Roth Conversion Ladder

LAST REVIEWED May 01 2020 8 MIN READ

By The Human Interest Team

If you’re planning to retire early and are looking for the best way to hold on to more of your money, you may want to consider setting up a Roth conversion ladder. You’re probably aware that different retirement savings and investment options each come with their own sets of regulations regarding penalties and taxes involved in withdrawing your funds. A Roth IRA is an appealing option for those looking to begin withdrawing retirement funds even earlier than age 59 1/2 because this kind of account allows for tax-free and penalty-free withdrawals as soon as your funds have been in the Roth IRA account for five years.

In order to understand how a Roth Conversion Ladder can help you get set up for early retirement, let’s first look more closely at the advantages and disadvantages of saving your money in a Roth IRA or traditional 401(k).

Roth IRA vs. Traditional 401(k)

A traditional 401(k) is an excellent option for building up retirement savings because contributions to this kind of retirement account are made from your pre-tax income and are matched by your employer. You won’t pay any taxes on a traditional 401(k) until you begin withdrawing from it at age 59 1/2 or later. A Roth IRA, on the other hand, is an account that you can make contributions to with your post-tax income.

The main benefit of a Roth IRA is that you will pay no taxes on withdrawals made after age 59 1/2. Unfortunately, without a Roth conversion ladder, withdrawals from either type of retirement account before age 59 1/2 will incur a 10% penalty, making early retirement just a little less appealing.

How a Roth Conversion Ladder Can Help

A Roth ladder allows you to take advantage of the benefits of both a traditional 401(k) and a Roth IRA while also minimizing the penalties that usually come along with early retirement. Converting retirement investments to Roth IRA accounts has become a popular solution for retirement planning because of the obvious advantage of tax-free distributions after retirement.

When carefully planned and properly implemented, a Roth conversion ladder will allow you to withdraw your retirement funds tax-free and penalty-free even before the age of 59 1/2.

Roth IRA Conversion Ladder: What You Need to Know

As you begin converting funds from other types of retirement accounts, including traditional 401(k)s and tax-sheltered retirement plans, into a Roth IRA account, there are a few things to keep in mind about the Roth ladder strategy.

First, when you make the conversion to a Roth IRA, you are setting yourself up to be able to make tax-free withdrawals after the age of 59 1/2. Second, while moving your money to a Roth IRA, you will not have to pay the 10% early withdrawal penalty, even if you do the conversion before age 59 1/2.

It is important to note, though, that although there is no 10% penalty incurred during the conversion process, you will have to pay income tax on the amount converted during the year that the conversion is made. This is where the key benefit of the Roth conversion ladder becomes apparent.

How a Roth Conversion Ladder Saves You Money

In contrast to converting all your retirement accounts into a Roth IRA all at once, a Roth conversion ladder is a strategy that allows you to continue converting your retirement investments a little at a time, even after you retire and even if you retire at an early age. Because a Roth conversion ladder consists of a series of smaller conversions made consistently over time, the taxes paid on each conversion are much lower than the amount you would have to pay on a single large conversion made all at once.

Additionally, letting each conversion or small contribution to your Roth IRA stand on its own allows you to set up a series of future withdrawals that will fall outside of the five-year minimum waiting period, allowing you to continue taking advantage of distributions that are free from the 10% early withdrawal penalty.

Because a Roth conversion ladder saves you money on both taxes and withdrawal penalties, this strategy really does create a win-win situation.

Building a Roth Conversion Ladder

In order to take advantage of the tax-free, penalty-free benefits of withdrawals from your Roth conversion balances in early retirement, all it takes is a little planning ahead. Basically, if you can anticipate the amount of money you will need each year after you retire, you can begin converting that amount of money from other accounts into a Roth IRA five years in advance.

For example, if you plan to retire at the age of 45, and you anticipate that you would like to live on a budget of $50,000 per year, you might choose to begin “laddering” Roth conversions in that amount, beginning at age 40. Making annual Roth conversions of $50,000 from age 40 to age 45, you will set yourself up to begin making withdrawals from age 45 through age 59 1/2, the age at which you can begin taking penalty-free withdrawals from any of your retirement plans as well as tax-free withdrawals from the balance in your Roth IRA account at that time.

Balancing the Roth Conversion Ladder With Other Retirement Savings

The Roth conversion ladder can be a crucial money-saving step for investing for early retirement, and it should be considered part of a broader retirement savings plan that involves other sources of income that you will be able to access later in life. A Roth conversion ladder is designed to create a tax-free, penalty-free source of income for your early retirement, but if you deplete too much of your retirement savings through this strategy, you may not have adequate savings to support yourself later on during the traditional retirement period.

Whichever retirement plan is right for you, Human Interest can help you put it into action. Complete our online form and talk with one of our financial professionals to begin securing your future today.

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