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 IRA||Traditional IRA||401(k)|
|In a nutshell||Pay taxes now, enjoy tax-free withdrawals later||Make tax-deductible contributions now, pay taxes later||Make 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+
|Taxes||Paid upfront. |
Contributions and earnings grow tax-free
|Paid upon withdrawal||Paid upon withdrawal|
|Penalties for withdrawals before age 59½||10% 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 taxes||10% 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 $6,000 contribution in 2022 and leave them until 2027. At 8% APY, your $6,000 contribution has generated $2,815.97 in earnings, so your total Roth IRA balance is now $8,815.97.
You can withdraw your original $6,000 contribution without penalty, but you can’t touch your $2,815.97 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 $6,000, 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 $6,000 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 Personal Capital.
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?
|Year||Age||Conversion amount (from Traditional > Roth)||Withdrawal amount (income)||Source|
Are There Any Drawbacks to a Roth Conversion Ladder?
Absolutely. Here are the big three:
- 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.
- 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 Personal Capital 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.
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