Is a Roth Conversion Ladder Right for You?

Key Takeaways

• An IRA Roth conversion ladder is a multiyear strategy that permits account holders to withdraw from their retirement account without penalty before they turn 59.5, but each converted amount must sit for 5 years.

• You’ll pay income tax when converting traditional IRA funds to Roth, so spreading conversions over several years helps manage the tax burden.

• Roth conversion ladders work best if you expect lower income years ahead (like early retirement) or think tax rates will rise, since you can lock in today’s rates.

To optimize their retirement savings, prospective investors and holders of an individual retirement account (IRA) should know how to strategically employ a Roth conversion ladder. Here are actionable insights into such ladders, and how using them can increase financial flexibility in retirement.

What is a Roth Conversion Ladder?

A Roth conversion ladder is a multiyear strategy that permits account holders to withdraw from their retirement account without penalty before they turn 59.5.

With such a strategy, money is transferred from a traditional IRA, 401(k), or other tax-deferred retirement account into a Roth IRA. The difference between it and a standard Roth IRA conversion is that money can be shifted without penalty multiple times annually, as long as the person is age eligible.

Why Consider a Roth Conversion Ladder?

There are a number of benefits that accompany Roth conversion ladders. The primary one is that contributions can be withdrawn at any time with no tax penalty before the investor turns 59.5, allowing for flexibility in retirement and better long-term tax management.

To avoid a 10% penalty, though, the converted amount must be held in the account for at least five years. Therefore, people should start a conversion ladder at least five years before the money will be needed.

Understanding Roth IRAs

Contributions are made with after-tax money. Therefore, investors can withdraw their contributions as often as they wish with no penalty if they are 59.5 or older.

Contributions for the 2024 tax year can total up to $7,000. For those aged 50 and older, there is also an additional $1,000. Contribution to a Roth IRA requires earned income that equals or exceeds their contribution.

Depending on the individual’s filing status and modified adjusted gross income (MAGI), their top Roth IRA contribution could be lowered to zero. So, contributing the full amount in 2024 requires a MAGI of less than $146,000 for single people or $230,000 for those married and filing jointly.

Investors who earn too much money for direct contributions to a Roth may be able to use the Backdoor Strategy to fund one. 

The Mechanics of a Roth Conversion Ladder

For withdrawal contributions to be tax and penalty free, not only must the person be at least age 59.5, there must also have been at least five years since their first contribution to a Roth account. That is called the “five-year” rule and impacts the investor’s financial planning.

Note that the waiting period applies to each conversion. This means that every conversion stands alone. So, if the converted amount is withdrawn before the waiting period’s expiration, there will be a 10% early withdrawal penalty from the IRS.

If the investor does wait five years after each conversion, however, the money can be withdrawn without tax or penalty. That is where the conversion ladder can be advantageous. Investors can perform a number of tax and penalty-free withdrawals by laddering their conversions.

Advantages of Using a Roth Conversion Ladder

There are some key advantages to using a Roth conversion ladder, including more financial control in retirement and the lack of required minimum distributions (RMDs). The latter is a marked departure from traditional IRAs and 401(k)s. 

The biggest selling point is tax-free withdrawals in retirement. This can particularly benefit those who want to maintain a lower tax bracket as opposed to converting a sizeable sum all at once. This staged strategy permits more predictable tax preparation.

Also, funds in a Roth IRA benefit from tax-free withdrawals and growth. And such am account permits more strategic timing of beneficiary withdrawals.  

Potential Drawbacks of the Roth Conversion Ladder

A significant drawback is that conversions are taxable: investors will owe ordinary income tax on the amount shifted into the Roth. Because the amount could be substantial, investors frequently spread conversions over several years.

This all calls for precise financial planning, except that there is also the risk of unexpected tax law changes.

Also note that because Roth IRAs have low contribution limits — up to $7,000 across all IRAs for 2024 — growing a nice-sized nest egg can be challenging.

Conversions vs. Annual Contributions

When it comes to conversions vs. annual contributions, there are differences between the two approaches.

With a conversion, funds are rolled from a pre-tax retirement account, like a 401(k) or another IRA, into a Roth. This avoids income taxes during retirement on the distributions.

However, this may mean income taxes may be owed now on the money converted. And depending on how much is converted, the additional taxable income could bump the investor up to a higher marginal tax bracket.

With a Roth contribution, money is invested into one’s Roth IRA from their checking or savings account or other after-tax source. Taxes have already been paid on the amount contributed to the Roth IRA. Subsequently, the money grows in the Roth account penalty and tax free.

Should I Do a Roth Conversion Ladder?

While a conversion ladder can be a beneficial approach for many investors, it’s not for everyone’s financial goals and plans. Before using one, investors should ask themselves:

• Do they expect years of lower income, maybe during a career break or early in retirement? That could be a good time for conversions as the tax rate may be relatively lower.
• Do you think tax rates will go up or that your income will increase in the future? A conversion could lock in lower rates.
• Do you need immediate access to your funds? If you do not, a ladder allows funds to grow tax free.

Retirement and Alternative Investments 

As a tax-favored way to make sure retirement savings last through the Golden Years, IRAs remain popular. And Willow Wealth, the leading alternative investment platform, offers one in the private market, providing diversification and refuge from constant volatility.

Willow Wealth’s IRA allows pre-retirees to add private-market investments to their retirement account, giving them better opportunities for improved returns. After all, the private market has outdone the S&P 500 in every downturn going back nearly two decades.

Willow Wealth’s plan supports all major accounts, making it easy for investors to shift all or part of a traditional IRA, a SIMPLE one, or SEP IRA, to it. They can also contribute all-new funding. What is more, those who have a 401(k) account, or multiple retirement accounts, may also roll over those.

There is another crucial benefit to participating in Willow Wealth’s retirement program: diversification. While there are no guarantees in a down market, crafting a portfolio of a variety of asset classes can lower overall risk and potentially improve returns.

Alternative Investments and Portfolio Diversification

Alternatives can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform. However, that meant the potentially exceptional gains these investments presented were also limited to these groups.

However, platforms like Willow Wealth provide curated access to private markets for individual investors.   

Investors can get started with minimum investments as low as $5,000 for their first investment (subject to certain exceptions). Willow Wealth offers a curated selection of opportunities across multiple asset classes, ranging from individual investments to diversified funds and automated portfolio solutions. While these investments carry risk, they open the door to opportunities across real estate, private credit, private equity, and more.  

Join more than 500,000 members and start investing in private markets today at willowwealth.com. 

Summary 

Among other benefits, a Roth conversion ladder can offer tax-free withdrawals, flexibility in retirement, and help with taxes over time. In short, it can help ensure that retirement savings last.

There are also potential drawbacks, including the need for precise planning. It is wise to consult with a financial advisor before implementing the strategy.