How does a Roth conversion ladder work? 

Many investors and advisers are familiar with the Roth IRA. It’s the go-to retirement account, since it allows for tax-free growth on earnings as well as tax-free withdrawals for the account owner.  

A Roth IRA account is all well and good, but what is a Roth conversion ladder? As with the backdoor Roth IRA, this is a process and not an actual type of retirement account. This is a technique that account owners can use to retire early, since they can access their contributions (not the earnings) before they reach the age of 59½.  

This of course raises questions: what is a Roth IRA conversion ladder? How does it work? How do you do a Roth IRA conversion ladder? In this article, InvestmentNews sheds some more light on this retirement planning strategy.  

What is a Roth conversion ladder?  

The Roth conversion ladder is a financial strategy that allows the owner of a Roth IRA to retire early and live off their Roth IRA conversions. But before you make any celebratory moves, remember that there are some caveats to this. So how do Roth IRA conversion ladders work? Here are the crucial points to know about them:  

1. It’s a multi-year strategy.

The Roth conversion ladder means that the account owner gradually accesses their Roth IRA contributions without penalties, even before they reach the age of 59½. This is essentially an early retirement scheme but done in line with certain restrictions and guidelines.  

2. It considers the 5-year rule.  

Account owners and advisers are guided by the five-year rule on Roth IRA withdrawals. This is to ensure that withdrawals of the contributions (note: contributions, not earnings) do not incur the 10% early withdrawal penalty and/or taxes.  

To maximize the benefits of the Roth ladder, any contributions can only be withdrawn after the requisite five-year period has passed. Remember that the five-year waiting period applies to each amount converted into the Roth IRA. By making a conversion every year over a multiyear period, the account owner creates a “ladder” of Roth conversions.  

Read more: Understanding the 5-Year Rule for Roth conversions   

3. It must be created at least five years before making withdrawals.

Withdrawals of contributions to a Roth IRA do not incur the 10% early withdrawal penalty for violating the five-year rule if the account owner is over 59½.  

That makes planning when to set up the Roth conversion ladder and making withdrawals vital. Meanwhile, in the years leading up to establishing this, your client must build their Roth IRA up with conversions.   

4. The investor must have enough in other retirement savings accounts. 

This is so they can have an income for the rest of their life. The exact amount depends on how much income they believe they will need to live during their full retirement age or projected retirement years. 

How to set up a Roth conversion ladder 

Building a Roth conversion ladder is a matter of knowing how and when to move the exact amounts around, then exercising patience. Here’s how to create a Roth ladder:  

Step 1. Begin by rolling over a 401(k) or traditional IRA into a Roth. This is the crucial first step when considering early retirement and using a Roth ladder. But as you prepare, don’t forget to have other sources of income or sources of funds as you build the Roth ladder. 

Step 2. Transfer the amount you want to withdraw later. This should be the annual amount you want to withdraw after five years (don’t forget the five-year rule!). Make sure to only transfer the amount that will cover your annual expenses. Do not transfer more than this amount to avoid getting into a higher tax bracket and losing more money to taxes.  

Step 3. Be patient. Let the five-year waiting period run its course. But be sure to have other sources of income and/or sources of funds while you wait.  

Step 4. Withdraw the money that was converted. This can be done as many times as there are funds in the Roth IRA.  

Why consider a Roth conversion ladder? 

There are certain situations and types of clients that could warrant this financial strategy. The most common reasons for clients to use this include:  

• They plan to retire early and would like to use some of the retirement funds as their source of income. 
• They predict that they’ll get placed in a higher tax bracket when they retire, so they prefer to take the tax hit now rather than later. 
• They have enough funds to cover their first five years of living expenses in early retirement. 

Sample Roth IRA conversion ladder 

et’s look at an example of a Roth IRA conversion ladder. This is assuming the account holder is 50 years old in 2022 and decides they’ll need at least $50,000 in after-tax contributions each year. Their Roth IRA conversion ladder might look something like this:  

In this situation, the account holder still has at least six more withdrawals to make if they don’t make any further contributions. They can withdraw the remaining $250,000 tax- and penalty-free later and have already withdrawn $200,000 before reaching the age of 59½.  

They don’t have to withdraw each contribution in its entirety. They can also choose to withdraw just enough to cover expenses. Doing this helps avoid getting bumped up to higher tax brackets and pay more income tax for the year.  

Notice that this is a significant amount of money to use up before the account owner even gets to their actual retirement age. For a Roth conversion ladder to work effectively, you should have enough money to see you through until you’re old enough to receive Social Security benefits.  

When is the best time to start the Roth IRA ladder? Is it better to start one for early retirement or do one when retired? This video can provide some insight.  

For getting Social Security, what is the Full Retirement Age? 

Full retirement age is when an individual is entitled to receive full retirement benefits. If a taxpayer was born in 1960 or later, their full retirement age is 67. 

The implication of this is that as early as age 62, they can start receiving social security benefits. However, anyone choosing to receive social security benefits earlier will have their benefits permanently reduced. Their benefits will be scaled down based on a retirement planner made by the SSA.  

But if a taxpayer delays their benefits until the age of 70, their benefits will be higher. They receive what’s known as delayed retirement credits in this case.  

Roth conversion ladder blunders to avoid 

When executed properly, Roth conversion ladders can help investors save money on their taxes. But if done hastily or without proper planning, this can result in having to pay more taxes. The common blunders in a Roth conversion ladder to be mindful of are:  

1. Not considering or forgetting about the five-year rule. 

Any hasty or ill-timed withdrawal before the five-year period of a single conversion elapses may result in a significant tax penalty. To avoid this, always ensure to wait five years for each of the conversions and withdrawals and that they are meticulously planned and spaced. 

2. the effects of the conversions on your tax bracket. 

Avoid converting too much money in a single year. This can potentially push your client into a higher tax bracket, incurring a higher tax. Convert smaller amounts spread over several years so your clients do not get edged into the next higher tax bracket.  

In 2024, the IRS has stipulated that the taxes range from 10% to a whopping 37%. If you or your client are not diligent when making the conversions and the withdrawals, the resulting tax bill can be hefty.  

The table below shows the IRS tax brackets for the different types of tax filers in 2024: 

3. Not considering the impact of market conditions. 

Doing the conversions when the market is on a high means having to pay higher taxes on the conversion, while converting during a market low reduces the taxes. Be patient and try to time the conversions to coincide with market downturns. 

4. Not having a backup plan. 

While the Roth ladder is a great tool to use for an early retirement, the caveat is that it can wipe out the funds in a Roth account. To reap the benefits of this financial strategy, a lot of capital is required.  

It’s best to advise clients not to pursue early retirement with a Roth ladder unless they have other assets or funds for when they reach full retirement. Remind them that they won’t receive any social security benefits until they turn 67. 

5. Using a Roth ladder in times of inflation.

There is at least one lesser-known benefit to the Roth ladder. In times when the market is in a downturn, this financial strategy can cushion the effects on your client’s retirement savings.  

As the Roth ladder means placing smaller amounts in a Roth IRA, investors can capture growth tax-free when the markets rebound eventually.  

The impact of Roth IRA contribution and income limits 

It’s worth remembering also that the restrictions on Roth IRA contributions and limits on income can influence your Roth conversion ladder. For 2024, the Roth IRA contribution limit is set at $7,000 for those younger than 50, and $8,000 for those aged 50 and older. 

There are no restrictions on the amount that can be converted to a Roth IRA. There are no income limits on the conversions either.  

To provide income during early retirement, the Roth IRA conversion ladder can be an excellent strategy. But bear in mind that the Roth conversion ladder is not a financial strategy that can be applied by or benefit everyone. It’s also not an instrument that anyone can live off forever unless they have invested a lot of money.  

As with single Roth conversions, timing is crucial to maximize the benefits of the Roth conversion ladder. This can be a complicated strategy that only makes sense if planned well. Moreover, your client must have the kind of retirement savings that can also provide a generous income until they reach their actual retirement age.  

What’s your opinion on the Roth conversion ladder? Is this a tool you will recommend to your clients? Feel free to check out the opinions of our contributors on retirement planning and other hot topics.