Roth Conversion Ladder - What is it?
This is a favorite move for tax optimizers and early retirees because it's a great way to reduce taxes and get your money out early.
It is predicated on two main ideas:
Contributions to Roth IRAs are withdraw-able at any time, tax- and penalty-free.
Conversions from a traditional (tax deferred) account to a Roth IRA count as contributions after 5 years.
So if we make conversions, eventually we'll have access to that money. That's the gist of it. We'll get into the specifics of how to do it later.
When would I use it?
It's really only applicable if you want to retire early. There are other situations in which you may want to do a Roth conversion by itself, such as during a year in which you have more space within a marginal bracket with a favorable rate, but the "ladder" strategy is for retiring early to live off of retirement savings accounts.
You Need to Understand 2 Things First
To reiterate, you're trying to convert your traditional accounts (401k, etc.) over to your Roth IRA so you can take it out early without a penalty. There are 2 things you need to understand for this:
(1) The 5 Year Rule
The first consideration you have is the 5 Year Rule. This rule affects us because when converting from a Traditional IRA to a Roth IRA, there is a 5 year waiting period before the conversion counts as a contribution and can then be withdrawn early.
How does this affect you? You're going to have to have a source of 5 years' worth of living expenses in liquid accounts that are not subject to income tax to make it through this 5-year gap, otherwise you'll have some serious tax bills.
What are examples of non-taxable sources? Really any liquid savings you have: checking, savings, and brokerage accounts. It could even be the contributions you have already made to your Roth account, since they are withdraw-able tax-free. If your Roth IRA is part of your plan for this, make sure that you have enough contributions so that you don't move into withdrawing earnings or accidentally withdrawing the conversion you made too early.
(2) Conversions are a Taxable Event
You're going from a tax-deferred account (traditional) to a post-tax account (Roth). This means that the money that hasn't been taxed yet will be income taxed on its way over to the Roth account--counting as income for that year. So you must be cognizant of how much you convert in any one year to avoid a boatload of taxes.
You would NOT convert the entire amount in one year. If you convert your entire account, say $1 million, then it will count as if you had an income of $1 million that year, and you will pay the full income tax on a $1 million income as if you were a rich person.
This is where the "ladder" comes in. You'll only be converting as much as you will need to live for a year -- in 5 years. For example: if you made the conversion in 2020, it would be the amount you expect to live on in 2025. Why in 5 years? Because that's when it will stop counting as a conversion and start counting as a contribution. This means that's when you can take it out without taxes or penalties. You'll continue to only convert that amount each year, so that conversion made year 1 are ready after year 5, and conversions made year 2 are ready after year 6, year 3 conversions are ready after year 7, and so on.
If you want to optimize your taxes...
Consider the standard deduction. If you're a married couple in 2020 who just decided to retire early with no income, then you can convert up to $24,800 for 0% taxes. That's because the standard deduction allows you to deduct that amount from your taxable income. If you plan this in a way to work along with your taxable brokerage account covering the rest of your expenses, you may be able to convert your entire tax-deferred account to Roth without ever paying taxes on that money. You could even do this while still avoiding any capital gains taxes in the brokerage account by keeping your income low enough to stay within the 0% long term capital gains bracket (the 0% bracket goes up to $80,000 in 2020).
Consider the marginal tax brackets. If you're not looking to play the system that hard as described above, or you just plain need more money than makes that strategy feasible, then at least consider the marginal tax rates. Right now, the marginal 10% goes up to $19,750 and the marginal 12% goes to $80,250. Considering the standard deduction of $24,800, that means to fill the 10% bracket would take conversion of $44,550 and to fill the 12% bracket would take a conversion of $105,050. If you feel comfortable paying 10% income tax on your money, you should convert at least $44,550 in that year, and if you feel comfortable paying 12% income tax, you should convert at least $105,050 -- otherwise you're wasting useful tax space. Remember, just because you convert that money now doesn't mean you have to withdraw it in 5 years, only that you can. So we want to convert as much as possible as soon as possible so that it's available when we want it.
How to do it - The Steps
A Step-By-Step Guide to Performing a Successful Roth Conversion Ladder:
Before you start the conversions:
Accumulate 5 years' worth of expenses in liquid accounts that are not income taxed.
Retire early.
Year 1:
Live on the accumulated wealth in your liquid accounts.
Roll all your previous 401(k)s and similar accounts into a traditional IRA, preferably with the same firm as your Roth IRA. Since this is pre-tax to pre-tax, this is not a taxable event, so you can do it all at once.
Convert money from your traditional IRA to your Roth IRA. The amount you convert should be at least as much as you will need in 5 years from the conversion year (the year you'll be using it) for that year's expenses. This will be a taxable event. Keeping the standard deduction and marginal tax rates in mind, you might want to convert up to the top of the marginal bracket if you think it is a good rate. You have now set the clock for 5 years until you can withdraw this money tax- and penalty-free.
Years 2-5:
Live on the accumulated wealth in your liquid accounts.
Convert money from your traditional IRA to your Roth IRA. The amount you convert should be at least as much as you will need in 5 years from the conversion year (the year you'll be using it) for that year's expenses. Keeping the standard deduction and marginal tax rates in mind, you might want to convert up to the top of the marginal bracket if you think it is a good rate. You have now set the clock for 5 years until you can withdraw this money tax- and penalty-free.
Year 6 and Forward:
The money you converted in year 1 is now considered a contribution; you may withdraw it without taxes or penalty. Take that amount as a distribution, and live on this amount.
Convert money from your traditional IRA to your Roth IRA. The amount you convert should be at least as much as you will need in 5 years from the conversion year (the year you'll be using it) for that year's expenses. Keeping the standard deduction and marginal tax rates in mind, you might want to convert up to the top of the marginal bracket if you think it is a good rate. You have now set the clock for 5 years until you can withdraw this money tax- and penalty-free.
Next year, in year 7, you will be able to access the money you converted in year 2, and so on. This pattern, referred to as a "ladder", continues indefinitely (as long as the money doesn't run out).
How will you know when you have enough money to retire early?
Read my post on the 4% rule of thumb and find out!
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