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Roth Ladders: Climb for Freedom

[Before reading this article, I strongly recommend reading Traditional or Roth and Is There a FIRE Backdoor?Please take the time to read the website disclosure statement if you have not already here.]

Climb for Freedom

Have you ever climbed a ladder to reach freedom? Whether literally or metaphorically, ladders help us reach unobtainable heights. Today, my goal is to show you how to achieve financial independence earlier and provide more flexibility for your future dollars by using a strategy known as Roth Ladder Conversions. 

This secret strategy is not only a way to buy freedom for younger workers but a way for older workers and those already retired to live life on their terms. As a wise individual once said, there are only two guarantees in life: Death and taxes. 

But, while we cannot control the first, we can control the second. So, join me as I demystify Roth ladders in today’s short post!

How they work

Roth ladder conversions are yearly conversions of pre-tax dollars into Roth ones; hence, a ladder is created by layering them yearly. We layer conversions because it allows us to harness the power of tax rates and annual income in a preferential manner. While you could convert traditional savings to Roth at any time and with any amount, the preferred time is when you have a lower tax bracket, converting up to the bracket you desire. By doing conversions this way, you pay an overall lower tax rate and gain access to your savings earlier.

Example

Stacy earns $250,000 a year, and her effective tax rate is 20%. Stacy saves $19,500 a year in the pre-tax format through her 401(k). After ten years of saving, Stacy accumulated has $500,000 through compound interest. 

Stacy then leaves her job to go on a sabbatical (or retire). She earns a part-time income of $30,000 a year by doing a small amount of consulting work; this modest income places her in the 8% effective tax bracket. Stacy now converts $50,000 a year for the next ten years; we will assume the money no longer grows to make this example easier. Thus, Stacy depletes her $500,000 in pre-tax savings to entirely Roth savings.

By converting to Roth in $50,000 chunks over ten years, Stacy saves over $50,000 in taxes. This savings of $50,000 comes from Stacy’s new effective tax rate of 12% instead of 20%. 

If the money had been invested in Roth originally, Stacy would have lost out on this $50,000. Instead, Stacy paid what she owed to Uncle Sam by being in a lower tax bracket, nothing more.

Early Retirement

Now the beauty of this strategy stems from the ability to use these converted dollars earlier than the standard retirement age, without penalty. Under the US tax code, Roth conversions can be withdrawn after five years, incurring no taxes or penalties on the converted amount for those under 59.5. Sorry, but you cannot touch the continuing growth within the Roth account until age 59.5. The government locks this up by applying taxes and penalties on this portion if you withdraw it.

So, suppose Stacy has adequate savings or part-time income to cover her expenses for the next five years while her Roth money ages. Stacy will now have a ladder of $50,000 a year that can be withdrawn once this period has elapsed. Thus, Stacy climbs her Roth ladder into early retirement!

The added benefit of Roth ladder conversions is the protection provided to Stacy if she suddenly needs a large chunk of money. Instead of paying taxes on it all at once at a higher rate, she has tax-free money locked in at lower rates.

What about those not trying to reach early retirement? For individuals who want to minimize RMD payments or the ten-year depletion rule under the SECURE Act for heirs, Roth ladders present a great escape. 

RMDs

For those who have never heard of RMDs before, these are required minimum distributions that the government makes individuals take, once they turn age 72, from traditional retirement accounts. An exception to RMDs applies to 401(k) and 403(b) account holders if they actively work at the employer tied to the account. 

Interestingly, suppose you have after-tax or Roth dollars in your employer retirement account. In that case, they are included in your RMD calculation. So, if you do not need these dollars, you should consider rolling them over into a Roth IRA, shielding them from otherwise not required distributions.

As learned so far, Roth ladders deplete traditional balances in IRA and 401(k) accounts, thus eliminating the need to partake in RMDs. Additionally, not only do Roth ladders save taxes by spreading income out over several tax years, but they also minimize the taxable estate that heirs will inherit! Thus, for those who do not want to be forced to take money out, Roth ladders provide a more palatable approach to converting money versus doing it all at once, protecting them and their heirs.

Depletion Rule

When Congress passed the SECURE Act in 2019, it changed the rules of the tax game. Most inheritors of traditional accounts now became required to deplete them to a zero-dollar balance within ten years. Previously, inheritors could drain accounts throughout their lifetime, thus incurring a smaller tax burden. Congress changed the rules to create a higher effective tax rate on inheritors, which now helps fund the government more than previously. Thus, if you plan to pass on substantial retirement assets onto your heirs, Roth ladders can help convert pre-tax balances through tax-efficient treatment to prevent your heirs from being burdened and shielding your estate.

A Note on Higher Tax Rates

There has been much talk lately in the media and professional circles around the fact that government debt has ballooned and that current tax rates are insufficient to keep the deficit in check. If you believe that tax rates will increase in the future from their recent lows, Roth ladders can help you lock in current tax rates.

In Summary

As illustrated above, Roth ladders a powerful tool. Not only can they help you achieve financial freedom at a younger age, but Roth ladders also help you manage your taxes later in life and death! By simply deferring taxes now to pay a lower tax rate in the future, hopefully, you can optimize your taxes and better control your retirement and life! What do you think of Roth ladders? Have you ever heard of or utilized them before? Let me know in the comments and as always, have a great day!


Mile High Finance Guy

finance demystified, one mountain at a time






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