Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How to Use a Roth IRA Ladder in Early Retirement
Transcript
- Lucas: You're forty-five, you've got eight hundred grand in a traditional IRA, and you just quit your job. Your spending is maybe forty thousand a year. How do you actually get your money out without paying a ten percent penalty? Luna: That's the million-dollar question for anyone retiring before fifty-nine and a half. And the answer a lot of us have heard about is the Roth IRA conversion ladder. Lucas: Right. It's one of those strategies that sounds more complicated than it really is. At its core, you're taking money from a traditional IRA, converting it to a Roth IRA, paying income tax on the converted amount today, and then after five years you can withdraw those converted funds penalty-free. Luna: So the five-year clock is the key. You convert in year one, you can't touch that money until year six. That means you need to start planning years before you actually need the cash. Lucas: Exactly. That's why this isn't something you figure out the month you retire. You want to start the ladder while you're still working, or at least the first rung as soon as you have a low-income year. Let's say you retire at forty-five. You'd convert a chunk of your traditional IRA in year one — maybe forty thousand dollars — and you pay income tax on that forty K. Your other income that year is low, so your tax bracket is probably the ten or twelve percent marginal rate. Luna: And you'd need enough cash in a taxable account or a Roth contribution basis to live on during that first five-year gap, right? Because you can't use the converted money until year six. Lucas: Precisely. That's the 'bridge' money. Most early retirees plan to fund years one through five from a taxable brokerage account, a savings account, or even Roth IRA contributions — which you can withdraw anytime tax- and penalty-free since they're after-tax money. Then in year six, the first conversion from year one becomes available. In year seven, year two's conversion opens up, and so on. Luna: So the ladder creates a self-sustaining pipeline. Each year you convert a new rung, and five years later that rung is ready to spend. Lucas: Exactly. And the beauty is you control the tax bill. If you retire early and your only income is maybe some dividends and a part-time gig, your marginal rate could be ten or twelve percent. That's a great time to convert. Compare that to waiting until you're seventy-two and RMDs kick in, when your IRA balance might be bigger and you're forced to withdraw at a potentially higher rate. Luna: Let me push back a little though. If you convert at twelve percent, you lock in that rate. But what if you have a year with a big expense — say you buy a car or do a home renovation — and you need to convert more than usual? That could push you into a higher bracket. Lucas: Great point. You want to manage the size of each rung carefully. Most people convert just enough to fill up the lower tax brackets. For a single filer in 2026, the twelve percent bracket goes up to about forty-seven thousand dollars in taxable income. If you have ten thousand in other income, you can convert about thirty-seven thousand and stay in twelve percent. Beyond that, you're paying twenty-two percent on the extra. Sometimes that's still worth it, but you'd want to run the numbers. Luna: And what about the five-year rule for each conversion? I know there's also a separate five-year rule for the Roth IRA itself. Lucas: Right. There are actually two five-year rules. The one we're talking about applies to conversions: each conversion has its own five-year clock. The other rule applies to earnings — if you withdraw earnings from a Roth IRA before age fifty-nine and a half and the account hasn't been open for five years, you pay tax and a penalty. But for a ladder, you're only withdrawing the converted principal, not earnings, so that second rule doesn't really come into play. Luna: Got it. So as long as you wait five years after each conversion, the principal is penalty-free. That's the ladder. Lucas: Now, there's a trap a lot of people miss. If you have any after-tax money in your traditional IRA — like nondeductible contributions — the pro-rata rule kicks in. You can't just convert the deductible portion and leave the after-tax portion. The IRS treats all your traditional IRA balances as one big pot, so a conversion includes a proportional mix of pre-tax and after-tax money. Luna: That's a headache. So if you have a large pre-tax IRA and a small after-tax basis, you're going to owe tax on most of the conversion anyway. Lucas: Exactly. That's why it's sometimes better to roll your after-tax basis into a Roth IRA first, if your plan allows it, or to avoid making nondeductible contributions if you're planning a ladder. Another pro tip: if you have a 401k from a former employer, you can roll that into a traditional IRA, but if you have a large 401k balance, that can complicate the pro-rata calculation. Some people roll their 401k into a separate IRA that doesn't get mixed in, but the IRS aggregation rule applies to all traditional IRAs — SEP, SIMPLE, and rollover IRAs all count. Luna: So if you're serious about a Roth ladder, you might want to keep your 401k separate from your IRA until you're ready to convert. Or even leave the 401k at the old employer. Lucas: Exactly. Or roll it into a new employer's plan. Let's talk about another wrinkle: the ACA subsidy. If you're retiring before Medicare age, your health insurance likely comes from the Affordable Care Act marketplace. Your premium subsidy is based on your modified adjusted gross income. A Roth conversion counts as income, so if you convert a big chunk, you could lose thousands in subsidies. Luna: That's a huge hidden cost. I've seen people convert an extra ten thousand dollars and lose a six-thousand-dollar subsidy. Suddenly their effective marginal rate is way higher than the tax bracket suggests. Lucas: Right. So you need to model your income not just for tax brackets but also for subsidy cliffs. The good news is the cliff was removed through 2025, but in 2026 it's back. So as of June 2026, we have to be careful. If your income goes above four hundred percent of the federal poverty level, subsidies phase out. For a single person in 2026, that's about fifty-one thousand dollars. So you want to keep your total income — including conversions — below that threshold if you want any subsidy at all. Luna: That really limits how much you can convert each year. It's not just about staying in the twelve percent bracket; it's about staying under the subsidy cap. Lucas: Exactly. For a lot of early retirees, the sweet spot is converting maybe twenty to thirty thousand dollars a year, depending on other income, so you stay under the cap and pay little to no tax. Build the ladder slowly. The important thing is to start early. If you retire at forty-five, you want at least five years of living expenses saved outside the IRA. That gives the ladder time to mature. Luna: What if you don't have five years of cash? Can you still do a ladder? Lucas: You can, but you need to be creative. Some people use a taxable brokerage account and pay capital gains tax. Others use a cash-value life insurance policy, or a home equity line of credit. There's also the rule of fifty-five: if you leave your job in the year you turn fifty-five or later, you can take penalty-free withdrawals from your 401k, not your IRA. So that's another bridge. Luna: That's a good backup for people who retire a bit later. But for the forty-five-year-old, the ladder is the gold standard. Lucas: I think so. Let me give you a concrete example. Say you're forty-five, single, spending forty thousand a year. You have a traditional IRA worth eight hundred thousand and a taxable brokerage account with two hundred thousand. Your plan: for the first five years, live off the taxable account. Each year, convert thirty-five thousand from your traditional IRA to your Roth IRA. Luna: And you're careful not to have other income, so you keep your total income under the ACA threshold. Lucas: Right. Year one, you pay about four thousand in federal income tax on that conversion, assuming the standard deduction and twelve percent bracket. Year six, you start withdrawing the year-one conversion from the Roth, and you convert another thirty-five thousand. By year ten, you've moved a big chunk of your IRA into Roth, and your future withdrawals are tax-free. Plus you've avoided the ten percent penalty entirely. Luna: And you've also reduced your future RMDs, because the Roth isn't subject to required minimum distributions. Lucas: That's a huge bonus. When you turn seventy-two, your traditional IRA balance is much smaller, so your RMDs are manageable. And the Roth keeps growing tax-free for the rest of your life — or your heirs. Luna: One last thing: what about married couples? The brackets are wider, and the ACA threshold is higher, so they have more room. Lucas: Absolutely. A married couple in 2026 can earn up to about ninety-four thousand and stay in the twelve percent bracket, and the ACA subsidy cap is about one hundred and four thousand for a family of four. That gives them a lot of conversion room. They could potentially convert sixty thousand a year and still pay low taxes and keep subsidies. Luna: That's a game changer. So the ladder works best for couples, but singles can make it work with careful planning. Lucas: Speaking of planning, if these kinds of money conversations have helped you think about a decision differently, there's a small way you can support the show. It's ad-free because of listeners who chip in at buy me a coffee dot com slash fexingo. That's buy me a coffee dot com slash f-e-x-i-n-g-o. No pressure at all — just a way to keep the conversation going. Luna: Yeah, every bit helps us keep doing these deep dives without any sponsor interruptions. Lucas: So back to the ladder. The key takeaway: start early, keep your conversion amounts modest, watch your ACA income limits, and be mindful of the pro-rata rule. It's a powerful tool, but it requires discipline and a multi-year view. Luna: And if you're not sure where to begin, I'd suggest running a few scenarios with tax software or a planner. The five-year timeline means you have some time to adjust. Lucas: Absolutely. And if you're already retired and haven't started a ladder, it's not too late. You can start one today — just make sure you have enough cash to cover the next five years first. Luna: Next episode, we'll talk about another early retirement withdrawal strategy: the 72 substantially equal periodic payments. That's a whole different beast. Lucas: It is. And it's worth understanding both options. But the Roth ladder is usually the more flexible choice. Thanks for listening.