Roth IRAs come with different rules than traditional IRAs. And savvy investors can take advantage of those differences to pull off several neat tricks.
One of those tricks? Using your individual retirement accounts before age 59 ½, the “official” minimum age for tapping into them.
But tax rules get complicated quickly, and you need to know what you’re doing if you don’t want the IRS rap-tap-tapping on your door. Although you don’t need a CPA certification to use a Roth conversion ladder, you do need to understand the rules and the process from start to finish.
What Is the Roth Conversion Ladder Strategy?
If you withdraw money from a traditional IRA before age 59 ½, the IRS hits you with a 10% early withdrawal penalty and makes you pay taxes on it. Hard stop.
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But Roth IRAs offer a little more leeway. You can withdraw contributions at any time tax-free, and if you convert (transfer) funds from a traditional retirement account such as an IRA or 401(k) to your Roth IRA, you can access those funds early too. With caveats, of course — this is the IRS we’re talking about, and they don’t make anything simple.
The IRS requires those converted funds to stay in your Roth IRA for at least five years, or they hit you with a penalty. That means you need to plan ahead if you want to pull out those converted funds before age 59 ½, transferring money over at least five years in advance.
But converting funds from a traditional retirement account to a Roth account is what accountants call a “taxable event.” In normalspeak, that means you owe income taxes on the money you move from a traditional account to a Roth account. And not at the lower capital gains tax rate either — you owe taxes at your ordinary income tax rate.
So you need to be careful how much you convert in a single year, so Uncle Sam doesn’t bankrupt you with taxes.
Enter: the Roth conversion ladder strategy. Over the course of several years, you gradually move money from your traditional retirement accounts to your Roth accounts, so that when the time comes, you can yank them out tax- and penalty-free.
How a Roth Conversion Ladder Works
If that overview left you with questions, well, you’re not alone. The strategy hinges on several tax rules, and you need to understand them all for the big picture to make sense.
Roth IRA Contribution & Income Limits
You can only contribute up to $6,000 per year in IRAs ($7,000 if you’re over 50 and qualify for the extra $1,000 catch-up contribution). That’s a combined limit for both Roth and traditional IRAs.
It’s hard to get rich investing just $6,000 per year unless you start as a teenager. However, employer-sponsored retirement plans such as 401(k)s, 403(b)s, TSPs, and SIMPLE IRAs allow higher contribution limits each year. Self-employed people can also contribute hefty amounts through SEP IRAs or solo 401(k)s.
If you contributed tens of thousands each year to one of these employer retirement plans, you can roll those funds over to your Roth IRA at any time.
Roth IRA Conversion
When you roll over money from a traditional workplace retirement account to a Roth IRA, you owe taxes on it. That’s because you didn’t pay taxes on the original contribution, it being deductible. The exception is if you contributed to a Roth 401(k) or Roth 403(b), in which case you already paid taxes on contributions.
That’s the bad news. The good news is that once in your Roth IRA, your contributions start compounding and growing tax-free. You’ll never owe another cent in taxes on the money in the account, assuming you don’t break the early withdrawal rules.
Laddering for Penalty-Free Early Withdrawals
Remember, although you can withdraw direct contributions to your Roth IRA any time penalty- and tax-free, you have to wait five years to withdraw rollover transfers.
Imagine you want to retire early five years from now and use $30,000 from your Roth IRA to help cover your living expenses. To pave the way, you roll over $30,000 from your employer retirement account to your Roth IRA this year, so that it will have sat in the account the requisite five years before you withdraw it.
Why $30,000, and not just roll over your entire balance now? Because you’ll owe income taxes on every dollar you roll over to your Roth IRA. If you have $150,000 in your workplace retirement account and you transferred all of it at once, you’d owe taxes on that entire amount plus all your other income. It would almost certainly drive you into a higher tax bracket.
So instead, you transfer $30,000 each year for the next five years. Five years from now, you can pull out the first $30,000 — the one you transferred this year. Each year thereafter, you can pull out another $30,000, because each conversion will have sat in the account for the mandatory five years.
How to Set Up a Roth IRA Conversion Ladder for Early Retirement Funds
Each time you convert funds from your traditional retirement account to your Roth IRA, that converted money must sit at least five years.
That means you have to plan at least five years in advance. Before you do anything else, set a target retirement date. Whether you’re aiming for extreme early retirement or to retire just a year or two before turning 59 ½, you need a timetable to work with.
Next, plan out how much you want to pull out in Roth IRA withdrawals each year between retiring and reaching age 59 ½. You can reduce the amount of money you need to take from your Roth IRA each year by combining other sources of income, from passive income streams to side hustles to semi-retirement gigs.
Then check how much you have in your Roth IRA currently. You don’t necessarily need to convert every dollar you plan to withdraw before reaching 59 ½ — you only need to convert the amount that you think you’ll be short.
Confused? Let’s illustrate how it works with an example.
Sample Roth Conversion Ladder
Say you’ve contributed $50,000 to your Roth IRA to date. You’re 48 now, you plan to retire at age 53, and you want to withdraw $30,000 in each of the six years before you reach 59 ½ and can withdraw money penalty-free from your Roth IRA.
So, you need $180,000 in combined contributions and converted funds, but you only have $50,000. That makes you $130,000 short (ignoring the returns you’ll earn between now and when you start withdrawing funds, for the sake of simplicity).
Because you want to start withdrawing money in five years, you should make your first conversion this year. For each of the next six years, you convert $21,667 from your workplace retirement account to your Roth IRA ($130,000 divided by six years equals $21,667). You pay income taxes on this $21,667 each year.
In five years from now, at age 53, you can withdraw your first $30,000 from your Roth IRA tax- and penalty-free. That same year, you’ll continue to convert $21,667 from your traditional account to your Roth IRA, to cover your withdrawal at age 58.
You’ll do the same thing the following year at age 54, but that’s the last year you’ll have to convert funds. After that, the five year rule no longer matters, because at 59 ½ you can withdraw the money penalty-free anyway. From that age onward, you can just withdraw money without having to keep converting funds.
As a final twist, imagine that you’re 49 instead of 48, and you want to retire in four years rather than five. You could still do it in this example, because you already have $50,000 in your Roth IRA that you directly contributed. So your first year in retirement, you could pull out $30,000 and not exceed the money you contributed. You still need to start converting money immediately, however, to cover your withdrawals five years from now.
Pros & Cons of Roth Conversion Ladders
Like every other financial strategy, Roth conversion ladders have their upsides and drawbacks. Make sure you understand both before starting any financial gymnastics.
Why do people do Roth conversion ladders?
- Avoid Penalties on Early Withdrawals. If you plan on retiring before 59 ½ and most of your savings is tied up in tax-deferred retirement accounts, you’d owe a 10% penalty on any money you withdraw early. By moving money to your Roth IRA, you can sidestep that penalty.
- Tax-Free Compounding. Between when you convert funds and when you retire, those funds compound and grow tax-free. Tax-free withdrawals also reduce how much you need saved for retirement. In contrast, you’ll owe taxes on withdrawals from your traditional retirement accounts once you retire, so Uncle Sam gets a cut of your compounded returns.
- No RMDs. You don’t have to take required minimum distributions (RMDs) from your Roth IRA, unlike traditional retirement accounts. In fact, you can leave it compounding for tax-free growth if you like and pass it on to your heirs in your estate plan.
- Available to High Earners. Roth IRAs come with income limits on contributions. However, high earners can use the backdoor Roth loophole to contribute money to a traditional IRA then convert it to their Roth IRA, dodging the income ceiling. More on this shortly.
There’s no free lunch, even when you pull off a clever stunt like a Roth conversion ladder. Watch out for these downsides when attempting this maneuver.
- You Owe Taxes Now. You owe income taxes this year on every dollar you convert from a traditional account to your Roth IRA. Converted funds get treated like all the rest of your taxable income, adding to your tax bill. In fact, the IRS expects you to prepay estimated taxes on Roth conversions when you do them, rather than waiting until you file your tax return. Fail to do so and you risk penalties.
- Potentially Higher Tax Bracket. Your tax rate may be higher than you’re used to on your earned income, too. A higher taxable income might push you into a higher income tax bracket, where you pay a higher rate on the converted amount than you’re used to paying.
- Advance Planning Required. Because the tax code imposes a five-year waiting period before you can withdraw converted funds penalty-free, you have to plan your retirement withdrawals years in advance.
- Complexity. Roth conversions can get complicated. You may need an accountant’s help to avoid blunders.
Should You Create a Roth IRA Conversion Ladder?
If you aim to reach financial independence and retire early, a Roth conversion ladder lets you tap into your tax-deferred retirement funds before age 59 ½.
But for it to make sense, you need either significant funds in a traditional retirement account or the ability to contribute large sums moving forward. If you don’t have much money in traditional accounts currently and don’t have access to an employer retirement account with high contribution limits, then you don’t have much to gain with a Roth conversion ladder.
Bear in mind that you need your retirement nest egg to last you until you die, not just until reaching 59 ½ or until you start collecting Social Security benefits. Sure, it’s great to maximize your tax-sheltered retirement contributions, but you might need more money saved for retirement than what you can contribute to tax-advantaged accounts.
Which means you likely need other investments, such as taxable brokerage accounts or real estate investments. And in that case, you may not need to tap your retirement accounts before the retirement age of 59 ½ — you can pull enough money from your other investments to last until then.
Finally, compare your tax rate now to your expected tax rate in retirement. If you think taxes will go up (a sadly reliable bet), or if you think you will personally be taxed at higher rates in the future, it often makes sense to bite the bullet and pay taxes now rather than in retirement. Young people in particular should consider this, especially given how long their retirement investments have to compound.
When in doubt, talk to a financial advisor to help you form a personalized plan for tackling retirement.
Roth IRA Conversion Ladder FAQs
What Is a Backdoor Roth IRA?
A backdoor Roth IRA contribution involves first contributing to a traditional IRA or workplace plan, then converting the money to your Roth IRA.
Why add the extra step? Because you can’t contribute to a Roth IRA if you earn too much. In 2022, your ability starts to phase out if you earn more than $129,000 ($204,000 for married couples filing jointly). By contrast, you can contribute to a traditional IRA no matter how much you earn however — the income limit on traditional IRAs applies to deducting the contribution, not making it.
Is There a Limit to How Much I Can Convert Into a Roth IRA Account?
There’s no limit on Roth conversion amounts per se, but you’ll hit other speed bumps.
First, you can only convert funds that you already contributed to a traditional retirement account. And while contribution limits vary by account, every account does impose annual limits on contributions.
Second, you have to pay federal income taxes immediately on money you convert from a traditional to a Roth account. Convert too much money in a single year and you’ll owe an enormous tax bill, and possibly drive yourself into a higher tax bracket.
How Is a Roth IRA Conversion Taxed?
Amounts you transfer from a traditional to a Roth account get taxed as part of your regular income for the year. For example, if you otherwise have an adjusted gross income of $80,000 and you convert $20,000 to your Roth IRA, the IRS taxes you on $100,000 of income.
The one difference is that you owe the taxes immediately upon converting the funds, and the IRS expects you to make an estimated tax payment to cover it.
Does a Roth Conversion Ladder Work With a Roth 401(k) Retirement Account?
Yes, you can roll money over from a traditional 401(k) to a Roth 401(k), but most people prefer Roth IRAs. You get to choose the brokerage, you get complete control over investments, the account isn’t tied to your employer, and you don’t have to take RMDs.
When Should I Start a Roth IRA Conversion Ladder?
Start a Roth conversion ladder at least five years before you plan to retire to satisfy the five-year rule. Ideally, spread your Roth IRA conversions over as many years as you can in order to minimize your taxes in each year that you convert money.
Roth IRAs offer the most flexibility of any retirement account.
You can open them with any brokerage (including robo-advisors) and invest in anything you like. You don’t have to move funds when you change jobs, and you don’t have to take RMDs. Roth IRAs also come with some unique rules, allowing you to withdraw funds early penalty-free for costs like college tuition or buying a home.
I started gradually moving my money over from my traditional IRA to my Roth IRA, especially when the market takes a nosedive. I plan on continuing to do so until I’ve emptied my traditional IRA entirely. But you have different personal finance needs than I do, so speak with a financial planner or accountant before converting your own retirement savings.