferred savings options, we owed almost nothing in taxes every year in spite of our combined (very very low) six figure income. It feels like we stumbled into a deep pit of tax liability. The Roth IRA Conversion Ladder is the tool we’ll use to climb up and escape the tax pit.

But first a note on tax deferred accounts in general. You can debate the merits of Roth versus traditional IRAs and 401ks all you want, but know that we saved well over a hundred thousand dollars in taxes by maxing out tax deferred options. Those six figure savings were invested over the years and have grown into even more money today. When we owe federal income taxes again (in a decade or two), we’ll have a huge war chest filled with all those tax savings over the years to pay future tax liabilities as they arise.

The basis of the Roth IRA Conversion Ladder comes from an IRS rule that allows any amounts converted from a traditional IRA to a Roth IRA to be withdrawn penalty free and tax free. The rule comes with some catches. The first is that you have to wait five tax years after the conversion before you can withdraw penalty free. The second catch is that you have to pay taxes at the time of conversion.

Here’s how it works in practice. Let’s say you convert $30,000 from your traditional IRA to a Roth IRA during 2015. You will have $30,000 of ordinary income in 2015 due to the conversion, and might owe tax on that amount depending on your filing status and other income earned during the year. In 2020, you can withdraw the $30,000 (but not any earnings) penalty free and tax free. Convert another $30,000 in 2016, pay the tax (if any), then you have $30,000 to withdraw in 2021. Convert another $30,000 in 2017, pay the tax (if any), then you have $30,000 to withdraw in 2022. Repeat each year and you have just built a Roth IRA Conversion Ladder of your own!

Let’s take a look at an example of a Roth IRA Conversion Ladder for a 45 year old early retiree:

Convert to Roth

Withdraw from Roth Age Notes 2015 $30000 0 45 2016 30000 0 46 2017 30000 0 47 2018 30000 0 48 2019 30000 0 49 2020 30000 30000 50 5 years since 2015 conversion 2021 30000 30000 51 5 years since 2016 conversion 2022 30000 30000 52 5 years since 2017 conversion 2023 30000 30000 53 5 years since 2018 conversion 2024 30000 30000 54 5 years since 2019 conversion 2025 30000 30000 55 5 years since 2020 conversion 2026 30000 30000 56 5 years since 2021 conversion 2027 30000 30000 57 5 years since 2022 conversion 2028 30000 30000 58 5 years since 2023 conversion 2029 30000 30000 59 5 years since 2024 conversion 2030 30000 30000 60 You're over 59.5 – do whatever

Planning for the Roth IRA Conversion Ladder

It takes a little planning to launch your Roth IRA Conversion Ladder successfully. Take a look at that table and you might notice two problems.

First, there’s no money to provide for living expenses in years one through five. You’ll have to cobble together five years of expenses from somewhere. This is where it pays to have some taxable investments on hand to get you through the first five years of early retirement while you’re setting up the Roth IRA Conversion Ladder. Leading up to early retirement, it might be necessary to back off of the tax-deferred contributions a little in order to top off a taxable portfolio that holds five years worth of expenses.

If you don’t have a sufficient amount in your taxable account, other options for funding the initial five years include:

withdrawing Roth IRA contributions (annual contributions can be withdrawn any time without paying tax or penalty)

(annual contributions can be withdrawn any time without paying tax or penalty) withdrawals from a 457 account if you have one (you’ll owe tax but no penalty)

side hustle income from a hobby or part time job

proceeds from sale of a business

severance pay

unemployment payments

Just remember to balance your tax liability in the last few years of work with your tax liability in the first five years of the Roth IRA Conversion Ladder. You might end up in the 10% or 15% bracket. Just make sure you don’t end up in the 25% bracket some years and the 0% bracket other years.

In our case, we managed to max out all tax deferred options every year. Eventually our incomes increased to the point where we were also saving a significant amount in our taxable accounts, too. The taxable account should get us through at least the first ten years of early retirement, allowing us to slowly set up our Roth IRA Conversion Ladder and stay in the 0% tax bracket most of the time.

The second problem is inflation. You can’t convert $30,000 today if you want to spend $30,000 in five years because inflation will erode the purchasing power of that $30,000. You’ll need to convert an inflated amount today to provide for future years’ expenses. If you want $30,000 in real terms (after inflation) in five years, you’ll need to convert around 16% extra to account for 3% annual inflation.

Instead of converting $30,000 today, you’ll need to convert $34,800 today to provide $30,000 of purchasing power in the sixth year. Then convert $35,800 in year two to fund year seven’s expenses, and so on.

Here’s a better Roth IRA Conversion Ladder that shows expenses for the first five years while setting up the ladder and the required amounts to cover inflation:

Convert to Roth Withdraw from Roth Withdraw from Taxable Age Notes 2015 $34800 0 30000 45 2016 35800 0 30900 46 2017 36900 0 31800 47 2018 38000 0 32800 48 2019 39100 0 33800 49 2020 40300 34800 0 50 5 years since 2015 conversion 2021 41500 35800 0 51 5 years since 2016 conversion 2022 42700 36900 0 52 5 years since 2017 conversion 2023 44000 38000 0 53 5 years since 2018 conversion 2024 45300 39100 0 54 5 years since 2019 conversion 2025 46700 40300 0 55 5 years since 2020 conversion 2026 48100 41500 0 56 5 years since 2021 conversion 2027 49500 42700 0 57 5 years since 2022 conversion 2028 51000 44000 0 58 5 years since 2023 conversion 2029 52500 45300 0 59 5 years since 2024 conversion 2030 54100 46700 0 60 You're over 59.5 – do whatever

In this table, the early retiree will have a consistent inflation adjusted $30,000 per year (in 2015 dollars). Withdrawals from the taxable account total $159,300 over the first five years of the withdrawal plan. That doesn’t mean the $159,300 has to be in the taxable account on day one, because some growth in the account is likely over the five year withdrawal period.

Taxes on the Roth IRA Conversion Ladder

Ignoring other income, a single person climbing the Roth IRA Conversion Ladder will pay $3,213 in federal income tax each year to keep the ladder going. That’s the tax due on a $34,800 IRA conversion. Since the standard deduction and personal exemption are indexed to inflation, the tax burden will remain $3,213 each year (in real terms).

Married couples with no children fare much better, owing only $1,420 in federal tax each year. Throw a child in the mix and the tax burden drops to $20 (due in part to a $1,000 child tax credit).

Since we have three kids, we could convert up to $58,750 each year without paying any federal income tax. Though we’ll probably keep our total income closer to $40,000 in order to optimize Affordable Care Act subsidies and other benefits tied to AGI as well as keep state income tax burden low.

Root of Good’s Roth IRA Conversion Ladder

So far we have dealt in hypotheticals. Here is the real Roth IRA Conversion Ladder we plan on following:

Year

Convert to Roth Withdraw from Roth 5 Yr. Roth IRA Conversion “Bank” Withdraw from Taxable Age 2015 23800 0 0 32400 35 2016 24500 0 0 33400 36 2017 25200 0 0 34400 37 2018 26000 0 0 35400 38 2019 26800 0 0 36500 39 2020 27600 0 23800 37600 40 2021 28400 0 48300 38700 41 2022 29300 0 73500 39800 42 2023 30200 0 99500 41000 43 2024 31000 0 126300 42300 44 2025 53800 43500 110400 0 45 2026 55400 44800 94000 0 46 2027 57000 46200 77100 0 47 2028 58700 47600 59700 0 48 2029 60500 49000 41700 0 49 2030 62300 50500 45000 0 50 2031 64200 52000 48400 0 51 2032 66100 53600 51800 0 52 2033 68100 55200 55300 0 53 2034 70100 56800 59000 0 54 2035 72200 58500 62800 0 55 2036 74400 60300 66700 0 56 2037 76600 62100 70700 0 57 2038 78900 63900 74900 0 58 2039 81300 65900 79100 0 59 2040 83800 67800 83500 0 60

Here are the assumptions to help understand our withdrawal plan:

Annual spending of $32,400 based on our early retirement budget, with increases for inflation each year

We have a $345,000 taxable account that we’ll spend down over the next 10 years. We need 1.6% investment returns to make that last for 10 years

Half of the amount spent each year from the taxable account is basis, the other half capital gain or dividend income. In other words, a $32,400 withdrawal is $16,200 return of capital (not taxed) and $16,200 income (dividends and capital gains)

We are aiming at $40,000 per year AGI which will produce a zero income tax bill for the next ten years, then we’ll owe $500 per year between 2025 and 2031 assuming our 2 year old is no longer a tax dependent. After that, our taxes will rise slightly.

In a nutshell, the table shows how we’ll be able to fund 25 years of early retirement before reaching age 59.5 without ever paying a 10% early withdrawal penalty. This plan also keeps our income taxes near zero for about half of that period and we won’t owe more than a couple thousand per year for the last ten years of the plan.

In the table I have a column labeled 5 Yr. Roth IRA Conversion “Bank”. I made this name up but it’s a critical component to any Roth IRA Conversion Ladder. It’s a running tally of how much 5+ year old Roth IRA conversions we have available each year. In year 2020, we will be able to withdraw the $23,800 converted in 2015. By 2024, the year before we plan on taking the first Roth IRA withdrawals, we’ll have $126,300 in the Five Year Roth IRA Conversion Bank. At the end of 2025, after taking the first Roth IRA withdrawal of $43,500, we will still have $110,400 in the bank.

Breaking the (Five Year Roth IRA Conversion) Bank?

By the end of 2029, our Five Year Roth IRA Conversion Bank will bottom out at only $41,700. That’s still almost one whole year of expenses in 2029. I’m not worried about coming that close to emptying our Five Year Roth IRA Conversion Bank because I have a few other cards up my sleeve.

I have a 457 account with $70,000 in it today (that will probably grow to $150,000+ by 2029) that lets me withdraw funds at any time without penalty (just pay the ordinary income tax on the withdrawal). The 457 can easily cover a multi-year Roth IRA Conversion Ladder shortfall in a pinch (with slightly sub-optimal tax impacts if amounts withdrawn are large).

We also have a Health Savings Account (HSA) with $60,000 in it today that offers tax free and penalty free withdrawals to cover any health related expenses. Since health related expenses are the biggest unknowns for us over the next several decades, this account will come in handy to smooth out the tax impact of withdrawals if we need a little extra cash in any given year.

And finally, we have $25,000 in Roth IRA contributions from a few low income years during college and some higher income years we were ineligible for traditional IRA contributions. I don’t want to confuse the details of the larger plan with this $25,000 of Roth IRA contributions, but know that we will technically be withdrawing this $25,000 of Roth IRA contributions in year 2025 when we make our first Roth IRA withdrawals. The IRS has rules (don’t they always?) on the order of Roth IRA withdrawals and they state that contributions come out first, then conversions. As a result, our $41,700 low point in our Five Year Roth IRA Conversion Bank will actually be $66,700.

Finding the rungs on your own Roth IRA Conversion Ladder

Reading over this post, I realize it sounds very complicated and in depth. Take it step by step and it isn’t that daunting a task to set up your own ladder.

1. Figure out what you’ll be spending each year in retirement. Here’s how we developed our $32,400 per year retirement budget. If you need to track expenses now, check out Personal Capital – it’s free and automates expense tracking for you.

2. Determine how you’ll fund the first five years of retirement while you’re setting up the ladder. Do you have extra cash on hand or a taxable brokerage account to bridge the gap?

3. Don’t forget to account for inflation when you start the Roth conversions. You’ll have to convert 16% more today to cover 3% inflation per year for five years.

4. Roth conversions sound scary but are pretty easy. At Vanguard, for example, you can execute a conversion in less than five minutes on their web page. If you need help, call your brokerage firm. It’s a five minute task once per year task once you get your plan figured out. And you can adjust as you go along if your plans change.

5. If you’re planning on paying for your own health insurance, consider your AGI level due to Roth Conversions in the context of the Affordable Care Act subsidies for health insurance. The sweet spot to maximize your subsidies is in the 150-200% of the federal poverty level range (<$31k for a family of 2, <$56k for a family of 5).

If you are approaching early retirement, how do you plan on funding your expenses each year? Or if you’re already retired early, how do you access your tax deferred savings?

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