Roth Conversion Ladder
Overview
The roth conversion ladder is essentially a loophole that will let you access
money from tax-deferred accounts (e.g. traditional IRA, traditional 401k) penalty free.
Why is this important? Because if you are under age 60 and unless you meet
certain criteria,
you will be hit with a penalty of 10% (in addition to taxes). Withdrawing money
before 59 1/2 is what is known as an "early" or "premature" distribution. Note that
you are able to withdraw the money, but you will have to pay the penalty.
However with a roth IRA you can always withdraw contributions. Note:
contributions are the money you put into the roth IRA. It does NOT include the
money earned from investing.
So... the big idea behind the "Roth Conversion Ladder" is to convert (move) money
from your traditional IRA and then withdraw the money from your roth IRA. There
are a few important caveats:
- Converting from a traditional IRA to a roth IRA is a TAXABLE event. That means
if you are in the 22% tax bracket you will pay 22% of the converted amount in taxes
- You have to wait 5 years from when the conversion took place otherwise you will
face a 10% penalty
IRS information here.
How this looks
How might this look in the context of early retirement?
- You will need to have "access" to 5 years of "income" to cover expenses (e.g. from
a savings account, taxable brokerage, roth IRA, traditional IRA and incur 10% in
penalties, ...).
- You will begin to set up the "ladder", where each year you will
convert the money you will need in 5 years from your traditional IRA (rollover any
other tax-deffered accounts into your traditional IRA to simplify this) into a roth IRA.
Ideally, you will be in a low tax bracket (since your income is likely low in retirement)
so this conversion will not be too costly.
- After 5 years is up, withdraw the converted money from your roth IRA, no penalties
and no taxes!
- Continue doing this until you are able to withdraw money from your traditional IRA
tax free (i.e. 59 1/2).