How a Roth Ladder Can Improve Your Retirement Savings

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The Roth IRA can be an attractive retirement account for all types of investors. One reason is that Roth IRAs can help you save money on taxes, especially if you plan to be in a higher tax bracket in the future.

A strategy called the Roth Conversion Ladder can help you realize more tax savings on money you may have stashed away in other retirement accounts.

What is a Roth Conversion Scale?

First, let’s start with the Roth IRA. A Roth IRA is a retirement account that allows investors to enjoy tax-free growth and make tax-free withdrawals in retirement. This is because you pay taxes on your money before you deposit it into the Roth. You can also withdraw your contributions at any time, without tax or penalty.

Roth IRAs have income limits as well as annual contribution limits — $6,500 in 2023 (or $7,500 if you’re 50 or older). But there’s no limit on the amount of money you can convert to a Roth IRA, and there’s no income limit on conversions either.

See: Thinking about a Roth conversion? If You Have an IRA, Consider This “Bear Market Bonus”

A Roth conversion ladder involves taking money out of tax-deferred retirement accounts and gradually transferring it into a Roth IRA. With inflation at a high of 40 years, now might be a good time to consider using this ladder to work your way up to tax-free withdrawals in the future.

How do Roth conversion scales work?

“You basically take a piece of it…a little bit each year, until you’ve either made your entire retirement tax-free or you’ve exhausted the top of your tax bracket,” says Renee. Collins, a chartered accountant. certified public planner and accountant with Retire Ready Inc., a financial planning firm in Chicago.

Roth’s scales are most useful for people who have most of their money in traditional IRAs and 401(k)s and expect to be in a higher tax bracket in the future, says Collins. Since these tax-deferred accounts require you to pay taxes after you make withdrawals, gradually transferring these funds to a Roth IRA now could mean tax savings in retirement.

This way, more of your money could benefit from tax-free growth. You can also make tax-free withdrawals from your converted Roth IRA contributions after five years. And don’t forget that the clock is set back five years for each new contribution you make.

Using a Roth conversion ladder is a form of tax diversification, which is when investors use a combination of taxable and non-taxable accounts to help reduce the tax they pay in retirement .

“Right now, what I’m seeing with most clients is that there’s no tax diversification,” says Collins. “And most clients don’t anticipate taxes, so they just assume they’ll be in a lower tax bracket in retirement.”

Also read about TIPS ladders: How to Get a Guaranteed 4.3% Retirement Spending Rate

Advantages of a Roth ladder during inflation

If you’ve been brave enough to look at your retirement savings accounts lately, you may have noticed some big drops.

The Dow Jones DJIA,
S&P 500 SPX,
and Nasdaq COMP,
are all down since the beginning of the year. Many stock prices fell, while inflation remained stubbornly high.

The benefit of the bear market for retirement investors is that if you converted some of your money from a tax-deferred retirement account into a Roth now, you would potentially pay less than if your portfolio hadn’t taken a hit. , says Ali Swart , CFP at Waldron Private Wealth, based in Bridgeville, Pennsylvania.

“The most important thing is that you put that money into a completely tax-free vehicle with the Roth IRA,” she says. “You convert a lower amount, and we all know the markets will eventually rebound, and all that growth will be captured tax-free.”

Roth scales and early retirement

Those who plan to take early retirement can also benefit from the Roth scales, as they can access tax-free withdrawals of their contributions (not income) before age 59½, provided the money has been in the account for five years. Trying to withdraw money before that could mean paying penalties in addition to income tax.

If you’re planning to retire early, the timing of your Roth scale is crucial, Swart says.

“Often people will start these Roth conversion ladders at least five years before they need the money, so they can wait that five-year period.”

See: 6 things that might change your mind about early retirement

Roth Scale Mistakes to Avoid

Although Roth scales can help you save money on taxes, they can also cause you to pay more taxes if you’re not careful.

To make sure a Roth scale is tax-efficient, you need to convert amounts that won’t put you into a higher tax bracket, Collins says.

This is why you make your conversions a “ladder” and do them gradually. The IRS has seven tax brackets that determine how much you pay in taxes. The higher the tax bracket, the more tax you pay. In 2022 and 2023, the lowest tax bracket is 10% and the highest is 37%.

“The advantage of conversion is that you don’t have to do the whole conversion in a year. You can do it over two years, three years, or whatever it takes to do the conversion, pay the taxes, and keep the tax rates relatively low,” says Collins.

She gives the example of someone who is in the 22% tax bracket in the 2022 tax year and expects to be in a higher tax bracket later.

This person would only convert amounts that would keep them in that 22% bracket, meaning they would not convert an amount that would increase their total income for that tax year above $89,075.

Their total income includes the Roth conversion amount and any other income they had for the year. If they convert more of their retirement savings into Roths, they would be pushed into the 24% tax bracket and end up paying more taxes.

Read next: The 401(k) contribution limit will increase by almost 10% in 2023, but it’s not always a good idea to maximize your retirement investments

When making a Roth scale you also want to be aware of the five-year rule for Roth accounts. Swart says you can do this by keeping track of when you make each conversion.

“You don’t want to implement the strategy and then mix up the years and accidentally take a 10% early withdrawal because you kind of canceled those five years.”

If you need help avoiding these kinds of problems with a Roth conversion scale, consider working with a tax advisor or finance professional to ensure you get the maximum tax benefit.

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Elizabeth Ayoola writes for NerdWallet. Email: [email protected]