Retiring Early? Avoid Withdrawal Penalty

Feb 7, 2022

If you retire early (before age 59 ½) and take funds from a retirement account, you could pay a 10% penalty! However, there’s a way around that penalty using a Roth IRA. You just need to count to five…read on.

The Lay of the “Roth IRA” Land

A Roth IRA is an individually owned retirement account to which investors contribute after-tax dollars. Those contributions are invested and grow tax-free. During retirement, distributions are received tax-free as well. In addition to these benefits, when it comes to withdrawing funds from a Roth IRA, there are a few rules to remember:

  • You can always withdraw your contributions tax and penalty-free.

  • If you withdraw earnings before age 59 ½, you will pay a 10% penalty.

  • There are no Required Minimum Distributions like there are with Traditional IRAs.

Not everyone can contribute to a Roth IRA; to do so, your income must fall below the Modified Adjusted Gross Income (MAGI) phase-out for your tax-filing status. However, contributions aren’t the only way to get money into a Roth IRA.

Dollars can also flow into the Roth IRA account through rollovers and conversions. For example, let’s say you contribute to a Roth 401k. Then, when you leave your job, you can roll the Roth portion of the 401k into a Roth IRA. This is known as a rollover.

On the other hand, a Roth IRA conversion is when you move money from a Traditional IRA into a Roth IRA. Traditional IRAs contain pre-tax dollars, so you’ll pay income tax on the amount converted to the Roth IRA in the year of the conversion.

How it Works: Count to Five (Years)

One of the lesser-known and lesser-acted upon rules of the Roth IRA is: Rollover and converted dollars must remain in the account for at least five years before you can withdraw the principal amount both tax and penalty-free (earnings not included).

For example, let’s say you converted $50,000 to a Roth IRA on January 1, 2017, and invested those funds in an S&P 500 index fund. On January 1, 2022, that $50,000 would be worth nearly $110,000. The best part? Now that the 5-year requirement is satisfied, you can withdraw $50,000 tax and penalty-free, regardless of your age.

Roth Early Retirement Strategy

The 5-year rule creates a unique planning opportunity for investors who want to access retirement funds before age 59 ½. This is where the “Roth Conversion Ladder” comes into play.

This strategy consists of several consecutive years of pre-tax conversions into a Roth IRA to fund early retirement spending needs. The key to this strategy is that you must begin converting at least five years before your intended retirement date.

Let’s say you are 50 years old and want to retire in five years. You project that you will spend $60,000 per year during retirement. So you would convert $60,000 to your Roth IRA every year for the next five years to provide funds to withdraw tax-free and penalty-free during your initial years of early retirement.

Strategy is NOT for Everyone

Question: Who is a good candidate for the “Roth Conversion Ladder”?

Answer: Strategy is not suitable for most people. However, for the right situation, it can be an early retirement solution.

Several traits should be present for a “Roth Conversion Ladder” to make sense:

  • First, you should only employ this strategy if you want to retire early or access retirement money before age 59 ½.

  • Second, you must have a source of funds to convert to a Roth IRA. A Traditional IRA is an ideal vessel to initiate Roth IRA conversions from, so you must have assets held in a Traditional IRA or inactive 401(k) plan. (An inactive 401(k) refers to a 401(k) from a past job to which you are not actively contributing. Once you separate from an employer, the 401(k) plan can be transferred into a Traditional IRA.)

  • Third, you must be in a low tax bracket. The best case is to have very little taxable income from other sources. To make financial sense, conversions need to be made over a series of lower-income years. Roth conversions are taxed at ordinary income rates, which climb up to 37% for high-income earners.

  • Finally, have cash in reserve to pay income tax created during the conversion years.

It is also important to note that by taking distributions from your Roth IRA prior to 59 ½, you may be forgoing several years of tax-free growth. You will want to factor this opportunity cost into your decision and overall financial situation.


The “Roth Conversion Ladder” strategy isn’t for everyone, but anyone considering early retirement should know about it. Pay the tax early, let the funds grow, count to five (years), and withdraw your principal both tax and penalty-free. This strategy can get complicated. Consult your financial planner or tax advisor before implementing.

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