How to Use Your Traditional 401(k) in Early Retirement (with No 10% Penalty)
What I imagine every day of early retirement looks like from your vacation home in the midst of some mountain range.
When I first learned about early retirement, I was blown away—so much so that I didn’t really ask any questions about what happened AFTER you retired at 35 or 40 years old.
All I knew was I needed to save as aggressively as possible, as early as possible.
But then I started to envision the actual logistics of early retirement and withdrawing money from these accounts that are designed to be used after age 59.5, and I wasn’t sure what it would entail. I was confident the early retirement community had the answers, though, and I wasn’t too concerned given the fact that these questions were still about 15 years away from relevance for me personally.
I realize this is a long way away for most of us, but I think it’s good to start taking these logistics into consideration now so you have an idea of how you’re going to plan for early retirement. For some of us, it might be less than 20 years away—and planning your #ExitStrategy will help you confirm that you’re setting up your accounts correctly for later.
More importantly, it might encourage you to keep aggressively contributing to your Traditional 401(k), because you’ll see that you can use this money whenever thanks to this tax loophole! Might as well maximize your tax-advantaged account to avoid the annual taxes that eat into your returns in other taxable investing accounts, right? Right.
Roth IRA Conversion Ladder
Today I want to talk about something called a Roth IRA conversion ladder, because it’s the magic tax loophole that enables you to use your Traditional 401(k) before age 59.5 without the 10% penalty that normally applies.
Here’s what to do:
Roll over your entire Traditional 401(k) to a Traditional IRA. This is a standard financial move in retirement or whenever you leave a company. Your 401(k) provider can help if you’re confused (so can a company I like called Capitalize; I’ve used them thrice now).
Perform a Roth IRA conversion with a strategically pre-determined chunk of the Traditional IRA (more on this in a moment). This is also pretty common, but there are tax implications. That’s why you want to wait to do to his until you’re retired and your taxable income is low (or nothing), because the amount you convert from Traditional to Roth will be taxed in your income bracket.
Wait 5 years. On January 1 of Year 6, you can use that converted money (the money you converted from a Traditional IRA to a Roth IRA) without any 10% penalty! Seriously!
I have no idea why this bit of tax code exists or works, but as of this original writing (December 2022, updated for 2024), it does.
The reason it’s called a ladder is because you’ll do it every year, that way (after the first five years) you’ll have a chunk converted and ready to go every single year.
How to pay no taxes on your Roth IRA conversion ladder
Ready to take this shit to the next level?
Let’s do an example, because I think it makes it way easier to understand.
Let’s pretend I’m ready to retire. It’s 2025.
For the next five years, I’ll be living off my taxable investment accounts, cash in my emergency fund, and side hustle income.
But for now, in 2023, I’m going to determine what our annual expenses are: In our case, it’s about $90,000 per year.
I’d roll over my entire 401(k) into a Rollover (Traditional) IRA, then convert $29,200 of it into a Roth IRA. Why $29,200?
I’m glad you asked: As a married person filing taxes jointly, I receive a standard deduction of $29,200. If you’re single, the standard deduction is $14,600 in 2024.
That means I could—hold onto your seat—invest my money into my 401(k) tax-free with Traditional contributions, then strategically only convert (read: pony up and pay the taxes on an amount) up to the standard deduction so it’s (once again) tax-free (because remember, I have no other earned income this year!).
By doing this, I’ve completely avoided taxation on my contribution, growth, and withdrawal, AND avoided the 10% early use penalty.
The kicker is that you’ll need to plan for supplementing this income with income from another source (a taxable investing account, side hustle income, etc.), assuming your expenses are lower than $14,600 or $29,200.
The good news? Capital gains are taxed much more forgivingly than earned income, so as long as your withdrawals from your taxable accounts are less than $61,625 as a single person, you’re paying 0% taxes on the entire amount. YUP.
The math works out like this for a single person:
$14,600 is your standard deduction, so you’ll pay no tax on your 401(k) > Traditional IRA > Roth IRA conversion chunk.
$47,025 is the upper limit for the 0% tax bracket for capital gains taxes on withdrawals of growth from a taxable account.
This means you’ll have $13,850 + $44,625 (or $61,625) in tax-free income. Remember what we said above? For couples, we need $90,000 in our plan, which means we’d convert $29,200 to Roth and withdraw up to $94,050 in capital gains tax free.
Because we only need $90,000, we can withdraw the full extent from the taxable account and reinvest what’s not spent, taking advantage of our 0% capital gains rate to step up our cost basis.
So the next year will pass in early retirement bliss: Sleeping in, working on passion projects, going to Mexico on a monthly basis—you know, the works.
By now, it’s the end of 2025, and it’s time to perform another conversion. Another conversion of $29,200 (or whatever the inflation-adjusted value is) from Traditional to Roth IRA.
Repeat this process in 2026, 2027, and 2028. At the beginning of 2029, my first $29,200 chunk will be available for spending, penalty-free. At the end of 2030, the money I converted in 2025 will be ready, and so on and so forth. Even after the $29,200 chunks start becoming available, you’ll still want to convert another chunk each year to continue the ladder in perpetuity.
Of course, you may have a fairly diversified pile of assets in all sorts of accounts, and you may still have some side hustles (that you do for fun) that produce some income.
Does this feel confusing?
It’s okay. In some ways, it’s intentionally confusing. We are exploiting a loophole in tax law, after all.
The key takeaway (for now) is that your Traditional 401(k) is still an incredible place to stockpile as much money as possible, because you’ll be able to spend a little time learning and enacting this process when early retirement comes.
And trust me, your freedom will be worth it. You’ve probably spent way more time and effort learning shit that mattered far less, right? This is one bit of fancy logistical footwork that will enable you to leave the workforce, and I’d say that’s well worth it.
