Pros and Cons of a Roth IRA Conversion Ladder: Is it Right for You?

It is often said that only two things in life are certain: death and taxes. We can’t really help with the first one, but we definitely have some say in the latter when it comes to taxes.

Like it or not, taxation is a major factor that influences our financial decisions. Taxes can influence what kind of house we buy, what kind of car we get, and pretty much every other financial decision in your life. There are entire industries built around reducing the amount of taxes people pay through clever financial vehicles.

Taxes also heavily affect how people save for retirement. A Roth IRA is one of the most frequently used retirement vehicles. This is because the Roth IRA allows you to contribute post-tax dollars so your investments can grow and be withdrawn tax-free. In contrast, with a traditional IRA, your money grows tax-free but you have to pay income tax when you actually withdraw it and use it during retirement.

In order to minimize these taxes, a lot of people set up a Roth IRA conversion ladder. A Roth IRA conversion ladder allows you to siphon money from a traditional IRA to a Roth IRA, preferably during low income years in order to minimize taxes as much as possible.

How Does a Roth IRA Conversion Ladder Work?

In general, a person cannot make contributions to a Roth IRA if their modified adjusted gross income (MAGI) is above a certain amount. As of 2021, the income limit for making contributions to a Roth IRA is $139,000 for single filers and $206,000 for married filers.

With a conversion ladder, you can transfer money from a Traditional IRA to your Roth IRA. You still have to pay income tax on these funds you transfer for that particular year. After 5 years, the amount of money you converted can now be withdrawn, without taxes or penalties!

Here is an example of what we mean. Say you convert $30,000 from your traditional IRA to a Roth IRA. You will pay income tax at your effective tax rate for that year. If, however, you have a low income year or are taking a year off, then it’s possible you don’t have to pay any taxes on the conversion! Then, once it’s in the Roth, that money will grow tax-free and you will not have to pay any income tax when you withdraw it.

The reason it’s called a Roth conversion ladder is because part of this strategy can entail you converting money year after year in a ladder format.

Also, once you retire, your income is likely to fall. If you are planning on partly relying on your Roth IRA during retirement, then any conversions may be tax-free or at least taxed at a very low rate. In other words, converting money to your Roth IRA from a traditional IRA can possibly be a way to not pay taxes on your retirement accounts.

One important thing to keep in mind about this setup is that you need to wait at least 5 years after making Roth IRA conversions. It’s important to realize each Roth IRA contribution must stand on its own and you have to wait for 5 years to get the tax benefits.

This is what a Roth IRA conversion ladder is: a series of conversions to your Roth IRA from other retirement funds. With a ladder, those who are usually ineligible to make contributions to their Roth IRA because their income is too high can still make contributions. The contributions are not tax-free, but the earnings and growth on that contribution would be tax-free. In other words, an IRA conversion ladder is a clever way to get around certain restrictions and tax-laws surrounding retirement funds, so you can enjoy more of your hard-earned money when you are in retirement.

Pros of a Roth IRA Conversion Ladder

- Fewer taxes in the future. The main benefit of opening up an IRA conversion ladder is that you will pay fewer taxes in the future. The key feature of a Roth IRA is that your contributions grow tax-free, even if the original contributions are not tax-free. Once you put money in a Roth IRA, you no longer have to pay taxes or penalties on it, provided you are making a qualified distribution. This fact goes double if you are in a high-income bracket as you get older. Overall, you will pay less in taxes with a Roth IRA than a traditional IRA.

- No minimum distribution requirement. Another benefit of a Roth IRA conversion ladder is that there’s no minimum age you have to take minimum distributions. With a traditional IRA, you also are legally required to start taking minimum distributions once you hit 72. A Roth IRA has no such minimum distribution requirement. A Roth IRA can also be passed on to your heirs with no penalties or distribution requirements.

- Get around income limits for a Roth IRA. There are income limits for tax-deductible contributions to a traditional IRA, which can actually work in favor of a Roth IRA. These nondeductible contributions can be converted to your Roth IRA. There is no tax liability on these contributions as you didn’t get a tax deduction for the initial contribution to the traditional IRA. You never have to use your Roth IRA money and that money can be passed down to heirs and they can withdraw any earnings completely tax-free.

- Versatility in retirement funds. It’s always a good idea to diversify and have your money in more than just one financial vehicles. That way, if one falters, the others can pick up the slack. With enough vehicles for retirement, your income can be substantially higher during retirement. The benefit of a Roth IRA is that it provides a source of income in retirement that does not increase your tax liability.

Cons of a Roth IRA Conversion Ladder

- Still have to pay income tax. Unfortunately, there is no way to get rid of income tax requirements for funds that are contributed to a traditional IRA. You will have to pay an income tax on that money when you convert it and put it into your Roth IRA, unless it’s during a low income tax year.

- Converting money can put you in a higher tax bracket. It is entirely possible that the conversion of the money can put you in a higher tax bracket. Say you are currently in the 12% tax bracket and you convert $30,000. That conversion may bump you up into a higher bracket, so you would have to pay a higher tax.

- You have to wait 5 years on conversions. Contributions to a Roth IRA can be withdrawn at any time with no strings attached. However, there is a 5-year waiting period on withdrawals for any earnings. If you try to withdraw any earnings before then you will have to pay a penalty.

- It can be hard to pay taxes on large conversions. Since Roth IRA conversions can be large sums of money, it can be hard to find the money to pay the income tax on the conversion. Illiquidity might require you to have withholding tax taken from your balance.

- May not benefit if you have a low tax rate in the future. The entire point of setting up a Roth IRA conversion ladder is so that you can have a sizable source of tax-free income in the future. If you have a lower income in the future than when you make the conversions, then you might be paying more on your conversions than had you just waited to use your traditional IRA when you hit retirement age. It’s important to consult with a tax professional for your particular situation.

Roth IRA Conversion Ladder Final Verdict

Taxation is inevitable in life. But, that doesn’t mean you can’t organize your finances in a way to legally pay fewer taxes and use the benefits the government has given you. A Roth IRA conversion ladder is a way fantastic way to pay less taxes and increase your total retirement savings. If you find yourself in a higher tax bracket in old age, whether it’s because taxes were increased or you make more money, a Roth IRA can help you save a lot on those taxes in the long-term.

A Roth IRA conversion ladder does have some risks though, chief among them being the large tax bill at the time of conversion and the potential of ending up in a lower tax bracket in old age than when you made the conversions. So, it’s important to review your options and consult a tax advisor for advice on whether to make a Roth IRA conversion ladder.

‍