How to set up your Roth Conversion Ladder
Utilizing a loophole to the penalty system in place around retirement funds might sound complicated. However, building an effective Roth conversion ladder is simply a matter of moving your money around and patience until it becomes usable. Start your Roth conversion ladder in just four steps.
- Start by rolling over your 401k into a Traditional IRA. You should do this once you quit your job. From the time you quit any job, you are free to move your 401k money from that job into an IRA. Also, be aware you aren’t obliged to keep it with the same company that was holding your original 401k. Make the choice that is best for you after considering the options.
- The next step is to transfer some funds from the traditional IRA account into a Roth IRA. Transfer the annual amount you want to access in five years. Do you already have some income from Roth investments you made while working? Then, I suggest only transferring the amount to bring this up to the amount of your annual expenses instead of transferring the entire sum of annual expenses. You will lose less money on taxes doing this in the end.
- Next comes patience. Wait five years. The “Five Year Rule” applies to any investments in an account like a Roth IRA. It means that the investor can only take out the invested money after a five-year waiting period.
- Finally, withdraw the money you converted like an old friend you haven’t seen for five years.
The “ladder” part of the strategy comes into it when you use the technique on a recurring annual basis. As you move toward retirement, you continue to use the ladder to supplement your annual funds until you have reached five years before 59 1/2 when the funds become available.
Why not just contribute annually to a Roth IRA?
You take money out of a tax-protected account when you transfer money from a traditional IRA into a Roth IRA. That means you need to be ready to pay taxes on any money you transfer from a 401k or IRA into a Roth IRA.
This is because contributions to a Roth IRA don’t lower your adjusted gross income, whereas you can get tax breaks when you make contributions to your 401k or traditional IRA. Instead, the money you transfer becomes taxable income for the year.
Another reason you should avoid contributing to a Roth IRA annually is if you are getting anywhere close to emptying your retirement accounts before retirement age. You need to have enough saved to keep up your preferred lifestyle for as long as you plan to be in retirement.
Additionally, you can only take money out of a Roth IRA five years after initially transferring the money into the account. You need to find some money to live on until then. You might already have this covered from
There are plenty of ways to do that, though. Here are a few I love:
Don’t forget about standard retirement accounts for early retirement
Since your Roth conversion ladder only provides you money until you reach 59 ½ years old, you need to have a retirement savings plan for the years beyond that. The first step to finding out exactly how much you need for retirement, which you can do following the steps in the next section.
However, when it comes to investing the money you save annually, you need to know what kinds of standard retirement accounts you should keep to make the most out of your money for early retirement?
You will likely be saving a significant portion of your income each year for retirement, particularly if your goal is to do this early. However, it would be best to maximize your retirement accounts to make the journey faster.
Although it will look different for anyone on the road to financial independence, the common accounts you can build while you are still working include:
- Traditional IRA
- 403b
- 401k
Each of these works slightly differently and has various potentials of effectiveness for your retirement funds. So what do I mean by maxing these accounts out each month or year?
All three of these accounts are tax-protected. The government caps the amount of investment in these so that those in a higher wage bracket don’t benefit more from tax breaks than most lower earners.
Reaching these caps is your goal.
From the time you build your net worth to your retirement goal, you are then ready to retire early and reap the rewards of these accounts using the Roth ladder strategy.
Commonly asked questions about a Roth conversion ladder
How much money should I convert each year?
The amount you should convert each year you employ the Roth ladder strategy depends on how much you have saved and how much you intend to spend each year. As long as you have enough saved for retirement, you should be able to send over the intended amount you will spend annually. So the real question is, how much should you save for retirement?
You’ll need to look at three numbers to figure this out:
- Your income, meaning the amount you make a year after tax.
- The amount you spend each year, or your expenses. These include absolutely everything you spend money on during the year, including utilities, groceries, rent, clothes, vacations, insurance, gas, etc.
- Your intended retirement date. Once you start considering “early” retirement, you get into a pretty subjective area. You need to set out a timeline for your early retirement plans to be truly prepared to be financially independent for the rest of your life.
You might figure all these numbers out and then, six years later, experience a significant life change. Remember to be flexible with all of these, whether they go up or down. You never know what life has in store for you.
Once you have calculated these numbers, you can come up with an annual savings rate for the precise amount you should be saving each month for your retirement.