Roth Conversion Ladder: Explained

The Roth conversion ladder is a powerful way you can pull funds from your Roth IRA or 401(k) without paying taxes. Normally, these types of withdrawals come with at least a 10% tax penalty. Fortunately, there is a way to escape the tax burden upon using the money. It’s clearly written in the US tax code but few people utilize it. The tax code states that any amount converted from a traditional IRA to a Roth IRA (or Rother 401(k) can be withdrawn – tax free. It’s simply a way of using the advantages of putting money into a pre-tax fund without really ever having to pay post-tax either.

It isn’t complicated, it doesn’t take much time, and it can be planned and executed quickly. In this post, I’ll discuss how it can be done. This is immensely helpful for those seeking early retirement.

To reach early retirement, you’ll need a massive source of passive income. However, through your working years, you’ve always thought to put the money into a tax-advantaged account like an IRA or the like. Smart. You’d now like to retire and access that money. But you can’t access it until age 59.5. Retiring at that age is hardly early retirement at all.

So what’s a person to do?

They begin building their roth conversion ladder as soon as they decide to set a retirement date. Reason being, you must wait 5 years after converting the money in order to withdraw it without the 10% penalty. Now to the annoying part.

When you convert money from a traditional IRA to a Roth IRA, it gets counted as ordinary income. You may need to pay taxes on that, depending on your entire income situation. But remember, we are looking at how to fund early retirement. This means retaining the most money in the long-term. This initially tax sting may hurt but you’ll likely only need to feel it for the few years before you retire. Why? Once you hit retirement, you’ll be able to withdraw this money tax-free. You also won’t have a lot of ordinary income from elsewhere. As you continue to build your ladder, you probably won’t have to pay ANY taxes. I’ll run a quick example:

Year 1: You’re still working. You have an income of $100,000. In retirement, you want to be able to withdraw $50,000 each year for living expenses. For this first year of your conversion, you’ll need to pay taxes on the $50,000 conversion plus pay income tax of your ordinary $150,000. True, those are a lot of taxes to pay.

Year 2: Same thing.

Year 3: Same thing.

Year 4: Same thing.

Year 5: DING DING DING DING DING! You’re now retired! Congratulations! You can now begin repeating the rewards of your roth conversion ladder. Now, as you build a rung, you take a rung. You get to withdraw the $50,000 you set aside 5 years ago tax-free. But remember to keep building. This year, you’ll need to contribute $50,000 as well. But the beauty of doing this conversion in retirement is that you have such a small tax burden. Income tax on $50,000 still keeps you pretty low in the tax brackets.

Year 6: Convert $50,000, take $50,000.

A Few Things to Remember about the Roth Conversion Ladder

Remember that $50,000 loses its buying power as time goes by. Many experts recommend estimating you’ll live to be 92. That said, $50,000 now and $50,000 when you’re nearly 100 will look completely different. Make sure to adjust for 3% inflation. $50,000 on year one, $51,500 on year two, etc. Make sure each rung of the ladder you build will make up for the run you take away.

I hope this makes sense to you. This is a very powerful way of being able to retire early. And don’t forget, you can use your Roth IRA funds to buy a house or fund your education as well!