Author Topic: Roth Ladder Confusion / Question  (Read 1475 times)

FIRE 20/20

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Roth Ladder Confusion / Question
« on: January 06, 2018, 09:34:24 AM »
I have a question about the mechanics of implementing the Roth Conversion Ladder.  If my description isn't clear, the Root of Good post demonstrates it pretty well in the "Root of Good’s Roth IRA Conversion Ladder".  http://rootofgood.com/roth-ira-conversion-ladder-early-retirement/  This post shows contributions to the ladder continuing at ages 55-60.  However, the purpose of the Roth conversion ladder is to avoid the 10% penalty for distributions prior to 59 1/2.  I don't need to have any money in a Roth IRA when I'm 60, 61, 62, etc. because I could just withdraw directly from my 401(k) or Traditional IRA.  For that reason, shouldn't you stop building the ladder at age 55 (or 54.5)?  I think the answer is yes - you should not contribute to the Roth Conversion ladder during the last 5 years prior to turning 59.5 because by the time you will reach those rungs you are able to withdraw directly from your 401(k) / Traditional IRA without any penalties (you still owe tax, thus the next question). 

Second question - If that is correct and you should stop adding rungs to the ladder at age ~55, then does it appear that you have zero income from ages 55-60?  You will not be taking distributions from a 401(k) or a Traditional IRA during those last 5 years before 59.5.  From age 55-59.5 you will be living on the Roth Conversion rungs you made created while you were ages 50-55, and you paid income tax on those conversions at the time you made them.  You would then start taking distributions from your 401(k)/Traditional IRA starting at 59.5 and would then begin paying income tax on those distributions.  Would it then be more efficient to create a half-rung starting at age 55 by converting $20k to your Roth, thus showing a low income ($20k) from years 55-60 due to conversions and then only need to take out $20k from your 401(k) / Traditional IRA in years 60-65?  This would have the benefit of showing $20k of income for 10 years rather than $0 income in 5 years and $40k in income for 5 years.  Given the progressive nature of the tax code and the resulting marginal tax rates I think that would be more efficient. 

Here's what I think it looks like.
Age 50 - have 5 years expenses available in taxable accounts.  Create first rung of Roth Ladder for withdrawal at 55.  Taxes paid on conversion.
51 - Spend 1 year of taxable accounts, have 4 years of expenses remaining in taxable accounts.  Create 2nd rung of Roth Ladder.  Taxes paid on conversion.
52 - Spend 1 year of taxable accounts, have 3 years of expenses remaining in taxable accounts.  Create 3rd rung of Roth Ladder.  Taxes paid on conversion.
53 - Spend 1 year of taxable accounts, have 2 years of expenses remaining in taxable accounts.  Create HALF SIZE rung of Roth Ladder.  Taxes paid on conversion at lower rate.
54 - Spend 1 year of taxable accounts, have 1 years of expenses remaining in taxable accounts.  Create half-size rung of Roth Ladder.
55 - Spend 1 year of taxable accounts, have 0 years of expenses remaining in taxable accounts.  Create half-size rung of Roth Ladder. 
56 - Spend 1st year of Roth Ladder (from age 50).  Create half-size 7th rung.
57 - Spend 2nd year of Roth Ladder (from age 51).  Create half-size 8th rung.
58 - Spend 3rd year of Roth Ladder (from age 52).  Create half-size 9th rung.
59 - Spend 4th year of Roth Ladder from age 59.0 to 59.5.  This rung is half-size and thus covers the half-year.  At age 59.5 withdraw half a year's of expenses from your 401(k) / Traditional IRA to get you to 60.  Pay tax on $20k withdrawal only.
60 - Spend half-size rung created at age 55.  This is tax free.  Withdraw half a year's expenses and pay tax on that $20k
61-64 Continue to spend half-rungs and half-size withdrawals as taxable income until the last half rung contribution you made at age 59. 
65+ No more conversion rungs - standard withdrawals from 401(k) / Traditional IRA cover full amount of expenses.

Does this make sense, or am I missing something obvious?  I have read every blog post I can find on Roth IRA conversion ladders but I haven't seen this addressed.  If someone has addressed it, can you point me to the article and did they come to the same conclusion I did?  I'd love to see a MadFientist post on this, but if he has written one up I haven't seen it. 

MDM

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Re: Roth Ladder Confusion / Question
« Reply #1 on: January 06, 2018, 10:32:51 AM »
Does this make sense, or am I missing something obvious?
Yes, it makes sense.  Perhaps missing a fine point: it is often worth paying a lower tax rate on a Roth conversion to avoid paying a higher tax rate later.

In other words, it might be worthwhile to convert to the top of the 10% bracket (or even higher, depending on circumstances) every year, instead of limiting conversions to the tax free amount.

seattlecyclone

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Re: Roth Ladder Confusion / Question
« Reply #2 on: January 06, 2018, 10:53:55 AM »
I have a question about the mechanics of implementing the Roth Conversion Ladder.  If my description isn't clear, the Root of Good post demonstrates it pretty well in the "Root of Good’s Roth IRA Conversion Ladder".  http://rootofgood.com/roth-ira-conversion-ladder-early-retirement/  This post shows contributions to the ladder continuing at ages 55-60.  However, the purpose of the Roth conversion ladder is to avoid the 10% penalty for distributions prior to 59 1/2.  I don't need to have any money in a Roth IRA when I'm 60, 61, 62, etc. because I could just withdraw directly from my 401(k) or Traditional IRA.  For that reason, shouldn't you stop building the ladder at age 55 (or 54.5)?  I think the answer is yes - you should not contribute to the Roth Conversion ladder during the last 5 years prior to turning 59.5 because by the time you will reach those rungs you are able to withdraw directly from your 401(k) / Traditional IRA without any penalties (you still owe tax, thus the next question).

Second question - If that is correct and you should stop adding rungs to the ladder at age ~55, then does it appear that you have zero income from ages 55-60?  You will not be taking distributions from a 401(k) or a Traditional IRA during those last 5 years before 59.5.  From age 55-59.5 you will be living on the Roth Conversion rungs you made created while you were ages 50-55, and you paid income tax on those conversions at the time you made them.  You would then start taking distributions from your 401(k)/Traditional IRA starting at 59.5 and would then begin paying income tax on those distributions.  Would it then be more efficient to create a half-rung starting at age 55 by converting $20k to your Roth, thus showing a low income ($20k) from years 55-60 due to conversions and then only need to take out $20k from your 401(k) / Traditional IRA in years 60-65?  This would have the benefit of showing $20k of income for 10 years rather than $0 income in 5 years and $40k in income for 5 years.  Given the progressive nature of the tax code and the resulting marginal tax rates I think that would be more efficient.

Further Roth conversions after 55 are not necessary for avoiding the 10% early withdrawal tax, as you note. Continuing to do some level of Roth conversions afterwards may be a good idea to use up the 0% taxable space under the standard deduction or to set your income to a favorable level for ACA subsidies or whatever other reason. As you note, keeping your income as steady as possible from year to year is generally the way to pay the least tax over your lifetime in a progressive tax system.

Also keep in mind that it's not strictly necessary to have the full five years in a taxable account. Other sources of savings that you could use during this time are previous Roth contributions, HSA funds that are substantiated by a previous medical bill, or just paying the 10% early withdrawal tax for part of your withdrawals. The Mad Fientist notes that contributing less than the maximum to your retirement accounts solely to build up a five-year taxable cushion can easily be worse than simply paying the extra 10% after you retire. This is especially true if you plan for your marginal tax rate to go down by 10% or more once you retire.

Catbert

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Re: Roth Ladder Confusion / Question
« Reply #3 on: January 06, 2018, 11:24:30 AM »
Another reason I person might want to keep converting is if they have a very large IRA/401k balance to reduce the RMDs that will be necessary after 70.5. 

FIRE 20/20

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Re: Roth Ladder Confusion / Question
« Reply #4 on: January 06, 2018, 12:47:14 PM »
Awesome - thank you all for your comments.  I was starting to feel like I was crazy because I hadn't seen this discussed anywhere.  I probably just missed the places it was posted.

Also keep in mind that it's not strictly necessary to have the full five years in a taxable account. Other sources of savings that you could use during this time are previous Roth contributions, HSA funds that are substantiated by a previous medical bill, or just paying the 10% early withdrawal tax for part of your withdrawals. The Mad Fientist notes that contributing less than the maximum to your retirement accounts solely to build up a five-year taxable cushion can easily be worse than simply paying the extra 10% after you retire. This is especially true if you plan for your marginal tax rate to go down by 10% or more once you retire.

seattlecyclone - this is a good point.  You mention a few optimizations that I skipped over in my post.  I wanted to keep it simple to make my question clear, but I'm glad you mention it in case anyone else reads this post at some point. 

Again, thanks Catbert, seattlecyclone, and MDM for confirming that I am not mistaken about how the Roth ladder works and suggesting additional optimizations and considerations.