It’s possible to annually extract ~$10k of money from (non-Roth) Traditional IRA/401k retirement plans, during early retirement, in a tax and penalty-free way.
Early retirement requires increasing financial assets and decreasing costs. One method of decreasing costs is reducing taxes. Contributing to Traditional IRAs and 401ks while you are employed will reduce taxes. However, you must wait until age 59.5 before accessing the money without penalties.
A Roth IRA Conversion Ladder can help you extract $10k out per year from tax-deferred retirement accounts, during your early retirement. This strategy works because of the following:
Each calendar year, you can take ~$6.5k standard deduction and ~$3.5k personal exemption, for a total of $10k of below the line deductions. Note that this amount adjusts for inflation each year and increases over time.
You can convert tax-deferred retirement accounts into a Roth IRA by declaring the amounts converted as income in the year the conversion takes place.
You can convert whatever portion of the account into a Roth that you desire.
Roth IRAs can have their principal contributions taken out without penalty, at any time, as long as the account has been open for at least five years.
When you do a paid conversion of tax-deferred accounts into a Roth, then the conversion will become a “principal contribution” to that Roth IRA after a period of five years.
Those are the requirements for this plan to work and as of this post in the year 2017, they are valid. Here is the general strategy:
January 1, 2018. You are 40 years old and retired. You have a Roth IRA balance of $200k and a 401k of $500k
You perform a conversion of $10k worth of 401k into the Roth IRA. The balances are now:
- Roth: $210k
- 401k: $490k
You have incurred a tax liability for this $10k of income, but due to standard deduction and personal exemption, you owe $0 in taxes.
You withdraw $10k from the Roth IRA. Your balances are now:
- Taxable: $10k
- Roth IRA: $200k
- 401k: $490k
The $10k you withdrew from the Roth IRA is an old principal contribution you made years ago as you were building it. There is no penalty and no tax on this withdrawal. Thus, you took $10k out of the 401k, tax and penalty-free in the year 2018.
Repeat for 5 years. You’ve now taken $50k over the course of 5 years from the 401k. At this point in time, it’s the year 2023. Your original 2018 Roth IRA conversion is now 5 years old and has become a principal contribution. Thus, that $10k is eligible to be removed tax and penalty free.
This strategy works as long as you have at least ~$50k in Roth IRA contributions prior to starting the ladder. It will take 5 years before your first conversion becomes seasoned into being considered a principal contribution. And once you hit that point, you can infinitely take out the $10k from the conversion 5 years prior.
$10k a year isn’t enough to live on for most people, but if you’re retiring early, you likely also have some taxable