If you’ve dreamt about early retirement, then you may have heard of a Roth IRA conversion ladder as one way to provide income. But what does this entail and how do you know whether it’s right for you?
If your retirement plans include retiring early, and you want to access some of your hard-earned savings without paying taxes on withdrawals or paying early withdrawal penalties, then you’ll want to understand the Roth IRA conversion ladder.
Roth IRA: The Basics
As you probably know, there are multiple types of IRAs (investment retirement accounts). A Roth IRA is one type that provides tax advantages via tax-free growth and withdrawals. You make contributions with after-tax funds that aren’t tax deductible, and those contributions can be up to $6,000 (unless you’re older than 50, in which case you can contribute up to $7,000, thanks to catch-up contributions).
And here’s another tax benefit of a Roth: If you’re at least 59 ½ years old and you’ve held your account for five years or more, you may take distributions without paying federal income tax.
What is a Roth IRA Conversion?
This means moving money from a tax-deferred account, such as a traditional IRA or 401(k), into a Roth IRA. In other words, you’re converting funds from one account to another.
At the time of conversion, you’ll be required to pay tax on the amount that you convert, but only at your marginal tax rate.
What is a Roth conversion ladder?
This strategic approach to conversion involves converting only a portion of your retirement savings each year and putting it into a Roth IRA account (as opposed to converting the entirety of your savings all at once).
There are two reasons this strategy can be a good one, and they both involve keeping more of the money you’ve worked so hard to save in your retirement plans.
First, if you were to convert everything at once, you’ll effectively increase your marginal tax rate, and pay more in taxes. When you only convert the minimum amount necessary to stay below that marginal rate, you’ll pay as little in taxes as possible.
Second, there is a rule specific to Roth IRAs which requires a five-year waiting period between conversion and withdrawing your money. If you fail to observe the five-year waiting period, you’ll pay income tax plus a 10% early withdrawal penalty.
Here’s why you can use a Roth IRA conversion ladder to fund early retirement:
Roth IRAs have a certain loophole that no other retirement account has: Because Roth IRA contributions aren’t tax-deductible, you can withdraw money tax-free even before you turn 59 ½.
This creates an opportunity for tax-free income that can fund early retirement. Note that for this option to make sense, you will need to have ample retirement savings for the income you need for the rest of your life.
Here’s an example of what this would look like:
Let’s say you have a traditional IRA and you are under age 59 ½, so you can’t take money out of that traditional IRA without incurring a penalty.
Instead, you’ll convert some of the funds from your traditional IRA to a Roth. How much you’ll convert depends on what you’ll need five years from now (adjusted for inflation), plus how much you can convert tax-free (without bumping yourself up to the next tax bracket).
Next, wait five years. In five years, you can begin drawing from the principal of that first “rung” of your conversion ladder. In the meantime, you’ll continue building your ladder by converting an additional chunk each year from your traditional IRA to your Roth.
The majority of your savings that’s in your traditional IRA will continue to grow, while you use five-year-old Roth principal to cover your expenses. Once you reach 59 ½ years old, you can start spending the gains in your Roth IRA without incurring a penalty.
So, is this option the right one for you?
Whether or not you should use a Roth IRA conversion ladder to fund early retirement will depend on a number of factors. Talk to your financial advisor to discuss early retirement planning and which strategies may be best for you.
Would you like to learn more about strategies for early retirement? The wealth advisors at Ironwood Wealth Management can help you create a comprehensive financial plan for every phase of your journey. Contact us today.