All types of investors can find the Roth IRA a very attractive retirement account. Roth IRAs are a great way to save taxes, especially if your future tax bracket will be higher.

The Roth conversion ladder strategy can provide tax savings for money that you have in retirement accounts.

What’s a Roth conversion ladder?

Let’s begin with the Roth IRA. The Roth IRA allows investors to have tax-free growth and tax-free withdrawals during retirement. This is because your money is subject to taxes before it goes into the Roth. Your contributions can be withdrawn at any time without penalty or tax.

Roth IRAs have income and contribution limits. In 2023, $6,500 (or $7,500 for those 50 years or older) are the annual contributions limits. There is no limit to the amount you can convert into a Roth IRA and no income limitations on conversions.

The Roth conversion ladder allows you to take money from tax-deferred retirement funds and slowly move it into a Roth IRA. This ladder can be used to climb the ladder and gain tax-free future withdrawals, with inflation at an all-time high of 40 years.

What do Roth conversion ladders look like?

Renee Collins is a certified financial planner and certified public accounting at Retire Ready Inc. in Chicago.

Collins states that Roth ladders can be most beneficial to those who have most of their wealth in traditional IRAs or 401(ks, and anticipate being in a higher tax bracket. You can save taxes by moving your tax-deferred funds to a Roth IRA gradually, as you will not have to pay taxes when you withdraw them.

This will allow you to grow your money tax-free. After five years, you can also withdraw tax-free your Roth IRA conversions. Remember that the clock runs for five years after each new contribution.

A Roth conversion ladder can be used to diversify your tax burden. This is where investors combine taxable and non-taxable accounts in order to lower their tax bill when they retire.

Collins states, “Right now I find that most clients don’t plan for tax diversification.” “And most clients don’t plan for taxes so they assume they’ll be in a lower bracket in retirement .”

Inflation benefits of a Roth ladder

You might have noticed large dips in your retirement savings accounts if you were brave enough to take a look at them recently.

Year to date, the Dow Jones, S&P 500, and Nasdaq have all been down. While stock prices have declined in many cases, inflation has remained high.

One upside to the down market in retirement investing is that you could convert some of your tax-deferred retirement funds into a Roth now. This would potentially lower your investment than if your portfolio had not taken a hit. Ali Swart, CFP at Waldron Private Wealth based in Bridgeville Pennsylvania, said:

She says, “The most important thing is that the money is going into a Roth IRA that is completely tax-free.” “You are converting a lower amount and we all know the markets will rebound eventually, so all that growth will be tax-free .”

Early retirement ladders

Roth ladders are also a great option for those who plan to retire early. They can withdraw their earnings (not contributions) tax-free before they reach age 59 1/2, provided the money is in the account for at least five years. You could face penalties if you try to withdraw money before this date.

Timing of your Roth ladder is critical if you plan to retire early. Swart advises.

“Often people start these Roth conversion ladders at minimum five years before they need the money. This allows them to wait that five-year period.”

Roth ladder mistakes to avoid

While Roth ladders may help you save tax money, they can also cause you to pay more taxes if not careful.

A Roth ladder should be tax-efficient. You should only convert amounts that don’t push you into a higher tax bracket.

You should make your conversions a ladder and do them slowly. There are seven income tax brackets used by the IRS to determine how much you will pay in taxes. The higher your tax bracket, the more taxes you will have to pay. The lowest tax bracket in 2022 and 2023 is 10%, while the highest is 37 %.

The nice thing about the conversion, is that it doesn’t take you one year to complete the whole process. Collins states that you can complete the conversion in two, three, or more years. You can still pay taxes and keep the tax rates low.

She gives an example of a person who is currently in the 22% tax bracket for the 2022 tax year but anticipates moving up to a higher bracket later.

This individual would only convert amounts to keep them in the 22% bracket. They wouldn’t convert any amount that would increase their total income for that year over $89,075.

Their total income includes the Roth conversion amount and all other income for the year. They would be taxed more if they converted more of their retirement savings to the Roth.

You should also be aware of the Roth five-year rule when you are doing a Roth ladder. Swart suggests that you keep track of the date and time you convert.

“You don’t want to implement the strategy, then get years mixed-up and accidentally incur 10% early withdrawal because that five year period was somehow void.”

A tax advisor or financial professional can help you avoid these issues when you use a Roth conversion ladder.