Planning for retirement is more than simply picking the right investments. We also must consider the type of investment or retirement accounts to use. There are various types of investment and retirement accounts one can use to prepare for retirement, with each having different rules around contribution amounts, distribution requirements, and taxes. To determine which type of account makes the most sense for you, start by comparing your current tax bracket with your anticipated tax bracket in retirement.
Generally, people who anticipate being in a higher tax bracket in retirement gravitate towards Roth IRAs. These tax-advantaged accounts allow people to pay taxes on contributions to the account now while they’re in a tentatively lower tax bracket, so they can enjoy tax-free growth potential and withdrawals when they retire. Another factor to consider is diversification. While this is generally considered when it comes to the types of investments, it is also important when it comes to taxes. Having multiple types of accounts with different tax benefits can create tax diversification.
To increase tax savings during golden years, investors can implement a strategy called a Roth conversion ladder. This strategy makes it possible to convert more non-Roth funds into a Roth account. This can be an attractive opportunity for individuals who want tax free income in retirement or want to add tax diversification to their retirement portfolio.
What is a Roth Conversion Ladder?
A Roth conversion ladder is when an individual takes tax-deferred retirement contributions, pays current taxes on the amount converted, including any gains, and rolls the funds into a Roth. A “ladder” is created by doing the conversions periodically over time, as short as a few months but generally over multiple tax years. Those tax-deferred funds may be housed in tax-deferred accounts like a traditional IRA or 401(k). Roth conversion ladders can make it possible for people to accumulate more in a Roth than they otherwise could.
Contribution limits for a Roth are relatively low, since they’re capped at $7,000 in 2024 and $8,000 for those 50 and older. However, with a Roth conversion ladder, people can exceed these limits. There is no limit on how much one can convert to a Roth nor are there limits on the number of conversions one can do.
Another benefit of Roth conversion ladders is that this opens the door for people who may not initially qualify for Roth IRAs due to income limits set by the IRS. Roth conversions open the door for these clients to take advantage of the tax benefits of a Roth IRA.
Roth conversion ladders can also be a useful tool for people planning to retire early. It can provide access to tax and penalty-free money since the principal conversion funds can be withdrawn before 59 ½, assuming they meet the 5-year rule. The 5-year rule says individuals can’t withdraw their conversion penalty-free until Roth funds have been in an account for 5 years, and this applies to every new Roth conversion. Withdrawing funds before the five-year mark can result in a 10% IRS penalty.
Some people aim to keep doing Roth conversions until they reach a point where their entire retirement pot is tax free.
Examples of Roth Conversion Ladders
As mentioned, Roth conversion ladders are done over time, and that timing depends on an individual’s goals. For instance, if Jackie, who is 50 years old, wants to retire in five years at the age of 55, and estimates needing $40,000 annually during retirement, she may start planning for that now and use a conversion ladder strategy. Her goal could be to convert $200,000 ($40,000 x 5 years) of her IRA and/or 401k money into a Roth.
Her ladder could include converting $40,000 a year via a Roth conversion every year starting at age 50 until she reaches her conversion amount goal of $200,000. Keeping the 5-year rule in mind, Jackie would be able to access her first $40,000 at 55 when she retires. She would also have access to that same amount every year for the next five years. The good thing is that right before the fifth year, Jackie would reach the age where she can make penalty-free withdrawals, which is 59 ½ for most tax-advantaged retirement accounts. People who plan to retire earlier than 55 would need to start their conversion ladder earlier to convert enough funds to last them until age 59 ½.
Tax Implications of Roth Conversion Ladders
It’s important to think about the tax implications of each conversion or how it may impact the amount of taxes an individual pays come tax season. The Roth conversions required to make a Roth ladder are usually taxable events since tax-deferred dollars or money an individual hasn’t yet paid taxes on are being converted into a Roth, which uses after-tax dollars. Converting too much money in one year could tip an individual into a higher tax bracket. Additionally, please remember that the IRS can change the tax code at any time. Regular check-ins are essential to make sure this strategy remains appropriate.
For instance, if a single person who is at the edge of a 22% tax bracket and has $90,000 in taxable income did a $50,000 conversion in one year, it would bump them into the 24% tax bracket. One should keep in mind how each conversion will affect your tax implications. If moving up a tax bracket isn’t ideal, individuals can give themselves a long horizon to convert funds so they can convert lesser amounts to ease their tax burden.
A Roth conversion ladder isn’t right for everyone, but it is important to have tax diversification to potentially lower taxes during retirement. Keeping some money in both tax-deferred and tax-free retirement accounts is one way to achieve this.
