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The Roth IRA can be an attractive retirement account to all types of investors. One reason is that Roth IRAs can help you save money on taxes, especially if you anticipate being in a higher tax bracket in the future.
A strategy called a Roth conversion ladder can help with more tax savings on money you may have stashed away in other retirement accounts.
What is a Roth conversion ladder?
First, let’s start with the Roth IRA. A Roth IRA is a retirement account that allows investors to enjoy tax-free growth and make tax-free withdrawals in retirement. That’s because you pay taxes on your money before depositing it into the Roth. You can also withdraw your contributions at any time, tax and penalty free.
Roth IRAs have income limits as well as annual contribution limits — $6,500 in 2023 (or $7,500 if you're age 50 or older). But there’s no limit on the amount of money you can convert to a Roth IRA, and there are no income limits on conversions, either.
A Roth conversion ladder is when you take money from tax-deferred retirement accounts and move it into a Roth IRA gradually. With inflation at a 40-year high, now might be a good time to consider using this ladder to climb your way to tax-free withdrawals in the future.
How do Roth conversion ladders work?
“You're basically taking a portion ... a little bit every year, until such time that either you've made your entire retirement tax free, or you've exhausted the top of your tax bracket,” says Renee Collins, a certified financial planner and certified public accountant at Retire Ready Inc., a financial planning firm in Chicago.
Roth ladders are most helpful to people who have most of their money in traditional IRAs and 401(k)s and expect to be in a higher tax bracket in the future, Collins says. Because those tax-deferred accounts require you to pay taxes once you make withdrawals, moving those funds gradually to a Roth IRA now could mean saving on taxes in retirement.
That way, more of your money could get tax-free growth. You can also make tax-free withdrawals of your converted Roth IRA contributions after five years. And remember, the clock is set to five years for every new contribution you make.
Using a Roth conversion ladder is a form of tax diversification, which is when investors use a mix of taxable and tax-free accounts to help lower the tax they pay when they retire.
“Right now, what I find with most clients is that there is no tax diversification,” Collins says. “And most clients don't plan for taxes, so they just assume that they're going to be in a lower tax bracket in retirement.”
Benefits of a Roth ladder during inflation
If you’ve been brave enough to look at your retirement savings accounts lately, you might’ve noticed big dips.
The Dow Jones, S&P 500 and Nasdaq are all down year to date. Many stock prices have dipped, while inflation has remained stubbornly high.
The upside to the down market for retirement investors is that if you convert some of your money from a tax-deferred retirement account into a Roth now, you’d potentially pay less than if your portfolio hadn’t taken a hit, says Ali Swart, a CFP at Waldron Private Wealth, based in Bridgeville, Pennsylvania.
“The more important thing is that you are getting that money into a completely tax-free vehicle with the Roth IRA,” she says. “You're converting a lower amount, and we all know that the markets will eventually rebound, and all of that growth is going to be captured tax-free.”
Roth ladders and early retirement
Those planning to retire early can also benefit from Roth ladders, as they can access tax-free withdrawals of their contributions (not earnings) before age 59½, as long as the money has been in the account for five years. Trying to take money out before that could mean paying penalties in addition to income tax.
If you are planning to retire early, the timing of your Roth ladder is crucial, Swart says.
“Oftentimes people will start these Roth conversion ladders at least five years before they're going to need the money, so that they can wait out that five-year period.”
Roth ladder mistakes to avoid
Although Roth ladders can help you save money on taxes, they can also lead to you paying more in taxes if you aren’t careful.
To ensure a Roth ladder is tax efficient, you should convert amounts that won’t tip you over into a higher tax bracket, Collins says.
This is why you’re making your conversions a “ladder” and doing them gradually. The IRS has seven income tax brackets that determine how much you pay in taxes. The higher the tax bracket, the more you pay in taxes. In 2022 and 2023, the lowest tax bracket is 10% and the highest is 37%.
“The nice thing about the conversion is that you don't have to take the entire conversion in one year. You can do it over a course of two years, three years, or whatever it takes to do the conversion, pay the taxes, and still keep the tax rates relatively low,” Collins says.
She provides an example of an individual who is in the 22% tax bracket in the 2022 tax year and anticipates being in a higher tax bracket later.
That individual would only convert amounts that would keep them within that 22% bracket, which means they wouldn’t convert an amount that would raise their total income for that tax year above $89,075.
Their total income includes the Roth conversion amount, and any other income they had for the year. If they convert more of their retirement savings into the Roth, they’d be pushed into the 24% tax bracket and end up paying more in taxes.
When doing a Roth ladder, you also want to be mindful of the five-year rule for Roth accounts. Swart says you can do that by keeping track of when you make every conversion.
“You don't want to implement the strategy and then get years mixed up and accidentally incur a 10% early withdrawal because you somehow voided that five years.”
If you want help avoiding those kinds of issues with a Roth conversion ladder, consider working with a tax advisor or financial professional to ensure you get the maximum tax benefits.