What is a Roth conversion ladder and why would you use a roth conversion ladder? I first learned about a Roth conversion ladder from the madfientist.com. Then I saw it on other FIRE websites and resources including the book – Quit Like A Millionaire.
The Roth conversion ladder is an important tool for anyone that hopes to retire early. Why is this? A Roth conversion ladder allows people to take out money before they are 59.5. Since you are trying to retire early, you most likely will need your money before 59 ½ . Roth IRA’s allow this as long as you wait 5 years after your contribution to withdraw money. You can only withdraw the contribution tax free. You can’t withdraw the earnings tax free before retirement age. You must be in the U.S. to execute this plan.
Additionally, if you want to retire early, the best way to do so is maximizing your pretax retirement accounts out. The downside of contributing a lot to pretax retirement accounts is that you can’t pull out money until you are 59 and a half.
If you max out your pretax accounts, you need a way to get them out before 59. The Roth conversion ladder allows this to happen.
Make sure to consult an accountant before pursuing this plan. Everyone’s financial situation is unique, and you wouldn’t want a surprise tax bill by pursuing this in the wrong manner.
The biggest concern converting your traditional IRA into a Roth IRA is that the contribution into a Roth IRA might kick you into a higher tax bracket.
As I spoke about before in this article, you want to max out your pretax retirement accounts. For most people this will be your company’s 401(k). The current year max for the 401k is $19,000.
Then you want to convert that 401k to a traditional IRA. You will do this when you quit your job or change jobs.
Once you are ready, you will convert that traditional IRA to Roth IRA.
Then you have to wait five years before accessing the funds from the first year of contribution.
Do this as long as you need the money. You can take breaks from contributing.
When should you start your roth conversion ladder. Ideally, you’d only start contributing once you left your job. You’d want to maximize benefits by doing this in a year where you have no other income because you could contribute up to your standard deduction and have no taxes do on the conversion. This is because the standard deduction is the level of income where everyone pays no taxes. In 2019, this is 12,200 for individuals and 24,400 for married couples. If you were single, you’d convert 12,200 to a roth ira if you had no other income. You could contribute to your Roth IRA before you quit your job. Just remember that you have to pay taxes on the conversion, so any amount of conversion above the standard deduction will incur taxes.
However, you should remember that you can only withdraw the contributions. You can’t withdraw the earnings in your Roth IRA before 59 ½ without a penalty. Whatever you wan’t your retirement withdrawal number to be, make sure that you contribute enough to your Roth IRA. You should also make sure that you have enough excess cash to pay the taxes on the conversion.
Again, this probably seems confusing, so make sure to consult an accountant before you pursue this plan yourself. You should also make sure that tax laws have not changed.
