What is a Roth IRA Conversion Ladder and Are There Drawbacks? How the Loophole Works for Early Retirement

Last Updated on June 29, 2021

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When it comes to retiring early, the Roth IRA gets high marks for early retirees. However, one of the main drawbacks of retiring early is that you won’t be able to touch your tax-sheltered retirement accounts [401 (k), 403(b), or traditional IRAs for example] until age 59 ½ without taxes and penalties. Enter the Roth IRA Conversion Ladder.

Before you purse your lips know that the Roth IRA conversion ladder is a loophole that can come to the rescue when it comes to early retirement, and it’s not as complicated as it might seem.

What is the Roth IRA Conversion Ladder?

The Roth IRA conversion ladder allows you to move money from a tax-deferred account like a 401(k) or traditional IRA into a Roth IRA where after only five years you can withdraw the converted funds. Hello new retiree!

Remember that with a Roth IRA your contributions are tax-deductible. They can be withdrawn penalty- and-tax-free at any time, and both your investment earnings and contributions are eligible to be withdrawn at age 59 ½ if your Roth is at least five-years old.

With a conversion, you can transfer money from your other retirement accounts into a Roth IRA. Five years after the conversion the money is then eligible for tax-free withdrawal. The win-win is that you now have an account you can draw money from before age 59 ½.

Roth IRA Conversion Ladder
The biggest drawback to a Roth IRA Conversion Ladder is that you’ll have to pay income tax but not the 10% withdrawal penalty on the amount you convert. Photo credit: Shutterstock.com

Are There Drawbacks to Climbing the Roth Conversion Ladder?

The biggest drawback is that you’ll have to pay income tax but not the 10% withdrawal penalty on the amount you convert. For example, if you wanted to convert $35,000 from one of your traditional (taxed) retirement accounts into your Roth IRA, and you’re in the 15% tax bracket, you’ll have to pay $5,250 in taxes in the year of the conversion.

As you continue to make conversions annually, your income will fall. In fact, if you’re already retired your income may even be limited to these Roth conversions, keeping you in a fairly low tax rate or perhaps even tax-free.

Further, when you take a Roth IRA conversion, there’s a five-year rule that applies to the withdrawal of your conversions. But if you delay withdrawing those contributions for at least five years, the 10% penalty no longer applies. (See IRS 590-B publication for details).

How Does the Conversion Ladder Work? And When Should You Do It?

So now that you know there is a new five-year waiting period for each conversion, the ladder comes from creating a series of tax-free, penalty-free withdrawals of Roth conversion balances. In essence, you’re “laddering” the conversions every year.

Because you must wait five years after each conversion to be able to withdraw your conversion balance untaxed, experts say to begin Roth IRA conversions at least five years before you plan to retire.

By the time your initial conversion is five years old you’ll be able to withdraw the $35,000 conversion you made. If you do this for at least five years before retirement, you’ll have a steady tax-free, penalty-free income of $35,000, or whatever your number is, per year through age 59.

Is the Process Complicated?

Making Roth IRA Conversions is a multi-step, multi-year process. But that’s really where the complication ends. There are even financial companies that can assist you with the process but essentially, five years before retirement you can begin taking lump sums from a 401(k) or other conventional accounts and converting it to a Roth.

Then every year until age 59 ½ when you’re eligible to take penalty-free, withdrawals from all your retirement plans, you’ll ladder your conversion by continuing to take lump sums and convert them to your Roth.

The purpose of the Roth IRA conversion is so you’ll have tax-free, penalty-free funds available for early retirement before age 59 ½. It’s a great strategy for early retirees, and most retirees report retiring well before the typical retirement age–before they’re eligible for social security benefits or withdrawals from their traditional retirement accounts.