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The Benefits of a Roth Conversion Ladder
Why do people go through the hassle of creating a Roth conversion ladder?
1. Tax-Free Compounding & Withdrawals in Retirement
The main benefit of a Roth conversion ladder is tax-free withdrawals in retirement. Since the money is converted from a traditional IRA or 401(k) into a Roth IRA, you won’t have to pay taxes on the money when you withdraw it in retirement.
Thus, your investments compound tax-free over time. Anyone who’s looked at a graph of compound interest can tell you the exponential growth you’ll earn over the course of decades — especially if you earn 15-30% returns on real estate syndications.
2. Incremental Transfers = Lower Tax Bills
By converting a portion of your traditional IRA or 401(k) into a Roth IRA each year, you spread out the extra taxes on the funds you’re converting. Ideally these small conversions keep your total taxable income in the lower tax brackets, you can avoid paying taxes at higher rates.
3. Withdraw Funds Before Age 59 ½
The main point of a Roth conversion ladder is to tap your retirement savings early. You get to withdraw funds from your Roth IRA before reaching 59 ½.
Which is pretty awesome, if you plan to reach financial independence and retire early (like I do).
4. Flexibility
Roth IRAs are far more flexible than traditional IRAs. As long as your account has been open for at least five years, you can withdraw regular contributions at any time, penalty-free.
But not conversions or earnings. To withdraw conversions early, the funds need to have sat in your Roth account for at least five years — hence the ladder.
Backdoor Roth Contributions
To be eligible to make normal contributions to a Roth IRA, your modified adjusted gross income (MAGI) must fall within certain limits. For the tax year 2023, single filers start losing the ability to contribute at a MAGI of $138,000, and can’t contribute at all if their MAGI exceeds $153,000.
For married couples, the ability to contribute to a Roth IRA starts phasing out at $218,000, and disappears entirely at $228,000 for tax year 2023.
But here’s the loophole: there’s no income limit to contribute to a traditional IRA, only income limits for taking the tax deduction from it. And there’s no income limit for converting traditional IRA funds to Roth IRA funds.
See where this is going?
High earners can contribute to a traditional IRA, then roll the funds over to a Roth IRA. There it will grow and compound tax-free, and you pay no further taxes on it.
If you did take the tax deduction on contributions to your traditional IRA, then you must pay income taxes when you roll over funds. But if you already paid taxes on the contributions — as a high earner who exceeded the income limits for deducting contributions — you don’t pay taxes on it twice. That portion of the rollover is not taxed, although you will owe taxes on any earnings you’ve accrued.
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