Building a Roth Conversion Ladder

If you’ve invested in a tax-deferred retirement savings account such as a traditional IRA or a 401(k), you might be interested in learning more about a Roth conversion ladder. This will allow you to convert your money into a Roth IRA without incurring any penalty. Sounds pretty amazing, right?


There’s no catch. However, it is wise to follow proper procedures in order to make the successful conversion of funds. We’ll show you what you need to know so that you can decide whether to build a Roth conversion or not.

A Roth Conversion Ladder is a way to move your money from a tax-deferred account, such as a 401(k) or traditional IRA, into a Roth IRA. You can then withdraw the funds from your Roth IRA after only five years.

What is a 401(k) and a Traditional IRA?

A 401(k) account is a company-sponsored retirement account that as an employee, you can contribute to retirement savings. With this type of retirement plan, you will have special tax benefits under IRS guidelines but also limitations to your contributions. Your investment is sometimes matched by your employer and is invested into a variety of mutual funds. 401(k) funds cannot be withdrawn until retirement without penalties.

A traditional IRA is an extremely common investment account and uses your individual pre-tax income to put away for retirement. Essentially, you purchase this IRA via a bank or brokerage and your earnings grow tax-free and the contributions are tax-deductible. Funds can be withdrawn at any time, but it is wise to wait until retirement due to a tax penalty for early withdrawal. Once you withdraw the money, you are subject to income tax and withdrawal rules.

Is a Roth IRA better?

A Roth IRA is a special retirement account where you pay taxes as you save, and then all withdrawals are tax-free. This can be beneficial if you think your taxes will be higher when you retire. You should know that you are limited to contributions to a Roth IRA.

Like a traditional IRA, if you withdraw earlier In a Roth IRA, you can save up for retirement and can withdraw from your account after the age of 59 and a half. In the case that you do withdraw from your account before the given age, you will be liable to pay a 10% penalty on your savings. There are only a few exceptions to this rule, for example, if you withdraw up to $10,000 for housing or medical bills.

A major advantage that a Roth IRA has over a traditional IRA is that withdrawals are not mandatory. Traditional IRAs, you have to make a minimum withdrawal amount after the age of 72. However, there is no such restriction for a Roth IRA. 

As far as the tax system is concerned, contributions to a Roth IRA are taxed at the account holder’s current income. Another great advantage that a Roth IRA has over any other retirement plan is that because contributions are already taxed, withdrawals are tax free – even if you make a withdrawal earlier than the specified age. However, there is a limit to these withdrawals after which you will incur a penalty of 10%. The only disadvantage of a Roth IRA is that you are liable to pay income tax before retirement. 

Why Would I Use a Roth Conversion Ladder?

Suppose you decide to retire early but this was not the plan before and you invested in a traditional IRA. What you can do is start a conversion from your traditional IRA and shift to a Roth IRA. Every transaction that you make is applicable to tax. Suppose you were 50 when you created the Roth IRA. By the age of 55, you will be able to retire and start making withdrawals. You will only be taxed on the conversions, not on the money that you withdraw. After that, you are only subject to income tax if you do not retire. 

How Do I Build a Roth Conversion Ladder?

There are four simple steps that you need to follow if you want a Roth IRA: 

  1. If you own a 401k, you cannot directly transfer your funds into a Roth IRA. First, you will have to roll over your 401k into a traditional IRA. 
  2. Once you have a traditional IRA, begin transferring your funds into a Roth IRA. Make sure to convert the amount that you will need in 5 years so that you can withdraw it by that time. 
  3. Wait for 5 years – If you have made a conversion from a traditional IRA to a Roth IRA, then you will have to wait out the 5 years in order to avoid the penalty. 
  4. Withdraw the money – If you reach the age of 59 and a half before the 5 year period ends, you can also withdraw your money then. You are not liable to make withdrawals, but you can as soon as the waiting period ends as per your needs. 

Conclusion

If you’re debating about whether to build a Roth conversion ladder, then you should know that it is best to switch only if you move from a low-income group to a high-income group. This is because a Roth IRA allows you to take advantage of tax benefits in the future which is more beneficial for those with higher income. Plus, you will still be able to access your funds even if you decide to retire early. However, make sure you don’t put all your eggs in one basket. Make sure you have other investment options to lean on in case one does not pan out.