Author Topic: Traditional IRA to Roth Conversion Ladder  (Read 9477 times)

beavertailbill

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Traditional IRA to Roth Conversion Ladder
« on: January 20, 2015, 07:33:20 AM »
So I have been reading a lot about the Roth IRA on both MMM and madfientist, it seems like a good strategy to reap tax gains on both sides of the transaction. I do; however, have a question. Does the conversion ladder only work if you actually retire early? I know the goal of any early retirement blog is to just that, retire early, but if it doesn't happen is the conversion ladder still a viable strategy? If one does not retire at least 5 years before the 59.5 start date or 70.5 RMD date is there still a benefit?

if the answer is no, is a roth ira the best way to go?

Mississippi Mudstache

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #1 on: January 20, 2015, 07:51:49 AM »
The Roth conversion ladder can still be helpful, even if you are working. I have a good bit of money in traditional IRAs, but when tax time comes along, I calculate how much I can move into a Roth without incurring any tax liability. This means I have an ever-growing balance of Roth IRA contributions that I can use at any time. This will be beneficial to me as an early retiree, but it could be just as useful to a worker who wants to, say, put a down payment on a house, or pay off a mortgage, or buy a car. The key to its usefulness is the ability to dial in the optimal amount of earned income in every given year.

Cheddar Stacker

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #2 on: January 20, 2015, 09:57:51 AM »
Having some funds in a traditional retirement account allows you to "create" taxable income by withdrawing it, or rolling it over into a Roth. This can be a very good thing.

If you put everything in a Roth you won't get a deduction on the way in. When you take it out it won't be taxable, but if that's your only source of "income" you could be leaving tax deductions on the table. If you simply live on $25K/year from a Roth IRA when you turn 60, you could have taxable income of negative $10K. In my opinion, that would be a wasted opportunity.

skyrefuge

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #3 on: January 20, 2015, 11:05:52 AM »
Does the conversion ladder only work if you actually retire early? I know the goal of any early retirement blog is to just that, retire early, but if it doesn't happen is the conversion ladder still a viable strategy?

The conversion ladder is only necessary if you retire early. It's a strategy to gain access to tax-deferred money without paying early-withdrawal penalties. If you retire at a "normal" age, there are no early-withdrawal penalties, so no need to employ the conversion strategy.

I think then what you're really asking is "if I don't plan to retire early, should I put my money in a Traditional IRA or a Roth IRA?"

That depends, as always, on what your current marginal tax rate is now vs. what you expect your average tax rate to be when you take distributions. The Traditional is the better choice when the first number is larger than the second.

For an MMM-style early retiree, the first number will almost always be larger than the second, because they will go from relatively high income during their working years to extremely low income during their retirement years. For a normal retiree, the answer is less clear, and depends on how enormous you expect your stash to grow; will the income it generates exceed the yearly income from your working years?

Certainly the option will still exist to convert Traditional to Roth in retirement or any other time (assuming laws don't change), but it will depend on your income levels and goals at the time to determine if that would be beneficial.

The general idea is that it's nice to get money in a Roth account at times when your tax rate is low (i.e., when your income is low). For a young worker this can be through direct contributions early in their career when they have a low salary. For an early-retiree, it can be through conversions because their salary is $0. Otherwise, when your tax rate/income is relatively "high", your money should go into/stay in a Traditional account.

I have a good bit of money in traditional IRAs, but when tax time comes along, I calculate how much I can move into a Roth without incurring any tax liability.

How do you do this? Doesn't any conversion amount raise your AGI, and thus, incur tax liability?

Homey The Clown

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #4 on: January 20, 2015, 12:12:46 PM »
The conversion ladder is only necessary if you retire early. It's a strategy to gain access to tax-deferred money without paying early-withdrawal penalties. If you retire at a "normal" age, there are no early-withdrawal penalties, so no need to employ the conversion strategy.

Isn't lowering your minimum withdrawals from tax-deferred accounts another reason to move money from those to Roth even if you are 59.5 or older? We could end up in a situation where the minimum withdrawals bump up our tax bracket, depending on our balance at retirement.

wrkirk

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #5 on: January 20, 2015, 12:18:03 PM »
I still don't quite understand how you get the money out of an IRA before 59.5 without paying the penalty for early withdrawal. Can someone fill me in or point me in the right direction to read about it myself? Thanks.

dandarc

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #6 on: January 20, 2015, 12:19:52 PM »
I still don't quite understand how you get the money out of an IRA before 59.5 without paying the penalty for early withdrawal. Can someone fill me in or point me in the right direction to read about it myself? Thanks.

Search these terms:

1.  Roth Ladder as discussed here.

2.  72(t) Substantially Equal Periodic Payments.

Cheddar Stacker

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #7 on: January 20, 2015, 12:27:03 PM »
The conversion ladder is only necessary if you retire early. It's a strategy to gain access to tax-deferred money without paying early-withdrawal penalties. If you retire at a "normal" age, there are no early-withdrawal penalties, so no need to employ the conversion strategy.

Isn't lowering your minimum withdrawals from tax-deferred accounts another reason to move money from those to Roth even if you are 59.5 or older? We could end up in a situation where the minimum withdrawals bump up our tax bracket, depending on our balance at retirement.

Yes. But you don't need the ladder system to do it. You just make a conversion. The ladder is more specifically related to this:

Convert year 1 ------> Withdraw year 6
Convert year 2 ------> Withdraw year 7
Convert year 3 ------> Withdraw year 8
Convert year 4 ------> Withdraw year 9
Convert year 5 ------> Withdraw year 10

You don't need the ladder after 59.5, but you should clear your T money into R money in a tax efficient way to avoid RMD's.

I still don't quite understand how you get the money out of an IRA before 59.5 without paying the penalty for early withdrawal. Can someone fill me in or point me in the right direction to read about it myself? Thanks.

Read this: http://jlcollinsnh.com/2013/12/05/stocks-part-xx-early-retirement-withdrawal-strategies-and-roth-conversion-ladders-from-a-mad-fientist/ or anything else written by the madfientist. Or keep reading around here, it will click.

RapmasterD

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #8 on: January 20, 2015, 01:22:03 PM »
I also thought Sol provided a very nice summary last night on a separate, and might I say, somewhat incendiary topic....ahem.

Thanks Sol.

<<The Roth conversion pipeline is a method in which you retire and then annually convert part of your pre-tax 401k to your Roth IRA, let it sit for five years, and then withdraw it for living expenses without ever paying taxes or penalties.  The challenge is to annually convert the highest amount which does not incur any tax liability.  For a family with a few kids, this amount can easily reach $60k/year under the current tax code, and for some people has been as high as $100k/year under special circumstances like having kids in college.

It has been explained in more detail on this forum many many times, but that's the abbreviated version.  You contribute your money to the 401k before taxes are paid, you convert it tax free, you wait five years, and then you withdraw it tax free and penalty free, regardless of your age.  Thus, the "tax-deferred" account becomes a "tax-free" account, assuming you have five years of patience.

The reason the previous poster said it doesn't work for very large amounts of money is that above about $60k/year the odds of you paying something in taxes start to go up.  You of course start at the 10% bracket on the first $18k of income, so if you wanted to draw $78k/year from your 401k and only had the typical $60k of tax shelter from deductions and exemptions and child tax credits, you'd pay 10% of $18k is $1800 on a total income of $78k, or a 2.3% tax rate.>>

StuckinBoston

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #9 on: January 20, 2015, 04:10:37 PM »
Does contributing to a traditional IRA, prior to rolling over your a pre-tax 401k bucket, have a negative effect on setting up a Roth IRA conversion ladder?

I ask because in one of the Mega backdoor Roth threads I recall reading that splitting earnings on after-tax money into a traditional IRA has negative consequences on setting up a Roth conversion ladder in retirement.  It sounded to me that a person should ideally have $0 in a traditional IRA prior to a pre-tax 401k rollover.   I may have misinterpreted the post - maybe someone can clarify?

seattlecyclone

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #10 on: January 20, 2015, 04:18:13 PM »
I ask because in one of the Mega backdoor Roth threads I recall reading that splitting earnings on after-tax money into a traditional IRA has negative consequences on setting up a Roth conversion ladder in retirement.  It sounded to me that a person should ideally have $0 in a traditional IRA prior to a pre-tax 401k rollover.   I may have misinterpreted the post - maybe someone can clarify?

I think you may have misinterpreted. Pre-tax traditional IRA balances are just fine for the Roth pipeline, whether those balances came from direct contributions to the IRA, 401(k) rollovers, or some combination.

You should avoid having pre-tax money in the traditional IRA if you want to do the "regular" backdoor Roth IRA (because pro-rata rules mean you're forced into converting the pre-tax and after-tax amounts in equal proportions).

MrMoogle

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #11 on: January 20, 2015, 05:18:20 PM »
Does contributing to a traditional IRA, prior to rolling over your a pre-tax 401k bucket, have a negative effect on setting up a Roth IRA conversion ladder?

I ask because in one of the Mega backdoor Roth threads I recall reading that splitting earnings on after-tax money into a traditional IRA has negative consequences on setting up a Roth conversion ladder in retirement.  It sounded to me that a person should ideally have $0 in a traditional IRA prior to a pre-tax 401k rollover.   I may have misinterpreted the post - maybe someone can clarify?

So, before September 2014, I believe this was true.  Since then, it's simpler to do a Mega Backdoor Roth.  Now, your pre-tax 401k contributions can go directly into a Roth IRA and your pre-tax 401k earnings can go directly into a tIRA.  If for some reason you were to roll over your pre-tax 401k into a pre-tax IRA, then this would come back into play.  There are pro-rata rules that could complicate things. 

maki

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #12 on: January 20, 2015, 06:03:08 PM »
+1 to sol's quoted explanation, and also so I can follow this.

wrkirk

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #13 on: January 20, 2015, 07:35:03 PM »
Thanks for the responses, I think I've got it on setting up the ladder once in early retirement.

My next, probably already discussed, question is once one reaches 59 1/2, does it make sense to hold any investments outside a ROTH? It seems like once I've hit the min. age, I should convert my remaining investments (all taxable, assuming I've laddered my way out of the TIRA) over to my ROTH for tax free usage at any amount per year without fear of tax brackets...or am I missing something? Can we convert taxable investments to a ROTH all at once or do we have to worry about income limits during conversion?

Cheddar Stacker

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #14 on: January 20, 2015, 07:49:13 PM »
Nope. Taxable can't be converted, it can only be contributed. So you're subject to the annual limits of 18k on 401k's, 5.500 on IRA's, etc. And you have to have earned income.

MrMoogle

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #15 on: January 20, 2015, 08:19:03 PM »
And you have to have earned income.

And this isn't investment income, I believe it can only be wage income.  It has to be earned in the year you add it to the IRA.

And just to be complete, it can't be excluded (like for expats).

Cheddar Stacker

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #16 on: January 20, 2015, 08:22:28 PM »
And you have to have earned income.

And this isn't investment income, I believe it can only be wage income.  It has to be earned in the year you add it to the IRA.

And just to be complete, it can't be excluded (like for expats).

Yep. It doesn't need to be "wages", but it needs to be earned. So you can have a self-employed business doing whatever and as long as you're actively involved that income is likely earned income. Passive investment income of any kind doesn't count.

StuckinBoston

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #17 on: January 21, 2015, 07:26:18 AM »
I ask because in one of the Mega backdoor Roth threads I recall reading that splitting earnings on after-tax money into a traditional IRA has negative consequences on setting up a Roth conversion ladder in retirement.  It sounded to me that a person should ideally have $0 in a traditional IRA prior to a pre-tax 401k rollover.   I may have misinterpreted the post - maybe someone can clarify?

I think you may have misinterpreted. Pre-tax traditional IRA balances are just fine for the Roth pipeline, whether those balances came from direct contributions to the IRA, 401(k) rollovers, or some combination.

You should avoid having pre-tax money in the traditional IRA if you want to do the "regular" backdoor Roth IRA (because pro-rata rules mean you're forced into converting the pre-tax and after-tax amounts in equal proportions).

Thanks, this does clarify the issue.

wrkirk

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Re: Traditional IRA to Roth Conversion Ladder
« Reply #18 on: January 22, 2015, 11:28:37 AM »
Thanks for the clarification Cheddar and MrMoogle.