Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How to Fund Early Retirement With a Roth Conversion Ladder
Transcript
- Lucas: If you're planning to retire before age 59 and a half — say, at 45 or 50 — you run into a classic problem: most of your retirement savings are probably in a 401 or traditional IRA, and if you pull money out early, you owe income tax plus a 10 percent penalty. Luna: Right, that penalty is brutal. Ten percent on top of whatever tax bracket you're in. Lucas: Exactly. So the Roth conversion ladder is a way to get that money out tax-free and penalty-free after a waiting period. The basic idea: you convert a chunk of your traditional IRA to a Roth IRA each year, pay income tax on the converted amount now, and then five years later you can withdraw those converted dollars — not the earnings, just the converted principal — completely tax-free and penalty-free. Luna: So you're essentially paying the tax today to avoid the penalty later. But why five years? Lucas: That's the IRS rule. Each conversion has its own five-year clock. You convert money in 2026, you can withdraw that specific converted amount starting in 2031. The clock starts January 1 of the conversion year, so technically if you convert in December 2026, you could withdraw in January 2031 — that's just over four years, but the IRS counts it as five tax years. Luna: Got it. So you need to plan ahead. You can't just decide to retire next month and start pulling from a Roth. Lucas: Right, you need to start the ladder at least five years before you need the money. But here's the beautiful part: if you're retiring early, you probably have a low income those first few years — no salary, just maybe some side income. That means you can convert large amounts at a very low tax rate, potentially even in the 10 or 12 percent bracket. Luna: So you're filling up your lower tax brackets with conversions instead of earning a salary. That's a tax arbitrage. Lucas: Exactly. Let's use an example. Say you're 45, you've got $800,000 in a traditional IRA, and you want to live on $50,000 a year. If you're single, the standard deduction for 2026 is about $15,000. So the first $15,000 of income is tax-free. Then the 10 percent bracket goes up to about $11,600, and the 12 percent bracket goes up to about $47,150. So you could convert up to roughly $58,000 and still be in the 12 percent bracket. That would cover your $50,000 spending plus a buffer. Luna: And you're not paying 22 or 24 percent on that conversion. You're paying at most 12 percent, which is probably lower than what you paid while working. Lucas: That's the whole point. Most people in their peak earning years are in the 22 or 24 percent bracket. So if you can convert at 12 percent, you're saving 10 to 12 percentage points on that money forever. Plus, once it's in the Roth, it grows tax-free and you never pay tax on withdrawals again. Luna: But there's a catch, right? The five-year rule has a specific order. You have to wait five years from each conversion, and you can only withdraw the converted amount, not the earnings, until you're 59 and a half. Lucas: Yes. Earnings in the Roth have their own five-year rule and are subject to tax and penalty if withdrawn early. So you need to keep track of your conversion basis. The good news is, the IRS requires you to track it, and your brokerage will report it on Form 8606. But practically, you want to avoid touching earnings until you're 59 and a half. If you plan right, you can have a five-year pipeline: convert money in year one, spend from a previous conversion in year six, and so on. Luna: So you're essentially building a series of five-year ladders. Convert a little each year, and after five years you have a steady stream of spendable money. Lucas: Exactly. And there's another nuance: the tax torpedo. If you have Social Security income later, or if you have a pension, adding Roth conversions on top can push you into a higher tax bracket and cause more of your Social Security to become taxable. So the ideal window for conversions is the gap years between retiring and claiming Social Security — usually ages 45 to 70. Luna: Which is exactly when most early retirees have the lowest income. So it's a natural fit. Lucas: Right. And there's a newer consideration: the SECURE Act 2.0, passed in 2022, changed some rules. One important one: starting in 2024, if you inherit an IRA from someone who died after 2023, you generally have to empty it within 10 years. But if it's a traditional inherited IRA, you can use a Roth conversion ladder to spread the tax hit over those 10 years instead of taking a big lump sum. Luna: That's a smart strategy for beneficiaries. Convert a portion each year to stay in a lower bracket. Lucas: Now, one thing to watch out for: the Net Investment Income Tax, or NIIT. If your modified adjusted gross income exceeds $200,000 for a single filer or $250,000 for married filing jointly, you pay an extra 3.8 percent on investment income, and Roth conversions can count toward that threshold. So if you're close to those numbers, you need to be careful. Luna: And Medicare surcharges, too. IRMAA — the Income-Related Monthly Adjustment Amount — kicks in at certain income levels. If you're 63 or older and doing conversions, you could spike your Medicare premiums two years later. Lucas: Yes, that's a huge one. The IRS looks at your tax return from two years prior to set your Part B and Part D premiums. So if you do a big conversion at 63, at 65 your Medicare premiums could double or triple. You really want to plan conversions before age 63, or keep your income below the first IRMAA threshold, which for 2026 is about $106,000 for a single filer. Luna: So the ideal strategy is to start conversions early, keep them modest, and avoid those cliffs. But what about the state tax angle? Some states tax IRA conversions differently. Lucas: Right. If you live in a state with no income tax — Texas, Florida, Nevada, etc — then you only owe federal tax on the conversion. But if you're in California, which taxes conversions at your marginal rate, you could be paying 9.3 percent or more on top of federal. Some people even move to a no-tax state for a few years specifically to do large conversions. Luna: That's a pretty aggressive move, but I've heard of it. 'Geographic tax arbitrage' — live in a low-tax state during your conversion years. Lucas: If our conversations about early retirement strategies have helped you think about your own plan, and you'd like to support the show staying ad-free, listeners like you are the reason we keep doing this. You can find us at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a simple way to help us keep the conversation going. No pressure at all. Lucas: So back to the mechanics. Another common question: can you do a Roth conversion if you're still working? Yes, absolutely. You can convert any amount from a traditional IRA to a Roth IRA at any time. But if you have a 401 at work, you can't directly convert that unless you leave your job or meet certain conditions. However, you can roll over your 401 to a traditional IRA after you leave, then convert from there. Luna: So the ladder works best for people who have already separated from their employer, or who have a traditional IRA from a previous job. Lucas: Exactly. And there's a specific order to the tax rules: you can't convert only the nondeductible portion of your IRA — the IRS aggregates all your traditional IRAs, including SEP and SIMPLE IRAs, for tax purposes. That's called the pro-rata rule. So if you have $100,000 in a traditional IRA, $80,000 of which is pre-tax and $20,000 is after-tax basis, and you convert $10,000, 80 percent of that conversion, or $8,000, is taxable. Luna: That catches a lot of people off guard. They think they can convert just the after-tax money and avoid tax. Lucas: Yeah, the pro-rata rule is a trap. To avoid it, you'd need to roll your pre-tax IRA money into a 401 at work — if the plan allows it — so that your traditional IRA has only after-tax basis. That's called a 'reverse rollover.' Then you can convert the after-tax money tax-free. Luna: That's advanced, but worth knowing. So let's say someone does this right: they retire at 45, convert $50,000 a year for five years, paying 12 percent tax each time. At 50, they start withdrawing that converted principal tax-free. By 59 and a half, the earnings in the Roth are also tax-free. What's the total tax savings compared to just taking traditional IRA withdrawals early? Lucas: Let's run the numbers. If you withdraw $50,000 from a traditional IRA at 45, you owe income tax on it — let's say 12 percent federal — plus the 10 percent penalty. That's 22 percent total, or $11,000 in tax and penalty. Plus, that withdrawal reduces your future growth. Over 20 years, the difference between paying 12 percent now vs 22 percent later can be tens of thousands of dollars. Luna: And if you're in a state with income tax, it's even bigger. So the ladder essentially eliminates the penalty and lets you control the tax timing. Lucas: Right. And there's one more benefit: Roth IRAs have no required minimum distributions, or RMDs. So if you don't need the money, you can let it grow tax-free for decades. That's huge for legacy planning. Luna: So the Roth conversion ladder is really the backbone of early retirement withdrawal planning. It's not the only tool — you might also use a taxable brokerage account or a health savings account — but it's the most tax-efficient way to access retirement funds before 59 and a half. Lucas: One caveat: the five-year rule applies separately to each conversion. So if you convert in 2026, you can withdraw that amount in 2031. But if you convert again in 2027, that new amount isn't available until 2032. So you need to keep a rolling spreadsheet of your conversions and their availability dates. Luna: That sounds like a pain, but most brokerage platforms now show your Roth conversion basis. And there are tools like NewRetirement or ProjectionLab that model this. Lucas: Absolutely. And one more thing: if you're married, you can double the low tax brackets. A married couple filing jointly in 2026 has a standard deduction of about $30,000, and the 12 percent bracket goes up to about $94,000. So a couple could convert over $120,000 a year and still be in the 12 percent bracket. That's a huge window. Luna: That's a powerful way to move a lot of money from tax-deferred to tax-free in just a few years. Lucas: And if you're aiming for financial independence, that tax-free money gives you tremendous flexibility. You can use it to cover large expenses without worrying about tax consequences. Luna: Alright, so what's the one takeaway for someone listening who's 40 and wants to retire at 50? Start planning now. Make sure you have enough in taxable or Roth accounts to cover the first five years, or start the conversion ladder early. Lucas: That's it. Build your ladder now, even if you're not retiring for a few years. Convert small amounts each year while your income is still moderate. It's one of the most powerful strategies in the early retiree's toolkit.