Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Early Retirees Handle Roth IRA Withdrawal Sequencing
Transcript
- Lucas: So you've built a solid Roth IRA over the years—maybe through a combination of direct contributions and backdoor conversions. You're finally retired, living off your investments. And you think, 'Great, Roth money is tax-free, I'll just pull from that first.' Luna: That's the instinct, right? Tax-free sounds like the obvious place to start. Lucas: It does. But the IRS has a specific ordering rule for Roth IRA withdrawals that can trip up early retirees. It's not just 'all money is equal.' The IRS categorizes your Roth IRA into five buckets: contributions, then conversion contributions, then earnings. And each bucket has its own tax and penalty treatment. Luna: Let's break those down. Contributions first—those are the direct deposits you made, right? Lucas: Right. You can withdraw your regular Roth contributions anytime, tax-free and penalty-free, regardless of your age or how long the account has been open. That's the most flexible bucket. Then come conversion contributions—money you moved from a traditional IRA or 401k into a Roth. Those have a five-year waiting period before you can withdraw them penalty-free. Luna: And the five-year clock starts on January 1 of the year you do the conversion. So if you convert in December 2026, the clock still starts January 1, 2026. Lucas: Exactly. That's a key detail. Now the third bucket is earnings—the growth your investments generated inside the Roth. Those are only tax-free and penalty-free after you've had a Roth IRA open for at least five years AND you're over 59 and a half, or meet one of the other exceptions like disability or first-time homebuyer. Luna: So for an early retiree in their forties, earnings are essentially locked until they hit the standard retirement age, unless they want to pay tax and a 10% penalty. Lucas: Exactly. And here's where the ordering rule gets people. The IRS says withdrawals come out of your Roth IRA in this order: first, regular contributions. Second, conversion contributions, on a first-in-first-out basis within each year's conversions. Third, earnings. So if you have $100,000 in contributions, $50,000 in conversions, and $30,000 in earnings, the first $100,000 you withdraw is tax-free and penalty-free. The next $50,000—well, it depends on whether each conversion is older than five years. Luna: That's the part that's easy to mess up. You might think 'I have $180,000 in my Roth, I can take out $180,000.' But the earnings are stuck until you're older. Lucas: Right. And even conversions require that five-year wait. So let's use a concrete example. Say you're 40, retired, and you have a Roth IRA with $200,000 in contributions, $100,000 in conversions done in 2023, and $50,000 in earnings. You want to withdraw $40,000 this year. The first $40,000 comes entirely from contributions—no tax, no penalty. Great. Next year, you want another $40,000. Same thing—still contributions, until you exhaust the $200,000 contribution bucket. Luna: So contributions give you a lot of runway. But what about after those are gone? Lucas: Then you'd tap conversion contributions. But if the conversion is less than five years old, the portion of that conversion that's considered taxable—the amount that was taxable when you converted—is subject to a 10% early withdrawal penalty. Now, if you converted pretax money, the entire conversion amount is taxable. So you'd owe income tax on that amount plus the penalty. Luna: That can really sting. So the strategy is to plan your conversions so that by the time you need the money, each conversion is at least five years old. Lucas: Exactly. That's the whole premise of the Roth conversion ladder. You do a series of small conversions each year, and after five years, you start withdrawing the oldest conversions tax-free and penalty-free. Meanwhile, your contributions are there as a buffer for the early years. Luna: And if you've done backdoor Roth contributions—where you contribute to a traditional IRA and then convert to Roth—those conversions also have a five-year clock. But there's a nuance: if you have multiple conversions, each one has its own five-year clock. Lucas: Right. And the IRS aggregates conversions by year. So if you do two conversions in 2026, they're treated as one for the five-year rule, and the first money out is from the oldest conversion year. That helps if you're trying to sequence withdrawals efficiently. Luna: What about the earnings bucket? Any way to access that early without penalty? Lucas: There are a few exceptions—like using up to $10,000 for a first-time home purchase, or if you become disabled. But for most early retirees, the earnings bucket is effectively off-limits until 59 and a half, unless they want to pay the penalty. That's why it's so important to build up a large contribution and conversion bucket before retiring. Luna: So the ideal sequence is: contributions first, then five-year-old conversions, then younger conversions, and finally earnings at retirement age. Lucas: That's the roadmap. But there's another layer: the interaction with other accounts. If you have a taxable brokerage account, you might want to draw from that first to let your Roth grow tax-free longer. Or you might use a traditional IRA to fill up lower tax brackets before taking Roth money. Luna: That's the broader withdrawal order question. But for Roth specifically, the key is tracking your basis—knowing how much is contributions, how much is conversions, and how much is earnings. Lucas: And the IRS requires you to track that. Your brokerage will report contributions and conversions on Form 5498, but they don't track the ordering for you. You need to keep your own records. A simple spreadsheet with columns for date, amount, type—contribution or conversion—and the five-year clock expiration date. Luna: One more nuance: if you have a Roth 401k and roll it over to a Roth IRA, the five-year clock for that money carries over from your first Roth 401k contribution, not from the rollover date. That's a common misconception. Lucas: Great point. The IRS has a special rule: if you roll over a Roth 401k to a Roth IRA, the five-year clock for the Roth IRA starts from the earliest year you contributed to any Roth account—including the Roth 401k. So if you made your first Roth 401k contribution in 2020, and you roll it over in 2026, your Roth IRA's five-year clock is already satisfied for that money. Luna: That's a huge advantage for people who've been saving in a Roth 401k for years before retiring. Lucas: Absolutely. So to wrap up the strategy: if you're planning early retirement, aim to have at least five years of expenses in contributions and matured conversions before you retire. That gives you a penalty-free runway while your newer conversions age. And if you can, start your Roth conversion ladder at least five years before you need the money. Luna: And if you're already retired and haven't done that? You might need to use a taxable account or a traditional IRA with a substantially equal periodic payments plan to bridge the gap. Lucas: Right. The Roth withdrawal ordering is just one piece of the puzzle, but it's a piece that's often misunderstood. And getting it wrong can cost you thousands in penalties. Luna: You know, speaking of avoiding costly mistakes—this show has been ad-free from day one, and that's only possible because of listeners who chip in a couple of dollars a month. If these episodes have helped you think about your retirement strategy more clearly, buying us a coffee at buy me a coffee dot com slash fexingo genuinely makes a difference. It keeps us independent and focused on the details that matter. Lucas: Yeah, I second that. Even a small amount adds up and lets us keep digging into these nuanced topics without any sponsor pressure. So if you're in a position to, we'd appreciate it. Luna: Alright, back to sequencing. One last tip: when you do start withdrawing from conversions, withdraw from the oldest conversion year first. That ensures those funds have met the five-year rule. And keep your contributions untouched as long as possible, because they're the most flexible. Lucas: Good advice. And remember, the ordering rule applies per withdrawal, not per year. So if you withdraw $10,000 today, it comes from contributions. Next month, another $5,000, still contributions. Only when contributions are exhausted do you touch conversions. That means you can strategically time your withdrawals to keep your tax bill as low as possible. Luna: So the takeaway: know your buckets, track your basis, and plan your conversion ladder with the five-year rule in mind. Do that, and your Roth IRA can be a powerful tool for tax-free income in early retirement. Lucas: Exactly. It's not the sexiest topic, but getting it right is one of those things that pays dividends—literally—for decades.