How a Roth Conversion Ladder Works for Early Retirees

If you’re planning to retire early, chances are you’ll benefit from setting up a Roth conversion ladder. This sneaky money hack let’s early retirees pay little (or no!) taxes in early years, to avoid a bigger tax burden in later years.

It’s also a great way to tap into traditional retirement accounts early, avoiding those nasty early withdrawal fees.

What is a Roth IRA Conversion Ladder?

A Roth conversion ladder is a multi-year transfer of retirement funds from tax-deferred accounts to tax-free accounts. It’s a process that can significantly lessen your tax burden, all while side stepping early withdraw penalties.

Since it’s a multi-year plan, a conversion ladder requires attention to detail and thorough planning. This post will walk through the ins and outs.

As for accessing funds without penalty, when you convert money from a tax-deferred account, such as a 401(k) or Traditional IRA, to a Roth IRA, these funds can be withdrawn from your Roth IRA after only five years.

Roth Conversion Special Rules:

Converting money from a 401(k) or Traditional IRA to a Roth IRA is quite common. But there are a few rules to be aware of before moving large sums of money around…

1. Roth conversions are a taxable event. This means you’ll need to pay income taxes on ALL the money you convert when you file the following year. Depending on your tax bracket, this could be a HUGE amount if you accidently convert too much.

2. Conversions have a 5 year rule. When pre-tax money is converted into a Roth IRA, each conversion has a five-year waiting period before funds can be withdrawn penalty free. So it’s really important to plan your spending and conversions early, and set up your ladder well before you need the funds.

If you withdraw converted funds before the five-year waiting period, the IRS will ding you with a 10% early withdrawal penalty. You can still withdraw money tax-free anytime from a Roth, because you already paid ordinary income tax when you converted the money.

Setting Up a Ladder of Conversions

While Roth conversion ladders can certainly help you save money on taxes, if you’re not careful, they can also cause you to pay more in taxes. As we stated earlier, a once-off large conversion will result in a huge tax bill. For example, if you are wanting to convert $1million in 401(k) funds to a Roth IRA, you’ll incur a massive tax bill the next year because you’re in the highest tax bracket!

Instead, the goal of a Roth conversion ladder is to create a series of conversions that will keep you in the minimum tax bracket. You’re simply taking a portion…a little bit every year, until either your entire retirement is accessible tax free, or you’ve reached the top of your tax bracket. Hence the reason why you’re making your conversions a “ladder” and doing them gradually.

Example of a Roth Conversion Ladder

Let’s say our friend “Gloria” wants to retire early at age 50. All of her retirement savings are in her 401(k), which would penalize her for accessing it early. She plans a Roth conversion ladder 5 years in advance (at age 45), giving her access to funds at age 50 without fees and minimizing tax liability.

Gloria determined that she needed at least $40,000 in tax-free income per year. At 45, she began making annual Roth IRA conversions of $40,000. In each year Gloria made the conversion, she paid the applicable tax on the amount converted.

When Gloria turns 50, her first conversion will be five years old. She will be eligible to withdraw the $40,000 conversion balance she made 5 years earlier. At the age of 59½ , Gloria can begin accessing any retirement plans penalty free. Although they may be subject to regular income tax. Additionally, any funds remaining in her Roth IRA account can be withdrawn tax free, indefinitely.

Gloria’s schedule of conversions:

In total, Gloria converted $400,000 from her 401(k) to her Roth IRA. By spreading out the conversions into smaller amounts with a conversion ladder, she was able to keep her tax liability very low, and also avoid early withdrawal penalties!

Saving the Most Money on Taxes

The example we used above shows a perfectly even split of conversions every year. But in reality, it probably won’t be this neat. And that’s because everyone’s income tax situation is different. Things can change a lot over the course of a decade.

To save the most money on taxing conversions, you’ll want to convert money in your low-income years, and avoid converting money in high income years. While it might put a little “kink” in your ladder, it will work out better tax-wise in the long run.

For example: Using the scenario above, let’s say Gloria finds some consulting work in the year 2031 when she is 53 years old. Let’s say she earns $100,000 that year – income she never anticipated!…

If Gloria completed a conversion that year, she’d be in a higher tax bracket than originally expected (paying income tax on $100,000 plus the $40,000 conversion – a total of $140,000). Instead, it’s in Gloria’s best interest to not convert anything that year, using her earned money to live off of instead of withdrawing funds from the Roth IRA.

All in all, if you use a Roth conversion ladder you’ll still want to re-assess your income each year. Use your estimated AGI to guide you on how much you should convert.

Who should use one, and when?

A Roth conversion ladder is most ideal for folks who need to access their pre-tax retirement funds before age 59½. This can avoid early withdrawal penalties.

It’s also really beneficial for those in lower tax income brackets (for example, early retirees with no or low income). Since converting money from pre-tax → post tax accounts is a taxable event, the best way to make conversions is in small amounts, slowly over multiple years, as opposed to a large one time conversion.

Roth conversion ladders rarely make sense for people older than age 55. That’s because once funds are converted, there’s a 5 year waiting period for penalty free withdrawals (we’ll discuss this 5 year rule further below). So instead of converting funds after age 55, you might as well just wait until age 60 (or, 59 ½) to withdraw penalty free anyway.

All in all, if you have the majority of your retirement nest egg tied up in Traditional IRAs and 401(k)s, and you plan to retire in your 30’s, 40’s or early 50’s, you’ll want to consider a Roth conversion ladder.

Roth Conversion Ladder FAQs:

Below are some common questions about Roth conversion ladders, along with quick answers!

When should I start a Roth conversion ladder?

You can make Roth conversions anytime you like. But keep in mind your ladder should start at least five years before you need to access the money.

Is a Roth conversion taxable?

Yes, the conversion event is taxable. Meaning, you’ll pay taxes on the money when you move it from a traditional IRA or 401(k) over to a Roth. However, once money is inside a Roth IRA it grows tax free. And those converted funds can be withdrawn tax free, anytime. Keep in mind, the IRS imposes a five-year waiting period. If you withdraw the converted sum before five years, you will be charged a 10% penalty.

Can you “undo” a Roth conversion if you make a mistake?

Nope. That’s why it’s super important to cross your T’s and dot your I’s before executing your Roth conversion ladder. You can’t just reverse a transaction if you screw it up.

Is there an age limit to Roth conversions?

Fortunately, there are no age restrictions to conducting a Roth conversion. Taking advantage of a ladder conversion could make sense at any age – depending on your specific financial situation. Planning in advance is key because you don’t want to be 75 and do a $1 million conversion. Plan to convert over many years – thus the “ladder” strategy.

What Is the difference between a Backdoor Roth and a Roth Conversion Ladder?

Roth conversion ladder is a multiyear approach that allows you to take tax-free and penalty-free IRA withdrawals before reaching the standard distribution age of 59½. You’re essential moving funds from retirement account to retirement account.  A Backdoor Roth, on the other hand, is a way to fund a Roth IRA if your income exceeds the limits for Roth contributions.

The Bottom Line:

It’s never an ideal plan to roll over all of your retirement savings into a Roth IRA and then blow through the money before reaching the age of 59½. Remember, you can’t even begin collecting Social Security payments until you’re 62 (and that’s only at a reduced rate). Additionally, most pensions (if you’re lucky enough to have one) don’t kick in until you’re 65.

That the purpose of a Roth IRA conversion ladder is to offer a tax-free and penalty-free income stream during early retirement. You must save enough money elsewhere to cover the whole of your retirement, not just the first few years.

If you are planning to retire early, the timing of your Roth conversion ladder is crucial. Be mindful of the five-year rule and the income tax brackets within the years you are making conversions.

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