Published on: July 27, 2020 Last modified: November 23, 2020

Tips on How to Successfully Manage a Roth IRA Conversion Ladder

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    There is something about going to work every day that makes you dream about retirement. Of course, one of the biggest concerns about retirement is having enough money to enjoy your retirement, and you already know Social Security isn’t going to cut it. Most of the experts agree that you’re going to need 80 percent of your current salary when you retire. So, if you’re making $100,000 a year now, you’ll need $80 annually once you retire. 

    Most people save for retirement in one of three accounts: an individual retirement account (IRA), a 401(K), or a Roth 401(K). Then, there may come a time when you want to manage a Roth IRA conversion ladder. This allows you to move money from an IRA or 401(K) into a Roth 401(K). You would want to do this to retire early and access your retirement funds before age 59 1/2, or your tax bracket has grown higher than you expected and it’s going to keep going up. Here’s what you need to know about Roth 401(K) and a Roth IRA conversion ladder, including the steps to creating a Roth IRA conversion ladder.

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    What Is a Roth 401(K)?

    Roth 401(K) is a retirement account that’s sponsored by your employer. In many cases, your employer matches the funds up to a certain percentage of your salary that you put into your Roth 401(K). With this type of 401(K), the money that you invest in the account has already been taxed by the Internal Revenue Service (IRS).

    Since the money was taxed before entering the account, you don’t have to pay taxes on the money upon withdrawing it at retirement. However, if you choose to take the money out before you reach the age of 59.5 or before five years, you’ll pay an early withdrawal penalty of up to 10 percent. There are some cases where you can take the money out early without paying a penalty, such as total disability. 

    Decide how to invest the money after placing funds into your Roth 401(K) and before taking it out in retirement. Many people invest it in safer mutual funds, while others sink the funds into stocks and bonds. There are rules about how much you can put into the Roth 401(K). As of 2019, the amount was $19,500 per year. Investors over 50 can put in catch-up contributions of up to an additional $6,000 per year. 

    If you leave your current employer, you need to make a decision about what to do with your Roth 401(K). You can cash it out, move it to an IRA, leave it in the current Roth 401(K), or move it to your new employer’s Roth 401(K).

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    What Is a Roth IRA Conversion Ladder?

    A Roth IRA is similar to a Roth 401(K) with the exception that you can withdraw money without a penalty at a younger age after five years. Further, you can place more funds into the account than a Roth 401(K). This is the type of account that you want to use if you want to retire early. 

    For example, if you want to retire at 45, it’s a long time before you’re going to reach 59.5 and be able to access your regular Roth 401(K) without the 10 percent penalty. Of course, you must plan ahead to be able to access funds at 45 because the money must be in the Roth IRA for at least five years. You need to start placing the money in the Roth IRA when you’re 40 and continue doing so each year until you reach the age of 54. The money you place in the Roth IRA at 54 will be available when you’re 59. After that year, you can access your regular Roth 401(K). 

    You need to be careful when moving funds from your 401(K) or IRA to a Roth IRA. You don’t want the IRS to audit your accounts and discover that you’ve done something incorrectly. When tackling a financial transaction like this, it’s always best to get a professional involved in the process. They can ensure that you’re determining your tax liability correctly.

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    Steps to Set Up a Roth IRA Conversion Ladder

    As you move money into a Roth IRA each year, it creates individual accounts that become available one after another and appear to resemble rungs on a ladder. Creating a Roth IRA conversion ladder seems fairly simple. However, since you need to pay taxes on the money you’re moving into the account so that you don’t pay taxes when you pull it out, it’s beneficial to work with a professional to ensure you don’t make any mistakes.

    How to Successfully Manage a Roth IRA

    Follow these steps to help you successfully create your Roth IRA conversion ladder.

    Step 1: Determine when you plan to retire.

    To create a successful Roth IRA conversion ladder, you need to think about when you plan to retire and what funds you have available. You can withdraw funds from your Roth IRA without facing tax penalties, but traditional Roth IRA contributions allow you to contribute only $6,000 per year (or $7,000, if you’re over 50). Instead, you’ll need to convert your funds from your IRA to a Roth IRA to maximize those contributions, as well as have a solid idea of how much money you’ll need to meet your annual income goals during retirement.

    Step 2: Move your money from your 401(k) to an IRA account.

    If you’re changing employers, it’s the ideal time to move your money from a 401(k) to an IRA. On the other hand, if you’re planning to change your retirement contributions to an IRA or Roth IRA account without changing jobs, you may want to work closely with a financial advisor to help you meet your goals.

    Step 3: Start moving funds from your IRA to a Roth IRA account.

    When you make the conversion from a traditional IRA to a Roth IRA, you will pay the taxable rate on those funds at that time. A few things to keep in mind:

    Since you’ll have to pay taxes on that amount based on your current income and how much you move over, you may want to move a certain amount per year. Many people will choose to move over around $40,000 to $50,000 per year. Consult an experienced tax attorney to learn more about the right plan for you and how to effectively move those funds over.

    Step 4: Continue those contributions over the next several years.

    You’ll likely need to continue your Roth IRA contributions for several years, based on how long you have until retirement and how much you have on hand. Make sure you keep an eye on your balance and contributions to ensure the amount will continue to meet your needs as you move toward that time. You may even need to continue conversions after you retire. 

    Suppose that you start Roth IRA conversions at 45 and plan to retire at 55, for example. From 55 to 59½, you’ll need to convert funds from your 401(k) or IRA account to your Roth IRA to make sure that you still have funds available.

    Step 5: Check your other retirement assets.

    The goal of a Roth IRA conversion ladder is to make it possible for you to retire early, before the age of 59½. If you have the assets on hand to do that, it’s an ideal way to extend your retirement years and enjoy them more without penalty.

    At the same time, however, you must ensure that you have funds on hand that will continue to pay for your lifestyle as you reach average retirement years. Continue contributing toward those other retirement assets as you get closer to maximize your savings.

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    Common Mistakes when Managing a Roth IRA Conversion Ladder

    Having a Roth IRA conversion ladder in place can make it easier for you to retire early. Unfortunately, some people commit errors that could make life difficult for them during those years. Working with an experienced tax attorney can help you avoid those errors, but here are a few mistakes to watch out for:

    Paying the wrong taxes on the amount converted to a Roth IRA

    Some people fail to pay the proper taxes based on those conversions, which can leave them with heavy tax penalties later. Make sure you’re working with an experienced tax attorney to ensure that you’re paying the right tax rate on your IRA contributions.

    Failing to plan for future retirement income

    You can quickly burn through a lot of money in the early years of retirement. If you’re planning to retire at the age of 50 and need $50,000 a year, for example, you may find that you go through $500,000 in your first 20 years of retirement — before you even hit the age of 59½. As a result, you may find yourself without the funds you need later. 

    First, make sure you have sources of retirement income outside your Roth IRA. You may use:

    You may also choose to enter into partial retirement in those earlier years, then fully retire when you reach later retirement age.

    Trying to access the funds too early

    You’ll need to wait five years after you make those initial contributions before you can access them without penalty. Some people want to get their hands on those funds faster, like if they’re planning for imminent retirement. These funds cannot be withdrawn without penalty, however.

    Start planning your Roth IRA contributions at least five years before your planned retirement. If possible, start your conversion ladder earlier than that so that you can access the maximum benefit from your retirement contributions. An experienced tax advisor can help you plan for all of these eventualities and more.

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    Get Help with Your Roth IRA Conversion Ladder

    Do you want to learn more about creating a Roth IRA conversion ladder? Do you have questions about whether a Roth IRA is the right choice for your retirement, or at what age you can securely retire? Contact Silver Tax Group for answers to all these questions and more.

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