How a Backdoor Roth IRA Conversion Could Help Your Early Retirement Strategy

convert-moneyIn the past I’ve talked before about how a 72t is a key part of my early retirement strategy.

In case you’re not aware of what that is, a 72t is a special exception in the IRS rules that allows you to take money out from your 401k or IRA before age 59-1/2 and without facing that stiff 10% penalty (we’ve got a whole post about it here).  For anyone looking to retire early, that’s a massive win!

While that’s all fine and good, one of the things I like to make sure of when it comes to my money strategy is to always be searching for something better.

Maybe an option with less rules or something that’s easier on your taxes?

Lately as I was poking around the Early Retirement forum, I came across one such strategy that I felt is definitely worth looking into further.  In fact it might just be even better than the 72t!

It’s called a Backdoor Roth IRA.  And even though it’s more commonly used by high income earners to move money from a traditional to a Roth IRA, it also has some not-so-obvious strategic advantages: Like the fact that it could be used to help fund your early retirement!

That’s right – conversions to a Roth IRA could be laddered in such a way that you could gain access to your nest egg without penalty and – if it’s done smart – taxes!

Here’s how this works:

What is a Backdoor Roth IRA Conversion?

Like I mentioned above, the conventional use of a backdoor Roth IRA conversion is for higher income earners to still be able contribute to a Roth IRA even though they exceed the IRS income limits.  Right now the completely phased out limit in 2015 is $193,000 for a married couple filing jointly.

Suppose you fit that description.  The way you would go about using a Backdoor Roth is simple.

  1. First you would contribute to a Traditional IRA (usually a non-deductible one).
  2. Then you would immediately convert the amount to a Roth IRA.

Pretty simple, right?

Great … How Does That Help Our Early Retirement Strategy?

Here’s where the magic happens …

To start, give yourself a quick Pop quiz: What’s the difference in withdrawal rules for a Traditional IRA vs a Roth IRA?

The answer:

  • You can’t touch any part of the Traditional IRA until age 59-1/2 without penalty.
  • With a Roth IRA you can touch just your contributions (after 5 years) without penalty; not the earnings.

Therein lies the trick!  That tiny bit of difference with the Roth is what will allow us to access our money earlier than age 59-1/2 without penalty.  And here’s how:

Example – A Roth IRA Conversion Ladder:

money-ladderSuppose you’re age 45 and have a traditional 401k at work worth $500,000.  You decide to retire early and quit your job, so you’re going to want to have access to that money!

The first thing you’d do is convert the 401k into a traditional IRA.  Since it’s a Traditional-to-Traditional rollover, there won’t be any taxes.  Just whatever fees (which is usually nothing) for the conversion.

Next you do a backdoor Roth IRA conversion from the Traditional IRA with a reasonable amount of the nest egg.  We’ll say $20,000 for this example.  You’ll of course pay taxes this year on that $20K since this is a Traditional to Roth conversion.

Now repeat that last step every year for the next 5 years and beyond.

On year 6, guess what?  The $20,000 you converted back in Year 1 is NOW eligible for withdrawal – penalty free!  So now you are free to take out the $20K conversion to do with as you please.  You just can’t take out any earnings you made from it.

Similarly in year 7 your second $20,000 conversion from year 2 now becomes eligible for withdrawal without penalty.

As you can guess, you can continue this on and on for as many years as you need.   Hence the name “ladder” as you move from one rung to the next.

Once you reach age 59-1/2 you can then access whatever retirement accounts you want and take out whatever amount you need.  That means you finally can touch all those earnings that grew upon your $20K contributions you made while they were sitting in the Roth IRA without penalty.

How is This Strategy Better Than a 72t?

Even though it’s good to have a few early retirement strategies up your sleeve, the more I looked into a Backdoor Roth Ladder, the more I realized that this technique really does have some pretty significant advantages over a 72t.

  1. With a 72t your withdrawals are fixed and based on a pre-calculated formula set by the IRS. There is very little room for flexibility based on what your actual needs are.  By contrast the Backdoor Roth is based on whatever amount YOU choose to convert.
  2. You have to continue the 72t withdrawals for at least 5 years or until you reach age 59-1/2, whichever is longer. That means even if you don’t need them for some reason, it doesn’t matter!  You still have to take them!  And IF you were to stop taking the withdrawals or mess up in any way, you’ll owe taxes and penalties on all the amounts you’ve withdrawn.  Ouch!  In contrast with the Roth IRA ladder, you can stop anytime you like without penalty.  Once you’ve met the five year wait, it’s up to you if you want to continue taking the money out.

What About the First Five Years?

Admittedly the one fatal flaw with a Backdoor Roth is the first five-year wait.  Going back to our earlier example, it wasn’t until Year 6 that we were actually able to touch our money.

But not to worry!  Here are a few ways around that issue:

  1. Use money from your taxable income bucket. This would be investments like your capital gains and dividends from stocks or mutual funds you own outside your retirement funds.
  2. If you’ve already got a Roth IRA, use the principal contributions you’ve already built up. Hopefully you’ve been investing in a Roth IRA already for 10 or 20 years and have a substantial amount of contributions already beyond the five year qualification.

Bonus Strategy!  Pay No Taxes At All!

tax-freeAs if that strategy wasn’t cool enough, now here’s the cherry on top – How to pay zero taxes on your tax-deferred savings!

Go back to our example at Year 6.  That year two things will happen:

  1. You’ll convert $20,000 from your Traditional IRA to your Roth IRA (to be used hypothetically for Year 11).  You’ll owe ordinary income taxes on this amount.
  2. You’ll withdraw your converted $20,000 (originally from Year 1) for living expenses.

Now suppose you only need $30,000 to cover all your living expenses.  That means you’ll have to get $10,000 from one of your other retirement buckets.

If you can make that extra $10,000 come from a taxable brokerage account in the form of capital gains and dividends, guess what?  You won’t owe any Federal taxes on it because you’re under the first $74,900 of your taxable income.

Observe how this looks from a tax perspective in Year 6:

+ $20,000 withdrawal from the $20K Roth IRA conversion for Year 11

+ $10,000 withdrawal from the Capital Gains and Dividends

– $0 for the Roth IRA withdrawal (Since you paid taxes on this during Year 1, it’s tax free now)

-$20,500 tax credit = $12,600 for a standard deduction and 2 x $3,950 for personal exemptions (you and your spouse)

= $9,500 in taxable income


  • Because your taxable income is below the total of standard deduction and two personal exemptions
  • And the $9,500 came from capital gains and dividends that don’t get taxed until your taxable income exceeds $74,900

You won’t owe any Federal taxes on the whole balance in Year 6 at all!

So what does that mean?  It means you just found a way to pay ABSOUTELY NO FEDERAL TAXES on your Year 11 income!

Check it out:

  • You paid no taxes when you first saved the money in your 401k.
  • You paid no taxes on the money while it grew in your 401k.
  • You’re paying no taxes on the money when you converted it into a Roth IRA
  • And now you’re paying no taxes when you finally withdraw the money!

SUCCESS!  That is indeed a pretty incredible trick!

Plan with Caution …

As with all early retirement investment strategies, the one thing you have to keep in mind throughout all of this is that you’ve really got to put some thought into NOT taking out too much money too soon.  Planning for early retirement is great and really exciting, but not at the expense of shooting yourself in the foot by the time you’re age 70 and too old or too unhealthy to work.

Always look at your plan from an overall view and be sure to do things in a way that will provide you with overwhelming confidence that your money will be safe and never run out prematurely.

Readers – Have you ever heard of a backdoor Roth IRA conversion or ladder?  Has anyone actually used one?

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