Why the Roth Conversion Ladder Is a Game Changer for Early Retirees

Roth Conversion Ladder

Are you looking for a way to save money for retirement while minimizing taxes? Look no further than the Roth conversion ladder. This strategy allows you to reduce taxes when working and then move money from a traditional IRA or 401(k) into a Roth IRA over time while paying little to no taxes. It is an advanced technique gaining popularity among early retirees and savvy investors.

What Is a Roth Account

Americans can take advantage of tax-advantaged retirement accounts for their tax planning. By and large, most of these accounts have specific tax incentives.

  1. You deposit post-tax money into a Roth IRA account. Contributions are not tax-deductible.
  2. A Roth IRA is a retirement account that provides tax-free growth because the money you contribute is taxed before you deposit it.
  3. You can withdraw your contributions (but not earnings) without penalty or taxes at any time.
  4. In certain situations, you can withdraw funds from a Roth IRA, using them to purchase your first starter home or pay for qualified educational expenses.
  5. If you’re over 59½ years old and have had a Roth account for at least five years, any earnings you withdraw will not be subject to taxes or penalties. Because of the tax-free growth and tax-free withdrawal opportunities, the IRS has imposed contribution and income limits for the Roth IRA account.
  6. In 2023, the annual contribution limit is $6,500. These numbers adjust by inflation, so expect them to continue increasing. Furthermore, you can make additional contributions of $1,000 if you are over 50. A popular way for high-income earners to contribute more to the Roth IRA is via the Mega Backdoor Roth strategy.
  7. There are also annual income limits to prevent high-income earners from using the tax advantages of a Roth IRA. To contribute the full amount in 2023, your MAGI should be less than $138,000 if your tax filing status is single and $218,000 for married filing jointly. These numbers adjust by inflation, so expect them to continue increasing. Individuals who exceed the income limit for contributing to a Roth IRA can consider using the Backdoor Roth IRA strategy to fund one.

Advantages of a Roth IRA

To determine when I can retire, one of the most significant puzzles to solve is how much I need to retire using some of the free retirement calculators. You then need to ensure that any investments for monthly income provide almost the same amount every month with no variability.

Taxes are one of the biggest unknowns depending on the tax brackets during retirement and where you live in retirement. Some states are more favorable for retirement compared to others.

A Roth IRA is a tax-advantaged account that allows you to withdraw money tax-free and has a considerable advantage over IRAs or 401(k) accounts that require tax payment on the contribution and earnings. Of course, the Health Savings Account is still my favorite account because it is triple tax-advantaged.

If you have a High Deductible Health Plan (HDHP), consider Lively HSA which is free and has no hidden fees. Also, Lively won’t charge you any fees to roll over or transfer your HSA to them. You can move your full or partial balance directly to Lively from your existing provider. Lively will contact your previous provider and handle the transfer on your behalf.

In most cases, there are tax and other penalties for withdrawing early from these retirement accounts. Not only will you have to pay taxes on the money you withdraw from the account, but you will also have to pay a 10% penalty.

Despite all the advantages of a Roth IRA, it is still better to contribute to a Traditional 401(k) than the Roth 401 (k) accounts when your human capital is high and you are in the highest tax brackets. Tax-advantaged accounts work to reduce taxes even for a 7 figure salary.

What Is a Roth Conversion Ladder

A Roth Conversion Ladder is a specific tactic investors use to convert money from a pre-tax retirement account into a Roth account. For example, you can transfer the funds in another retirement account – like a 401k, IRA, or 403(b)- into your Roth IRA. The Roth IRA conversion allows you to get the benefits of a tax-free withdrawal on your Roth IRA.

Now, you may be thinking that this allows you to double dip: After all, a Roth Conversion Ladder may enable you to contribute AND a withdrawal tax-free. That isn’t the case: You must pay your ordinary income tax when converting. However, you will not have to pay the early withdrawal penalty.

In some situations, this Roth Conversion Ladder may work in your favor: You will still have to pay income tax, but depending on your situation, your income tax may be lower.

Roth IRA conversions are often advantageous in certain situations, like when paying an income tax now means you can avoid paying a higher one in the future.

As such, you can use a Roth IRA conversion to grow your retirement savings account while legally avoiding paying extensive taxes.

Is a Roth IRA Conversion Ladder Worth It

There are a few scenarios in which a Roth IRA conversion could truly work out in your favor, boost your retirement savings, and allow you to reduce your overall tax burden. If you want to reduce your income taxes or potentially retire early, a Roth IRA conversion can be a critical tool.

Tax Optimized Withdrawal

Converting from a traditional IRA to a Roth IRA will allow you to withdraw your money penalty-free. If you are new to retirement planning, you may be shocked to realize how much you pay in taxes, even on retirement accounts where growth occurs tax-free. Roth conversion ladders can enable you to reduce the taxes you pay substantially and help fund early retirement. You have greater control over the amount you convert each year and consequently on your tax bill.

Lower Required Minimum Distribution (RMD)

You also have to consider when required minimum distributions occur. Traditional IRAs have a required minimum distribution, meaning you must start withdrawing a minimum amount of money at 72 or 73, depending on when you were born. This can be a problem for some wealthier investors who want to leave money in their traditional IRAs for as long as possible.

Leaving money in an IRA for as long as possible makes sense, as investment growth occurs tax-free within such a retirement account. Once you withdraw it, you are taxed on any gains you may make, and you will lose a substantial portion of your investment gains to taxes.

Workaround for Stretch IRA Elimination

Unfortunately, the SECURE Act eliminated the Stretch IRA. The balance of inherited IRAs must be disbursed within ten years of the spouse’s death. For individuals who have a large 401(k) or IRA balance, the 10-year disbursement limit would bump their kids into a higher tax bracket. Unfortunately, SECURE Act 2.0 did not rectify the elimination of the Stretch IRA, so a Roth conversion ladder to reduce the IRA balance seems a better estate planning strategy.

However, if you use a Roth IRA conversion ladder, you do not have to make any minimum withdrawals. Investment gains and principal in Roth IRAs can be allowed to grow as long as possible, enabling wealthy individuals who don’t need the money to keep their growth going for an extended period. 

You can leave the money in the Roth IRA forever. Indeed, you can even allow your heirs to inherit the money, and while they may have to pay some estate taxes, the money will have grown tax-free. Of course, ensure you have a revocable living trust created in advance to avoid probate taxes.

Trust & Will provides state-specific trusts for the protection and transfer of your most important financial assets. You can also nominate legal guardians for your children to make sure they are looked after by someone you know and trust, in case something happens to you.

The Roth IRA conversion is critical for building generational wealth and preserving wealth. If you want to ensure you have as much money as possible to leave to your heirs, a Roth IRA conversion can be a critically important tool. Of course, this depends on your financial situation: The key benefit of any tax-deferred retirement tool is that YOU have the money, not your heirs.

Increase Roth IRA Retirement Savings

Finally, as noted above, a Roth IRA has income limits. Also, Roth IRA contributions are limited. However, using a Roth IRA conversion, you can transfer your wealth into a Roth IRA regardless of how much money you make.

There is no maximum amount for conversions to Roth IRAs. This means you can convert any amount you choose, $10,000 or $900,000, from your Traditional IRA to your Roth IRA in a single tax year or over several years.

What Are the Disadvantages of Roth Conversion Ladders

The above may make it seem like using a Roth IRA conversion ladder is the perfect strategy for you and your personal finances. There are undoubtedly many benefits to such a conversion. However, to be clear, there are always additional consequences that you need to consider.

Temporary Increase in Taxable Income

A Roth IRA conversion will temporarily result in more taxable income you will have to pay. This means less money for retirement and more money that you waste on taxes. Such a conversion may still work well for you, depending on your financial situation.

However, it ultimately comes down to whether or not you truly need the rollover. If you don’t need it, you could be wasting money. Furthermore, depending on the timing of the conversion, you may wind up losing money on social security benefits or hurting the ability of a loved one to get financial aid.

That being said, the reverse is also true: If you are not paying exceptionally high taxes at a given moment, it may be the perfect time to make such a conversion. This ultimately depends on your tax situation; timing is critical for a Roth IRA conversion.

Wait as long as you can before making the conversion. Doing so in your highest earning years may mean you are in the highest possible tax bracket, which means you lose more money. Waiting until you are in a lower tax bracket may mean that you can save more money.

Need Additional Income Sources During Five Year Waiting Period

You can take out your contributions from a Roth IRA anytime without facing taxes or penalties. However, keep in mind that Roth IRA conversions operate differently. They require a wait time of five years for each conversion. It means that each conversion is treated individually. If you withdraw the converted amount before the five-year waiting period has expired, the IRS will impose a 10% early withdrawal penalty.

So if you need to fund your lifestyle during the 5-year waiting period, you need additional sources of income. Assuming you are no longer working, you would need to rely on your taxable investments during the five-year waiting period. Although taxable accounts are not popular as retirement funds, they are versatile in their usage, and one should start contributing to them.

M1 Finance is the perfect investment platform for taxable accounts due to zero fees, very low minimums, automated investment with automatic rebalancing. The pre-built asset allocations and fractional shares helps one get started right away.

Additional Tracking Complexity

It would help if you tracked the contributions and timing of the conversions each year to optimize paying the least taxes. Many individuals may avoid the additional complexity and opt for accessing their IRA using simple IRS rules such as Substantially Equal Periodic Payments (SEPP) under section 72(t). A tax planning software can compute your marginal tax rate, so it is not a significant inconvenience but something to be aware of.

When To Start a Roth Conversion Ladder

You should begin a Roth conversion ladder at least five years before you expect to use the funds.

Since you will pay income tax on the converted amount in the year of conversion, there are two schools of thought for the timing of starting a Roth conversion ladder.

  1. Start the conversion ladder five years before you plan to retire early. The funds will be tax-free and penalty-free by the time you retire. To avoid paying excessive taxes and ease into early retirement, pick up a low-stress retirement job. Since the low-stress job pays less, you will be in a lower tax bracket to make the conversions. You can also opt for easy jobs that pay well and work part time.
  2. Start the conversion ladder after you retire. Since the converted funds are not accessible for five years, you must rely on your other investments for those five years. You may have rental property investments or fixed-income investments which can fund your retirement savings for five years.

As you can see from the above, specific timing considerations, come into play when deciding if and when to make such a tax conversion. However, it’s not just a matter of your tax bill. Critical life events can also create a significant difference when making such a tax conversion.

Lump Sum Payments

For example, let’s say you come into a windfall of money. This money can come from many sources, including the sale of a business, insurance payments, or death benefit policies. In that instance, you can accelerate the timing of your Roth IRA conversion and get your money into a Roth IRA in a faster timeframe than you would have otherwise. You may have a higher tax bill, but theoretically, you could use your lump sum payment to offset this tax bill. Furthermore, you could use the lump sum payment to contribute to charities or other tax deduction methods, potentially reducing your tax bill even further.

Market Downturns

It’s important to remember that market downturns can also be critical in your Roth conversion strategy. A market downturn reduces the value of your retirement portfolio. This reduced value will temporarily – and hopefully artificially – reduce the entire value of your portfolio, which will also reduce your tax bill. 

A market downturn may be the perfect moment to make a conversion, as it will allow you to have a reduced tax bill during this conversion.

Medicare Timing

Finally, consider making the conversion before you reach 65. When determining your overall premiums, Medicare considers your income from the past two years. Your premiums will be much higher if you convert between 63-65. If you are going to do a Roth IRA conversion, consider making such a conversion happen before 63, as you will avoid getting hit with higher premiums thanks to a temporarily high taxable income.

Once you reach 59.5 years old, you can withdraw money from your other tax-deferred retirement plans without being charged a penalty and only have to pay regular income tax. So ideally, you may not need to do Roth conversions unless you want to avoid RMDs.

How To Setup a Roth IRA Conversion Ladder

Setting up a Roth IRA Conversion Ladder has 3 steps.

  1. Roll over your previous employer’s 401(k) into a Traditional IRA. Ideally, it would help if you did this as soon as you leave your job.
  2. Calculate how much you need in retirement and what is your retirement date.
  3. Determine your Roth conversion ladder start date and amount to convert.

Assume you want to retire at 40 and need $40,000 annually for your living expenses. If you don’t have other income-producing assets, you should start building your Ladder at 35 by converting $40,000 from pre-tax accounts into a Roth IRA. So although you will pay higher taxes for the first five years of conversion, you have no other options. Remember that you’ll have to wait five years to withdraw each converted amount.

You can do a Roth IRA conversion of $40,000 every year until you turn 54. By doing this, you will have enough funds to cover you until the age of 59.5, after which you can withdraw from your Roth IRA without incurring taxes or penalties.

After 59.5, you can also directly withdraw from your tax-deferred accounts, such as IRAs and 401(k)s, without paying a penalty. You will need to pay taxes on your tax-deferred withdrawals since you never paid taxes on that money.

An example table demonstrates how you can build a Roth IRA conversion ladder.

YearAgeConversion AmountWithdrawal AmountSource of Funds
202840$40,000$40,0002023 conversion
202941$40,000$40,0002024 conversion
203042$40,000$40,0002025 conversion
203143$40,000$40,0002026 conversion
203244$40,000$40,0002027 conversion
203345$40,000$40,0002028 conversion
203446$40,000$40,0002029 conversion
203547$40,000$40,0002030 conversion
203648$40,000$40,0002031 conversion
203749$40,000$40,0002032 conversion
203850$40,000$40,0002033 conversion
203951$40,000$40,0002034 conversion
204052$40,000$40,0002035 conversion
204153$40,000$40,0002036 conversion
204254$40,000$40,0002037 conversion
204355$0$40,0002038 conversion
204456$0$40,0002039 conversion
204557$0$40,0002040 conversion
204658$0$40,0002041 conversion
204759$0$40,0002042 conversion
Example of a Roth IRA Conversion Ladder

How Does the Roth Conversion Ladder Work With Early Retirement

Using a Roth conversion ladder, you can avoid the significant fees for withdrawing funds early from retirement accounts like a 401(k) or IRA. If you withdraw from an IRA before the age of 59.5, you will face a 10% penalty in addition to taxes. However, if you convert your retirement funds to a Roth IRA, you can withdraw them without penalty after five years from the conversion date. This means that you can access your retirement funds earlier and enjoy financial independence

Converting to a Roth IRA will result in tax consequences. You will have to pay ordinary income tax rates for any retirement savings that are transferred from a tax-deferred retirement account into a Roth IRA during the year of the conversion.

For example, If you transfer $40,000 from an old 401(k) plan to a Roth IRA and are in the 12% tax bracket, you’ll owe $4,800 in federal income tax on the converted amount.

It is common for people to spread out the conversion of their traditional IRA to a Roth IRA over multiple years to reduce tax liability. This approach can lower their tax bracket and minimize the taxes owed during the conversion years.

Early retirement provides a sweet spot where your income is low for several years before RMDs and is ideal for planning the Roth conversions.

What Are the Best Practices for A Roth Conversion Ladder

When engaging in a Roth IRA conversion, remember a few things.

Plan for Taxes

First, such a conversion must be reported as income on your taxes. Doing so can result in a significant tax bill, as it may mean that you are transferring a substantial amount of income into your bank account. As a result, you may have to pay income tax that is much higher than what you would otherwise pay.

Get the Timing Right

Fortunately, there is a way around this: You can reduce your taxable income by making this transfer over a multi-year period. Doing so will help to reduce your overall tax bill. A multi-year conversion may be an excellent way of avoiding paying taxes on your conversion, particularly if you can structure the conversion so that it keeps you out of a higher tax bracket.

Doing these conversions will allow you to accomplish the same ultimate goal – make tax-free withdrawals – even at a slower pace. 

Consider Tax Deductions

Furthermore, if you are examining a conversion, do so at a time when you are already getting a heavy amount of deductions, thus reducing your overall tax bill. You can take advantage of this period and make more extensive contributions to your Roth IRA conversion than you would otherwise. This will eat into your tax deductions but allow you to convert more without paying more taxes.

Maximize the Tax Bracket

Make the conversion at the end of the year, and max out whatever tax bracket you are in. 

Stay Flexible and Consider All Income Sources

You do not have to convert the same amount annually or even convert each year. Depending on your tax situation, you have flexibility in the amount and timing of conversions. For example, you might have opted for a deferred compensation plan and receive monthly income starting at 50.

Why Not Just Contribute Annually to a Roth IRA

Contributing to a Roth IRA does not decrease your adjusted gross income (AGI), unlike contributing to a traditional IRA or 401k, which can provide tax benefits. You should always max out your 401(k) or contribute to an IRA.

Also, for individuals pursuing financial independence, having funds in a taxable brokerage account to be withdrawn for any emergency provides greater flexibility.

And Roth IRA has income and contribution limits, as mentioned earlier, making it harder to have a substantial balance.

With all that said, if you have already maxed out your tax-deferred accounts, have a sizeable taxable brokerage account, and adequate emergency fund, contribute to the Roth IRA.

But remember the principles of diversification. Most of these accounts would be highly biased toward stock investing. There are several alternative investments, including real estate investments which one can explore based on your investment goals and risk tolerance.

Will the Government Remove the Roth IRA Conversion

It is, of course, impossible to say what policymakers will do in the future. However, a Roth IRA conversion is seen by many in Washington as a way that wealthy individuals manipulate the system to benefit their finances at the taxpayers’ expense. As such, there are periodic attempts to eliminate the ability of wealthy individuals to use the Roth IRA conversion to fund their retirements.

Indeed, there have been efforts – mainly by President Biden and Congressional Democrats – to remove the Roth IRA Conversion Ladder as late as 2021 in the Build Back Better bill. The argument has been that the wealthy use a scheme to avoid paying taxes. However, thus far, those efforts have been unsuccessful.

Despite the passage of multiple tax acts over the past two years, Congressional Democrats have been unable to remove the Roth IRA Conversion from the tax code, meaning it is still available for the foreseeable future. That’s not to say that it always will be available, and there can always be political or policy changes from the federal or state government that eliminates these conversions. Thus far, those have yet to happen.

All of this being said, you want to make sure that you are paying attention to changes in the tax law or at least working with a financial advisor who has their ear to the ground in this area. There is no question that changes to the tax code are among the few constants of policy changes in Washington.

It is in your interest to monitor these changes and alter your retirement savings accordingly. As noted above, the Roth IRA tax conversion has, thus far, survived attempts to eliminate it due to the lack of votes favoring the Democrats. However, in case of a successful effort, consider altering your conversion strategy, as doing so may allow you to get ahead of any potential changes to federal policy.

So, Is a Roth IRA Tax Conversion Right for Me

As you can see, this fundamental question has no set answer. Loopholes in the American taxation system may give you a significant tax break and better prepare for your retirement via a Roth IRA tax conversion. That’s not to say that such a conversion is for everyone, and there are critical financial landmines to consider when examining the possibility of such a tax conversion.

If you are already 55, you can retire early by directly accessing your 401(k). But for younger early retirees, a Roth IRA conversion can help you reduce your tax bill and potentially retire early.

I am using the Roth Conversion ladder to fund my early retirement as an early retiree. At the start of the year, I estimate my tax liability and decide how much I want to convert while staying in the lowest tax bracket.

Of course, I might have a surprise, such as one of my moonshot stocks or cryptocurrency investments exploding higher, in which case I might skip the Roth Conversion for that year as these events would push me into a higher tax bracket.

Else I would do the Roth Conversion in December, providing yearly expenses for the following year.

When making a significant financial decision, you should research and ensure that you get this decision right.

How you structure any conversion is critical in retirement planning and keeping your tax bill as low as possible, so you will want to work with a financial expert to ensure that you get this conversion right.

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  1. Thanks for the article! I’d really love to understand some of the considerations when deciding to rollover a Roth 401(k) to a Roth IRA for early retirement. Does most of the article apply also to rollovers from a Roth 401(k)? Are rollovers also “conversions” but just without the tax consequences in the year they are done?

    I also have the option to go the other way, from Roth IRA to Roth 401(k). I think it more advantageous to have the funds in the IRA, since I can avoid withdrawing earnings. But how are “earnings” defined when rollover funds are involved?

    I’ve got a substantial portion in a Roth IRA from a previous employer’s Roth 401(k), already in there 5 years, and I’m wondering how much I can take out tax and penalty free! (Shoot, maybe I could retire tomorrow.) I would love to hear your thoughts. I also have a current Roth 401(k) that permits in-service withdrawals so maybe I could use this strategy with that account instead of a Trad 401(k)?

    I am faced with a ticking 5 year clock and not sure what to do. I could take out loans from the Roth 401(k), but then there’s UBIT, and the low limits. And I also have to decide going forward where to contribute matching contributions, Roth or Traditional. I would love to year your thoughts on options for using a Roth 401(k) to best advantage for early retirement.

    1. Thank you Fuse. Let me start by saying that I am not a licensed professional and you should always consult a licensed professional for tax and investment advice.

      The article is written for converting from a traditional IRA to a Roth IRA. The tax advantage is utilizing the tax break during the working years by contributing to your traditional 401(k). Then relying on your “low-income years” just prior to retirement or after retirement to do the conversions when you are in a low tax bracket. Finally enjoy the tax free Roth benefits after 5 years.

      It is interesting that you have a substantial portion in your Roth IRA. Personally I always prefer the traditional 401(k) over the Roth 401(k). My thoughts on this topic are at https://financialfreedomcountdown.com/roth-401k-vs-traditional-401k/
      Not sure of your age and financial situation where the two edge cases apply, which might make Roth 401(k) better than Traditional 401(k)?
      You can always switch future contributions now to take advantage of Traditional.

      If your current Roth 401(k) has an option of in-service withdrawal you could also look into contributing $22,500 to your traditional 401(k) limits to take the tax benefits and then using the excess contributions of $43,500 as non-deductible which can be rolled over by in-service withdrawals to the Roth bucket.

      On the bright side since most of your funds are already in a Roth format you do not need to apply the hair cut of taxes when deciding if your nest egg is enough to retire. Calculate how much you need for living expenses and then decide if you are good to retire tomorrow.
      You did mention UBIT so are you planning to use the funds to invest in an active trade or business?

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