Roth IRA Conversion Ladder: What Is It For? And How to Set It Up?

Thang Truong
Thang Truong
Updated on:

Funding your retirement is often confusing and complex. Where to put your money so that you enjoy a good rate of return, but have the least amount of taxes and fees to pay? Also, what happens if you really need the money you set aside? What if you want to retire early? A Roth IRA conversion ladder may work for you. What is a Roth IRA conversion ladder? How does it work? Why do I want one? We’ll answer these and other questions in this article.

What is Roth IRA?

Just a brief refresher on what a Roth IRA is: it’s a retirement account that holds some investments. You add to this account with after-tax dollars, so that when you go to withdraw the money, it will be tax-free. The only caveat is that you must have owned the account for five years before you can take withdrawals. Remember that, it’s important.

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What is a Roth IRA Conversion?

A conversion is when you transfer money from other retirement accounts into a Roth IRA. You’ll have to pay income tax on the amount you convert at your ordinary income tax rate when you do the conversion (remember, your other retirement accounts such as IRA’s and 401(k)’s are tax-deferred, so you haven’t paid any taxes yet). When you retire, the money will be tax-free because you already paid the taxes. You must have owned the account for five years, though. If you do a conversion, you’ll have a 5-year waiting period for every conversion that you do.

Roth IRA Conversion Ladder: What Is It For?

To set up a Roth IRA conversion ladder, you’ll take a portion of the money in your other retirement accounts and convert it into a Roth. The next year, you’ll do another conversion, the next year another, and so on. These staggered conversions are why it’s called a ladder.

The question is why you need to do a Roth IRA conversion ladder. The short answer is that most people do Roth IRA conversion ladder to support their early retirement. Instead of retiring at age 65, like most of us, they plan to retire at age 50, for example. At age 50, they wouldn’t have access to their retirement accounts such as 401K and IRA without paying 10% penalty. Converting money from their 401K or IRA to a Roth IRA account in the right way, ie. following the steps to do a Roth IRA conversion ladder, they will be able to access money in their Roth IRA account from age 50 to 59 1/2 without paying penalty.

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Roth IRA Conversion Ladder and Early Retirement

Say your goal is to retire at age 50. Given that you can’t touch your IRA’s, your pensions, or your 401(K) until you’re at least 59 ½ and Social Security won’t kick in until you’re at least 62, what money will you live on from ages 50 to age 59 1/2 ?

You can access your Roth IRA conversions. If you start converting IRA or 401(k) money to a Roth at age 45, the first year you can access the money in your Roth IRA is age 50 to avoid the 5-year penalty of Roth IRA account. That’s what you can live on for that year. You also converted IRA and 401(k) money so that you could access it at age 51. This might be more helpful with a graph.

YearYour ageConversionYear availableYour age
when you access $

If you have figured out you will need $40,000 a year to retire early, you simply convert $40,000 from your other retirement accounts into a Roth account every year, starting in 2015. The first year you can access the money will be in 2020, when you’re 50. You will then have $40,000 every year until you turn 55, but you can do this for nine years as well, or however long you need it.

>>MORE: How Much Savings is Required to Retire at Age 55?

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Why Not Just Convert the Money to a Roth All At Once?

You can, but keep in mind that your 401(k) money and IRA accounts are tax-deferred. If you convert all the money to a Roth IRA all at once, you will have to pay taxes on the whole amount. That could be a significant tax bill. If you convert $100,000 all at once, you will pay taxes at your ordinary tax rate. If you make over $40,125 as an individual or over $80, 250 as a married couple filing jointly, your ordinary income tax rate for 2020 is 22%. If you make over $518,400 as a single person or over $622,050 as a married couple, your tax rate is 37%. On your $100,000 conversion, you’ll pay $37,000 in taxes. When you retire and your only income is retirement accounts, your tax rate will be much lower.

>>MORE: How Much Income Tax Will You Have to Pay in Retirement? A Case Study

Why Not Just Invest in a Roth IRA in the First Place?

The IRS has rules around how much you can contribute to a Roth. For 2020, you can only contribute $6,000 a year, or $7,000 a year if you’re over 50. Your 401(k), on the other hand, has contribution limits of $19,500 for 2020, and some employers will match funds. There is no limit on how much money you can convert to a Roth. You can convert any amount that’s in your 401(k), which could be as much as $39,000 if your employer matches your full contribution. And your money is, of course, invested so it’s earning money over time.

In addition, if your income is too high, you might not be qualified to put money in a Roth IRA account. According to IRS, in 2020, if your income is more than $139,000 (single) or $206,000 (couple), you are not qualified to invest in a Roth IRA account. Although there are backdoor ways to save your money in a Roth IRA account, you can still max out your savings in 401K and IRA accounts and convert them to a Roth IRA account using this conversion ladder method.

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What About the Money Earned on the Roth IRA Account?

The Roth is basically an investment account, so you’re hoping it earns money. While you can withdraw all the money you put into it without penalty, the gains on the account are taxed, and if you try to take them before you turn 59 ½, you will also incur a 10% penalty. On the positive side, the IRS has already decided a withdrawal order for you. First is regular contributions, then conversion, and gains are last. If you withdraw only the amount you converted, it should be tax-free because you already paid the taxes on it when you made the conversion.

>>MORE: Self-Directed Roth IRA: Its Pros and Cons? How is It Different from a Regular Roth IRA Account?

Last Thoughts

Early retirement is a great financial goal that many of us strive for. Creating a Roth conversion ladder will help to make those goals a reality. You’ll be able to enjoy tax-free retirement money for as long as you need, leaving you with more time and freedom to do what you really want.

Thang Truong

Thang Truong covers small business insurance and small business success at BravoPolicy. He is a licensed P&C insurance agent. Previously, he held product leadership positions at, Capital One, NerdWallet, and Mulberry Technology. He holds a MBA degree from UC Berkeley - Haas School of Business.

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