Roth IRA Conversion Ladder: Ultimate Tax Hack for Early Retirees?

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You might have heard that the secret to early retirement is to set up a “Roth conversion ladder,” which sounds kind of biblical.

In reality, it’s a financial planning sleight of hand that involves regular transfers from your tax-deferred accounts into your Roth so you can pull them out as tax- and penalty-free income well before your 60s.

It’s pretty slick, sure, but it’s not for everyone. A successful conversion ladder requires lots of math, planning, capital, and even minor ethical considerations.

So in keeping with the theme of ladders, let’s take this retirement hack one step at a time. Let’s start climbing.

The Short Version

  • Roth IRA conversion ladders are an “early retirement hack” that allows you to treat early Roth IRA withdrawals as tax- and penalty-free income.
  • The process requires you to make annual conversions (transfers) from tax-deferred retirement accounts into your Roth IRA five years before your planned early retirement.
  • The advantage of Roth conversions, in general, is that you can pay taxes on your retirement savings now while you’re in a lower tax bracket.
  • However, the capital requirements are steep, and you can risk paying more taxes than you usually would at retirement.

How Roth IRAs Work

Let’s begin with a bit about Roth IRAs and why they’re the base of many “retirement hacks.”

Roth IRAs vs Traditional IRAs and 401(k)s

Unlike with tax-deferred accounts, contributions to Roth IRAs are taxable upfront. Which is neither good nor bad  — it's just another option.

Plus, Roth IRAs have special rules that help you avoid IRS penalties for early withdrawals.

 Roth IRATraditional IRA401(k)
In a nutshellPay taxes now, enjoy tax-free withdrawals laterMake tax-deductible contributions now, pay taxes laterMake tax-deductible contributions now, pay taxes later (plus employer matching and other benefits)
Maximum annual contribution in 2022$6,000 for ages <50
$7,000 for ages 50+
$6,000 for ages
$7,000 for ages 50+
$20,500 for ages <50
$27,000 for ages 50+
TaxesPaid upfront.
Contributions and earnings grow tax-free
Paid upon withdrawalPaid upon withdrawal
Penalties for withdrawals before age 59½10% IRS penalty on earnings and conversions (not contributions)

Unless you meet the five-year rule for each
10% IRS penalty on earnings and contributions, plus regular income taxes10% IRS penalty on earnings and contributions, plus regular income taxes

Did you see it? The hidden “back door” for avoiding the 10% IRS penalty for early withdrawals?

You can always withdraw contributions you’ve made to your Roth IRA. Since you’ve already paid taxes on those, the IRS considers that money yours. But your earnings and conversions are locked up. You can’t touch ‘em without incurring that nasty 10% penalty.

That is, not until you reach the five-year rule.

The Roth IRA Five-Year Rule

The Roth IRA has two “five-year rules” that dictate when you can pull out your earnings and conversions without penalty.

The five-year rule for earnings (aka accrued interest) states that you can’t withdraw earnings penalty-free until:

  • You reach age 59 ½, and
  • Your Roth IRA is at least five years old

Let’s say you max out your $6,500 contribution in 2023 and leave them until 2028. At 8% APY, your $6,500 contribution has generated $3,184 in earnings, so your total Roth IRA balance is now $9,684.

You can withdraw your original $6,500 contribution without penalty, but you can’t touch your $3,184 earnings until you’re 59 ½.

Granted, there are a few exceptions, such as a first-time home purchase, college expenses, and birth or adoption expenses. But by and large, your earnings are locked up.

But when it comes to your contributions, once you convert money to a Roth IRA, you can pull it out penalty-free after just five years, whether you’re 25 or 55.

How Roth Conversions Work

A conversion is when you move funds from a tax-deferred retirement account into your Roth IRA.

Unlike direct contributions with an annual cap of $6,500, conversions to Roth IRAs have no upper limit. If you want, you can convert $5,000 or $500,000 from your Traditional IRA to your Roth IRA in a single tax year.

Naturally, Roth conversions are a popular strategy among high-earners who no longer qualify for annual Roth contributions. They’re also helpful for anyone who wants to contribute more than $6,500 a year.

There are two main advantages to a Roth IRA conversion:

Roth IRAs Enable Early Withdrawals

With few exceptions, you can’t touch the money in your Traditional IRA or 401(k) before age 59 ½ without incurring the heavy 10% penalty. But if you move the money from your tax-deferred account into a Roth IRA via a conversion, you can withdraw that money within five years without incurring penalties.

Roth IRAs Can Potentially Reduce Taxes

The IRS counts the money you convert from your Traditional IRA to your Roth IRA as income for that year, so you’ll have to pay tax on it.

Remember, conversions help you to avoid penalties, not taxes.

That being said, a well-timed conversion can still help you save on taxes. If you think you’ll have a higher income during retirement than you do today, paying taxes now– while in a lower tax bracket– could save you some money.

To find out precisely how much money a Roth conversion might save you, spend a few minutes tinkering around with the Roth Conversional Calculator at Empower.

Anyways, the strategy of “sneaking” funds from your Traditional IRA into your Roth IRA is so common that it has a nickname. CFPs call it “The Backdoor Roth.”

Read more >>> Paying Taxes on Investments 2022 Guide

Are Backdoor Roth IRAs Illegal or Unethical?

Nope! In fact, the IRS explains precisely how to do them (although Uncle Sam never uses the term “backdoor”).

As for ethics, consider this: backdoor Roth IRAs are pretty standard, and many CFPs even encourage them as a viable retirement strategy. According to Forbes, out of 200 million U.S. tax filers in 2018, 724,000 performed a Roth conversion.

However, nearly one in five Roth conversions were from households making $500,000 annually, which drew some negative attention in Congress. After all, Senator William Roth conceived of Roth IRAs to help the lower and middle classes.

In late 2021, Congressional Democrats proposed sweeping limitations on Roth conversions. As of 2032, account balances will cap around $10 million, and anyone making more than $400,000 can no longer make conversions of any kind.

So to recap, Roth conversions move funds from a traditional retirement account into a Roth to achieve three main goals:

  • Enable optional early withdrawals once five years are up
  • Pay taxes earlier while you’re in a lower tax bracket
  • Enjoy tax- and penalty-free income in retirement

So how do Roth conversion ladders enable early retirement?

YearAgeConversion amount (from Traditional > Roth)Withdrawal amount (income)Source
203050$60,000$60,0002025 conversion
203151$60,000$60,0002026 conversion
203252$60,000$60,0002027 conversion
203353$60,000$60,0002028 conversion
203454$60,000$60,0002029 conversion
203555$0$60,0002030 conversion
203656$0$60,0002031 conversion
203757$0$60,0002032 conversion
203858$0$60,0002033 conversion
203959$0$60,0002034 conversion
204060$0$60,000Regular withdrawal

Are There Any Drawbacks to a Roth Conversion Ladder?

Absolutely. Here are the big three:

  1. It eats up your savings — To pull off the Roth conversion ladder illustrated above, you’d have to burn through $600,000 worth of retirement capital before age 59 ½. Keep in mind that we don’t qualify for maximum social security benefits until age 67.
  2. You might pay more taxes — If you earn $160,000 in 2025 and convert $60,000, your taxable income that year will be $220,000. Roughly $55,000 would fall within the much higher 32% tax bracket. Instead, if you’d waited until retirement, when your total annual income was your withdrawal of $60,000, you could have avoided the 32% tax bracket entirely.

Again, to determine whether a Roth conversion is right for you, tinker with the Roth Conversion Calculator at Empower and then speak to your financial planner. A successful Roth conversion ladder ensures you have enough capital to last through all retirement.

The Bottom Line

For something known as a “hack,” Roth IRA conversion ladders are pretty dang complex and require large amounts of capital and math. But if you plan to retire early, it's worth chatting about them with your financial planner.

Further reading:

Chris Butsch

Chris helps young people prosper - both mentally and financially. In addition to publishing personal finance advice for Investor Junkie and Money Under 30, Chris speaks on the topics of positive psychology and leadership through CAMPUSPEAK and sits on the advisory board of the Blockchain Chamber of Commerce.

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