One popular strategy for reducing future taxes on retirement savings is through Roth individual retirement account (IRA) conversions. By transferring pretax or nondeductible IRA funds to a Roth IRA, individuals can enjoy tax-free growth on their investments. However, this strategy comes with an upfront tax hit, which can be managed using a Roth conversion ladder.
Certified financial planner Preston Cherry explains that a Roth conversion ladder involves spreading out conversions over several years, allowing individuals to pay taxes in smaller increments. This strategic approach requires careful consideration of income levels, tax projections, and future withdrawals to maximize tax savings.
Ashton Lawrence, another certified financial planner, emphasizes the importance of long-term planning when using a Roth conversion ladder. By breaking down large conversions into smaller chunks over time, individuals can minimize the impact on their adjusted gross income and avoid triggering other tax consequences.
Lawrence stresses that the key benefit of a conversion ladder is the ability to achieve tax-free compounded growth on future gains. This strategy is particularly attractive for early retirees who want to access their retirement funds before the age of 59 ½ without incurring penalties.
While traditional Roth conversions allow individuals to access their contributions at any time, earnings are typically subject to a 10% early withdrawal penalty before the age of 59 ½. However, Roth conversions can be tapped without penalty or taxes after five years, providing early retirees with the flexibility to access their funds when needed.
It is important to note that each conversion is subject to its own 5-year aging period, and Roth IRA accounts must be open for at least five years to avoid taxes or penalties, even after reaching the age of 59 ½. Lawrence advises early retirees to carefully consider the trade-off between accessing funds early and forgoing future tax-free growth.
According to Cherry, the longer you can leave your converted IRA balance untouched, the more you stand to benefit from compound growth. It is crucial to ensure that the upfront taxes paid on the conversion break even before tapping into the account to make the strategy financially rewarding in the long run.
Roth conversion ladders offer a strategic and tactical approach to retirement planning, allowing individuals to maximize tax savings and enjoy tax-free growth on their investments. By carefully evaluating income levels, tax projections, and future withdrawals, individuals can create a customized strategy that aligns with their long-term financial goals. Early retirees, in particular, can benefit from the flexibility of Roth conversion ladders in accessing their retirement funds without incurring penalties.