Roth Conversion Ladders for Early Retirement

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Have you ever wondered how to access your retirement accounts before traditional retirement (age 59 1/2) without paying the IRS a penalty? Roth conversions can be a great way to build a tax and penalty free balance accessible to you in early retirement. Since Roth contributions are not reversible and the IRS requires tax payments on any amounts converted in a given year, I will lay what you should consider before executing a conversion. This will help ensure you make the best decision possible on when and how much to convert. I will also break down the daunting Roth Conversion Ladder and give tips to make them more approachable. First, a refresher on the basics of Roth IRAs might be helpful before you dive in.

Why is the Roth IRA beneficial in early retirement?

• Access to prior contributions (principal) penalty free – that means no 10% IRS penalty will be paid on withdrawals as long as as they withdrawn 5 years after contribution).
• Access to prior contributions (principal) tax-free – since taxes were paid when you converted from Traditional to Roth, the money can be removed tax-free later.
• Investment earnings grow tax-free (dividends and capital gain within the account do not add to taxable income each year).
• Flexibility: When used strategically, Roth IRAs can help control your total taxable income during withdrawal years (and therefore your highest tax rate paid in a given year). A popular visual aid for explaining the value of flexibility in tax planning is The Tax Control Triangle This idea is a part of the philosophy of tax diversification, a strategy for thinking long-term about reducing taxes rather than just during the current year. Tax diversification will lower taxes throughout your lifetime.

Roth Conversions

Roth Conversions are a tactic that help you contribute to a Roth IRA. Because there are annual contribution limits and income limits on Roth IRA contributions, those wanting to accumulate larger Roth IRA balances (and Roth IRA contribution balances) may want to consider conversions at opportune points in their lives.

A conversion is executed by moving funds from a Traditional (pre-tax) retirement account into a Roth IRA. Depending on your workplace retirement plan rules (if they allow “in-service distributions“) and whether you still have funds sitting in a prior employer retirement accounts or a Traditional IRA, you may need to move funds from a workplace plan to a Traditional IRA first (a non-taxable rollover), then over to the Roth IRA. If you already have funds in a Traditional IRA, then just one transaction will be necessary from Traditional IRA to your Roth IRA. Most of the major brokerage houses allow you to convert through the click of a couple of buttons. You also may be able to move actual shares of securities (rather than cash) between your Traditional and Roth accounts for your conversion (this can be beneficial if you would pay a fee to sell shares).

Considerations for a successful conversion:

Make sure you’ve gone through these questions and are satisfied with your answers before converting. Remember, conversions cannot be undone!

• What’s your current marginal (highest) tax rate?
• How much you will spend each year in retirement?
• Will a conversion save you taxes (i.e. What are your estimated future effective and marginal tax rates)?
• What’s the optimal amount to convert (given the answers to the above questions)?

Tax Consequences

In the tax year the conversion takes place you will be required to pay taxes on the amount you converted from your Traditional to your Roth IRA. Your brokerage will give you a form 1099-R showing the amount converted that you will need to report on your taxes. The transaction is not reversible! A best practice is to have the money available to pay the taxes on the conversion from a non-retirement account or current year earnings.

Roth Conversion Ladder

The conversion ladder is a multi-year Roth conversion strategy that creates tiers of tax/penalty free money that will be available for later years. The reason to complete a ladder strategy over multiple years rather than just “one and done” is in order to avoid taxes at higher rates. As taxable income increases over income thresholds (tax brackets) in a given year, that income is taxed at a higher rate (a marginal tax rate).

The Roth Conversion 5 year rule is important to consider when planning Roth conversion ladders. The 5- year rule states that amounts converted from a Traditional IRA over to a Roth IRA have to remain in the Roth IRA for 5 years before they can be withdrawn penalty-free. You therefore should take this rule into consideration when planning your conversion ladder and future Roth IRA distributions.

Rules for Successful Roth Conversions

1. Convert at the lowest tax rate possible (during low earning years and 2022- 2025 due to lower tax rates provided by the Tax Cut and Jobs Act)
2. As early as possible: this allows a longer time for your money to compound and grow in your Roth IRA – which means more tax-free money in the future.
3. During a recession or correction: “Converting on sale”. While we never know how long a market contraction might be, if your general belief is that the market will increase over the long-term then converting when the market has a downturn can result in your conversion having a greater opportunity for growth than converting during a bull market. Please keep in mind that waiting for a recession to convert is market timing. To avoid market timing, the best approach will generally be #2 above which is as early as possible.

Who’s an Ideal Candidate for Roth Conversions or Ladders?

The best candidates have not accumulated significant Roth IRA balances or significant contribution balances to their account. This can be because you’re relatively young, you’re a higher earner and are ineligible for Roth IRA contributions or back door contributions, or you started investing in your Roth IRA later in life. Other cases follow:

• Most of your wealth in Pre-tax retirement accounts.
• You have a year with lower earnings: you take a sabbatical, are in school, are caring for family, etc.
• Recently retired – living on savings and non-qualified investments and want to create Roth IRA funds funds for later
• You’re in your 60s and wanting reduce your RMDs

Roth Conversion Ladder Example

John is single and plans to retire in 5 years at the age of 40 and wants to be able to spend $30k per year in retirement.  John has decided that he’d like to have $21k each year available from his Roth IRA tax free and he’ll take his remaining $9k from savings and his non-qualified investments. John will complete the following conversion ladder:

• Roth conversions of $15K for each of the next 5 years. He’ll also continue to make his $6k annual Roth contribution as well. With the $15k conversion and $6k regular contributions he will have $21k available to spend in the future. For simplicity I assume John’s Roth IRA has been open for 5 years even though he didn’t make contributions until 2022. There is a separate 5 year rule for Roth contributions that funds can only be withdrawn penalty free if the account has been open for 5 years.
• With conversions of $15k, he will pay a lower tax on the amount converted at 22% compared to the 25% tax rate he’d pay during early retirement by paying the penalty plus 15% tax. In the final year, 2026 John may need to do some tax planning (contributing to his pre-tax 401k or taking a smaller conversion) to avoid pay tax at the 25% tax rate on a portion of his conversion since that is the year tax rates will reset. 
• After retirement he can ratchet conversions up to $30-40k to convert for use in later years if appropriate.