How And Why To Set Up A Roth IRA Conversion Ladder

How And Why To Set Up A Roth IRA Conversion Ladder

One problem with retiring early is that you can't access your tax-sheltered retirement accounts until 59 1/2 without taxes and penalties. Luckily the Roth IRA conversion ladder can help solve this problem.

A Roth IRA conversion ladder entails moving your money from a tax-deferred account, such as a 401(k) or traditional IRA, into a Roth IRA. The benefit of doing this is that you can withdraw the converted funds from your Roth IRA after only five years.

Hello, early retirement!

The Basics Of Roth IRAs

Before we go any further, let’s take a quick look at Roth IRAs and how they are uniquely suited to early retirement. Roth IRAs are similar to tax-deferred retirement options with a few key differences:

  • Contributions are not tax-deductible
  • Contributions can be withdrawn anytime penalty and tax-free
  • Both investment earnings and contributions can be withdrawn tax and penalty-free as long as you are at least 59 1/2 and your Roth IRA is at least five years old

There are other loopholes for taking money out of a Roth IRA, such as using them to pay for a first-time home purchase or qualifying educational expenses. However, for the purpose of early retirement, the three points above are key.

Here's an article that discusses the other loopholes if you are curious.

Now let’s look at the other piece of the puzzle–the Roth IRAs conversion.

The Roth IRA And Early Retirement

As retirement plans go, Roth's are pretty unconventional. While you don’t get the benefit of tax-deductible contributions, you do get tax-free growth.

At age 59 ½, you can begin making withdrawals of both contributions and investment income fully tax-free. Got that? Tax-free income in retirement–not tax-deferred.

Not surprisingly, this has led to a massive wave of Roth IRA conversions. That’s where investors move money from regular retirement accounts–401(k), 403(b), and traditional IRA plans–into Roth IRAs.

This is referred to as a Roth IRA conversion.

Unlike simple rollovers of funds from one retirement plan to another, Roth IRA conversions generally have tax consequences. You will have to pay ordinary income tax–but not an early withdrawal penalty–on any retirement savings transferred into a Roth IRA in the year of conversion.

For example, if you move $40,000 from an old 401(k) plan into a Roth IRA, and you’re in the 12% tax bracket, you’ll have to pay $4,800 in federal income tax on the amount converted–$40,000 X 12%. (Non-tax deductible contributions to the 401(k) plan would not be taxable, but that’s a complicated topic we don’t have time to discuss here.)

On the surface, that may seem scary. If you’re looking to create a stream of tax-free income in retirement that benefit usually outweighs the current year tax liability.

Because of the tax liability, it’s most common for people to do a Roth IRA conversion over several years. That will minimize both your tax bracket and your taxes in the years of conversion.

Creating A Roth IRA Conversion “Ladder”

Withdrawals from a Roth IRA can be taken tax-free. This creates a potential source of tax-free income even in early retirement.

There’s a loophole with Roth IRAs that pertains only to Roth IRAs and no other retirement plans. It’s a loophole that’s made to order for early retirement.

Since Roth IRA contributions are not tax-deductible, they can be withdrawn tax-free at any time. That means even before you turn 59 1/2 and are in the plan for at least five years.

This has to do with IRS Ordering Rules, which allows the first withdrawals taken from your Roth IRA to be regular contributions. Since your contributions were already taxed, you can withdraw them without paying ordinary income tax or an early withdrawal penalty.

Roth IRA conversions are different. The IRS imposes a five-year waiting period after each conversion. If you withdraw the converted balance before five years you will be hit with a 10% early withdrawal penalty. (You won’t have to pay ordinary income tax because you already paid it when you converted the funds to the Roth.)

Here's more info from Investopedia on the five-year waiting period.

Related: Why You Should Fund Your Roth Even If You Don't Need It

Why Conversions And Not Annual Contributions?

Wondering why it’s necessary to do a conversion, and not simply make annual Roth IRA contributions? It has to do with dollar amounts.

In 2019, Roth IRA contributions are limited to just $6,000 per year, or $7,000 if you’re 50 or older. While the cap gets adjusted for inflation periodically, it's still very low.

It would take a very long time to accumulate a large Roth IRA account with such small contributions. If you plan to use your Roth IRA for early retirement, you may not have enough money saved in your Roth to support you until you can access your 401(k).

It’s more likely you have that kind of money saved in other retirement plans. This is particularly true of employer-sponsored plans, like 401(k)s. You will have both higher contribution amounts and a potential employer match.

Taking advantage of conversions allows you to contribute your annual contributions to the Roth. It also allows you to move money over from your 401(k) allowing for a much larger balance in the Roth.

Creating Your Own Roth IRA Conversion Ladder For Early Retirement

If you start doing Roth IRA conversions for at least five years before your planned early retirement, you’ll be able to begin withdrawing those contribution balances. They will be tax-free and penalty-free by the time you early retire.

As an example, let’s say you plan to retire at 50. You decide that you need at least $40,000 in tax-free income per year. At 45, you begin making annual Roth IRA conversions of $40,000. In each year you make the conversion, you pay the applicable tax on the amount converted.

By the time you turn 50–and your initial conversion is five years old–you’ll be able to withdraw the $40,000 conversion balance you made at age 45. If you do this for ten years, beginning at age 45, you’ll have a steady tax-free, penalty-free income of $40,000 per year through age 59.

At age 59 1/2, you can begin tapping any and all other retirement plans you have available, penalty-free, and subject only to ordinary income tax. And, of course, any amounts you have remaining in your Roth IRA account can continue to be withdrawn on a tax-free basis.

We’re throwing out a lot of numbers, so let’s see how this works in the table below.

YearAge At The Time Of The ActionRoth IRA Conversion AmountRoth IRA Withdrawal AmountSource Of Funds Withdrawn
201845$40,000N/AN/A
20194640,000N/AN/A
20204740,000N/AN/A
20214840,000N/AN/A
20224940,000N/AN/A
20235040,000$40,0002018 Conversion
20245140,00040,0002019 Conversion
20255240,00040,0002020Conversion
20265340,00040,0002021 Conversion
20275440,00040,0002022 Conversion
20285540,00040,0002023 Conversion
20295640,00040,0002024 Conversion
20305740,00040,0002025 Conversion
20315840,00040,0002026 Conversion
20325940,00040,0002027 Conversion
Totals15 Years$400,000 Converted$400,000 Withdrawn

An Important Caveat To The Roth IRA Conversion Ladder

As you can see from the table above, a Roth IRA conversion ladder can do an outstanding job of providing you with tax-free, penalty-free retirement withdrawals well before age 59 1/2.

But there’s a Part B to this strategy that’s equally important. If you’re going to use a Roth IRA conversion ladder to fund your early retirement years, you have to make sure there’ll be plenty of retirement assets left by the time you reach 59 ½.

In the example above, the total amount of retirement capital used for the Roth IRA conversion ladder is $400,000. That’s a lot of capital to burn through before you even reach 60.

For the strategy to work, you’ll have to have enough other retirement savings to provide you with an income for the rest of your life. Exactly how much that will be will depend upon how much income you’ll need during the traditional retirement years.

Complicating this issue is the fact that you won’t be eligible for Social Security until age 62 at the earliest. And if you begin taking benefits then, it will be at a greatly reduced level. Full retirement age for Social Security purposes–the age at which you’re entitled to your full retirement benefit–doesn’t begin until age 67 for most people today.

That means you may continue to be entirely dependent on your retirement savings between the time you reach 59 ½ and you begin collecting Social Security benefits. That would take a very large retirement portfolio.

Related: When To Claim Social Security

Lowering The Amount Of Retirement Savings You’ll Devote To The Conversion Ladder

Two alternatives to consider include:

  1. Utilize SEPP withdrawals to avoid penalties.
  2. Expect less income from the Roth IRA conversion ladder, and rely on additional sources of income in early retirement.

The Roth IRA conversion ladder is an excellent strategy to provide income during the early retirement years. But it only makes sense if you have the kind of retirement savings that will also provide a generous income when traditional retirement arrives.

Related Articles:

How And Why To Set Up A Roth IRA Conversion Ladder

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15 thoughts on “How And Why To Set Up A Roth IRA Conversion Ladder”

  1. My 401k is set up as a Roth 401K with a 4% match which I’ve been maxing out for years. This was before I thought about FI and was simply thinking I wanted my $ to be taken out tax free at 59.5. Now I’m wondering if I shouldn’t be doing the traditional 401K so I’m not hit with the taxes now and then do the conversion ladder later. I’ll be FI/RE in about 3-4 years but actually don’t plan on touching the funds for a long time since my wife will continue to work and make good $ for probably 10-15 years. My education on taxes is the area I’m lacking the most! Suggestions?

    • Switch if you can even if its just a few years. You can convert a lot more per year than the 6k per individual if you and your wife are defferring almost 40k a year in a traditional 401k. You can always start taking withdrawls from the roth 401k if you absolutely have to but hopefully you have enough in your taxable accounts to let that sucker grow as long as you can. People do the ladder because you are not taking big chunks, and if your post retirement income is low enough, you pay hardly any taxes on the conversions which can offset the fact your not letting it grow. It’s still worth doing even if its for a few years and could give you some extra income in 5 years post FI that could come in handy!

  2. Good refresher on Roth IRA conversion. I had previously read this in Madfientist and if I remember correctly in retire by 40. Also, I believe there is a minor error in the table, the value of ‘Roth IRA conversion amount’ should be zero from years 55 to 59 otherwise the amount will total to $600,000 converted

  3. Isn’t the conversion amount considered income? Using your example, it would be hard to remain in the 12% bracket while doing conversions of this size. Thus, an ideal time to do any Roth IRA conversion would be when you’re temporarily unemployed or working p/t. That’s what my situation is: I began a semi-retirement at age 58 earlier this spring but am still working p/t, which I plan to keep doing for several years at least. The p/t work should cover about 90% of my annual expenses. I hope to be able to top off my income near year’s end at the top of the 12% bracket with some Roth IRA conversions, but this won’t likely be a meaningful amount of money unless I bump myself into the 22% bracket.

    • Yes, it is indeed considered income. I agree with you and would only convert in lower-income years. I think a good rule of thumb is to have enough in passive income streams and liquid and non-qualified assets to meet your monetary needs the first several years of retirement so that you can indeed keep that earned income level low and take advantage of a lower tax bracket for the conversion.

  4. Hey guys, love the podcasts. One assumption people using this strategy should be aware of is thr ROTH rules could change or ROTH could cease to exist. Congress is always looking for more money. If that happened the tax consequences would be disastrous because all money is in tax deferred accounts. The Wealthy Accountant had mentioned his concern regarding how long Roths may be around also. Thanks for all the great podcasts!

  5. Can I do backdoor Roth if I have an existing IRA? I have my 401k in my ex-employers plan but want to move it to Vanguard. I am considering not doing so as because I think due to the “Aggregation Rule” I will be taxed on the entire IRA if I move it and still want to do backdoor roth. Any guidance will help. Thanks!!!

    • Since 401k and IRA are separate aggregations, a way to minimize taxes on converting a IRA is:
      1. move the pre-tax portion from IRA to 401k
      2. convert all of IRA
      3. delay rolling 401k to IRA until after Dec. 31 since Form 8606 uses Dec. 31 balance for prorate rule.

  6. Can I continue to convert my Traditional IRA to a Roth IRA from age 59.5 to age 70.5?

    All of the comments hint that conversion should take place prior to 59.5 as if conversions are only done by people who have retired early. however, if I have plenty of post-tax savings and retire at age 60, it seems like creating the ladder at age 60 to… 70, will still be advantageous, so that I can withdraw money tax-free at age 65, 66, 67, etc., and maybe after age 70.5 when RMDs kick in?

    Is there anything that would preclude that?

    Thank you

  7. Wouldn’t you want to start the conversion ladder in your first year of retirement rather than 5 years before? You’re likely within high income years those last 5 years and would be paying your marginal tax rate on those. If you’re going to do it 5 years before retirement, it would make just as much sense to do it 10 or 15 years before.

  8. Is the Roth conversion ladder irrelevant to people with 457 retirement accounts since the funds can be withdrawn just with taxes, no penalties, at time of withdrawal?

    • Emma, I have a 457(b). The answer to your question is: No. Hypothetically, if you’re earning 6% on average in your 457(b) but you could be earning 8% by having that same amount invested in nearly identical funds in an IRA, that would certainly be relevant. It could be the difference between being well off when you’re 65 or just remaining middle income.

      457(b)’s, like 401k’s, have management fees and limited investment options. The investment options themselves may have higher than average expense ratios (fees you pay for owning the mutual funds) because they work out a deal with your plan provider to be an option in your plan. If you wanted to buy shares of a stock, say Tesla or Amazon, in your 457(b), you most likely cannot. The 457(b) custodian gets to pick and choose the investment options that they offer and then they charge you fees every year, regardless of how good or bad your investments perform. What funds they offer are not offered because they are the best funds available to you. They are offered to you because the 457(b) provider can make money by offering it to you. 457(b) and 401k providers are for-profit BUSINESSES. They are in it to make money. Most people do not even know what the fees they pay just for having money in a workplace retirement account like a 457(b) or a 401k. A traditional or Roth IRA is self-directed and should have low or no management fees. You pick which mutual funds or stocks or commodities to buy and hold in your IRA’s. The IRA is like a regular brokerage account, but with special tax rules and benefits.

      If you will be taking regular withdrawals out of your 457(b) before age 59 1/2 and plan to deplete it pretty quickly, then you may be better off keeping your money there despite the lack of fund choices and management fees. But probably not. It depends. If you plan on leaving the bulk of the money in the account to grow for many years, it’s best left parked elsewhere where high expense ratios and management fees will not stunt your compound growth. In fact, depending on the fees and expenses in your 457(b), even paying a 10% early withdrawal penalty on small yearly withdrawal amounts from an IRA may actually allow you to have more money a long way down the road if the bulk of your investments left in the account grow at a greater rate without those high expense ratios and management fees in the 457(b).

      The drawback to converting your 457(b) to an IRA or Roth IRA is that you immediately lose the ability to withdraw money penalty free. But the benefit is that you get to invest in any and all stocks, mutual funds, etc. that exist and you pay little or no management fees. Tesla, Amazon, gold ETF’s, Vanguard funds with 0.04% expense ratios. The world is your oyster with your money in the IRA or Roth IRA. And with the Roth IRA, 5 years after converting, the value of that converted amount (but not the earnings/growth it has made) is yours to withdraw again penalty free, should you need it. Or it can stay there not being eaten away by fees and instead growing at a greater rate than it could likely achieve in your 457(b), year after year.

      Also, consider this: You don’t have to do one or the other – you can do both. As long as your 457(b) plan allows it, you can rollover only part of your 457(b) to a traditional IRA and leave some remaining in your 457(b). Then you can use the traditional IRA to do Roth conversions into a Roth IRA year after year and create the 5-year-waiting-period ladder referenced in this article. And during the 5-year waiting period while you wait for your Roth conversions to vest, you can make your living-expense withdrawals from what you left in your 457(b) while at the same time, a larger portion of your unconverted balance sits in your IRA invested in the investment vehicles you chose (with low expenses and not costing you anything in fees).

      In my opinion, when you are no longer working, it makes little to no sense to leave money parked in almost any 457(b) or 401k or any other workplace investment plan. Their fees and investment choice restrictions are only acceptable when weighed against their high annual contribution limits and potential employer matches and those are only good because they allow you to “overload” them every year during your working career when compared to the relatively low IRA contribution limit. Once you are not contributing to these workplace accounts, I would move my money into an account where I could invest it in lower cost securities with lower or no management expenses and fees.

      For more understanding of how fund expense ratios and management fees affect the growth of your nest egg, follow this link (or cut and paste it) to a calculator that allows you to look at the long-term cost of mutual fund expenses and management fees: https://www.dinkytown.net/java/compare-investment-fees.html . Type in your 457(b) account value as the starting amount, put in $0 as the annual contribution (as you won’t be contributing after you’ve left the job), and check out the hypothetical account values 20 years down the road when you pay 0.2% expenses (like in your own IRA) when compared to paying 1% or 2% in expenses and management fees (like in your 457(b)). It’s staggering.

      So the answer to your question regarding whether or not the Roth conversion ladder is irrelevant to people with 457(b) accounts? No. The answer in your particular situation depends on your individualized plans and goals and is something for which you will have to weigh the pros and cons to make the decisions that are best for you now, 5 years from now, and 20+ years down the road.

  9. Thanks for this article! I am having a hard time wrapping my brain around Roth conversion ladders and this was a great place to start.

    My main question relates to your phrase, “That’s a lot of capital to burn through before you even reach 60.” Why is this the case? Is there a requirement that I must withdraw the full $40,000 that I converted each year? While I am waiting for the 5 year period to expire, is it invested, and if so, where are those gains at the end of the 5 years (perhaps left out of your chart for simplicity?)? I assume they are also tax free since they happen post conversion, can you please confirm my understanding on this?

    I’m primarily interested in conversions for the purposes of avoiding RMDs. It is likely that my money will outlive me if I can keep it invested, and pass it in Roth form to any heirs. What are the possible pitfalls when using this strategy for that purpose that I should be aware of?

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