What Is a Roth Conversion Ladder?

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A Roth conversion ladder is an investment approach where you convert a portion of your retirement savings from one kind of retirement savings account into a Roth IRA.

A Roth conversion ladder is an investment approach where you convert a portion of your retirement savings from one kind of retirement savings account into a Roth IRA. You do this over time instead of converting all of the savings at once. 

Here’s why this strategy can be beneficial for you, with explanations of how it works. 

Definition and Example of Roth Conversion Ladder

A Roth conversion ladder is a specific investment strategy. This strategy involves converting some—but not all—of your retirement savings into a Roth IRA annually. 

This investing approach is popular for two reasons. To start, converting in small chunks instead of converting all at once decreases your marginal tax rate and helps you pay less in taxes. This is because only converting the minimum amount needed to stay below the marginal rate allows you to pay the least taxes.

The second reason to use a Roth conversion ladder is because of a rule surrounding Roth IRAs. You have to comply with a five-year waiting period between conversion and withdrawing your earnings from the Roth IRA. If you withdraw any part of your earnings before that period ends, you’ll need to pay income tax and a 10% early withdrawal penalty.

Now, this five-year period only applies to your earnings—not your contributions. Roth IRA contributions are made with after-tax money, so you already paid taxes on it before you deposited it into the Roth IRA account. That means you can withdraw your contributions at any time.

Converting your money bit by bit instead of all at once can kick off that five-year waiting period early. However, you'll have a five-year waiting period every time you convert money as part of the Roth conversion ladder strategy.

A Roth IRA conversion involves transitioning assets held in another type of retirement account—like a traditional IRA or a 401(k)—into a Roth IRA. 

To understand how a Roth conversion ladder works, it’s helpful to know what a Roth IRA is and how conversions work. A Roth IRA is an individual retirement account where you can invest after-tax income. You can withdraw from this tax-free account after the age of 59.5, and after you’ve held it for five years.

The money in a Roth IRA is invested in assets like stocks, mutual funds, and exchange-traded funds (ETFs). You can open this type of account at a bank, credit union, brokerage, and other select financial institutions.

You can convert assets from the following types of retirement accounts into a Roth conversion ladder:

  • Traditional IRA
  • 401(k)
  • 403(b)
  • 457(b)

Converting assets into a Roth IRA works well if you don’t plan to access the funds in your Roth IRA for at least five years or if you don’t anticipate being in the same—or higher—tax bracket in retirement as you’re in now. The strategy is also good if you can afford to pay conversion taxes without tapping into your retirement fund.

How a Roth Conversion Ladder Works

The building blocks of Roth IRAs show you why a conversion can be beneficial—this is how a Roth conversion ladder works.

Let’s say you have money in a traditional IRA. You can choose to convert some of the funds from your traditional IRA to a Roth each year. As you make these annual conversions, the funds that remain in the traditional IRA are still growing.

By converting assets in small chunks, you’re able to decrease your marginal tax rate and pay less in taxes, especially if your conversions are below the marginal tax rate. This allows you to pay the least amount of taxes. 

There is no limit to how many conversions you can make, so you can break them up into small chunks over many years.

Once you convert funds as a part of the Roth conversion ladder, you’re not allowed to recharacterize them or reverse the conversion. It’s important to be aware of the tax implications of this type of financial move. It’s also beneficial if you plan to have enough money set aside to pay income taxes after the conversion without tapping into the retirement fund, allowing those assets to continue growing in value.

Once you convert funds, the five-year period begins. For example, if you converted $10,000 in 2022, you wouldn't be able to withdraw any earnings until at least 2027, five years later. However, this is how the ladder may benefit you. For example, let's say you have $50,000 in a traditional IRA. If you converted $10,000 in 2022, and then another $10,000 in 2023, you'd be able to withdraw money from the Roth IRA in 2027 and 2028 tax-free. Also, this benefits you because converting $10,000 per year and paying taxes on that smaller amount saves you more money than if you converted all $50,000 at once and paid taxes on that larger amount.

What It Means for Individual Investors

A Roth conversion ladder can help you save money on your taxes, particularly if your income level is lower when you convert than it will be in the future. You’ll be able to capitalize on the lower tax rate on a lower amount of money and allow your retirement savings to grow tax-free.

Key Takeaways

  • A Roth conversion ladder is an investment strategy that involves converting small portions of retirement savings from one account into a Roth IRA over time. 
  • Converting assets in small chunks over multiple years can help you save on taxes.
  • Assets held in various retirement accounts such as traditional IRAs, 401(k)s, and 403(b)s can be converted into a Roth IRA.

Article Sources

  1. Financial Industry Regulatory Authority. "Individual Retirement Accounts."

  2. Wells Fargo. "Converting to a Roth IRA."

  3. Ironwood Wealth Management. "Should You Use a Roth IRA Conversion Ladder To Fund Early Retirement?"