“Is A Backdoor Roth IRA A Good Move?” on Daily Capital is probably the best post on the internet that explains who should do a backdoor Roth IRA, how to do a backdoor Roth IRA, who is allowed to do a backdoor Roth IRA, the risks of a backdoor Roth IRA, and who doesn’t need to do a backdoor Roth IRA. Have a read and I’m sure you’ll agree.
Long time readers know that I’m one of the biggest detractors of the Roth IRA program. The main reality is: most people will make less in retirement than during their working years. Therefore, taxes should be lower, all things being equal. I present many more arguments as to why a Roth IRA is suboptimal.
But after spending some time editing the Daily Capital post, I’ve come around to the idea that for some people, a backdoor Roth IRA is a good move. Here are three main reasons why a backdoor Roth IRA should be considered.
WHY THE BACKDOOR ROTH IRA IS A GOOD IDEA
1) Get around discrimination by the government. One of the most disappointing things about the government is its seemingly arbitrary income limits for who gets to contribute to a government-backed retirement program and who doesn’t. If you are an individual who makes over $129,000 a year, or a married couple who makes over $191,000 a year, you are not allowed to contribute to a Roth IRA.
In the past, I thought this discrimination was fine because who the hell in the 28% or higher tax bracket would ever want to pay taxes up front given it’s likely that their tax bracket will be the same or lower during retirement. Honestly folks, if you believe you are going to make more money during retirement than while working, you are smoking crack.
But the reason why America is so great is due to our freedom of choice. Take our ability to choose away and we become diabolical. Although we all know having health insurance is a good idea, millions of people still opt out for whatever reason. America will always pride itself on giving people the equal opportunity to choose, but by limiting income amounts to allow people to save for retirement, that runs counter to the essence of who we are.
The backdoor Roth IRA allows for people who cannot contribute the normal route to contribute to a traditional IRA after taxes, and then systematically convert such funds every year into a Roth IRA in order for the funds to never be taxed again. The term “backdoor” is generally reserved as an illicit way of doing something. I’m all for legally exploiting loopholes to save on taxes. Eventually, you can see the government eliminating the backdoor Roth IRA.
2) No required minimum distributions. For a traditional IRA, if it’s either your own IRA or one you inherited from a spouse, you have to start withdrawing funds at age 70½. If it’s an IRA you inherited from someone else (such as a parent), you have to start almost immediately. The IRS calls this ‘Required Minimum Distribution’ or RMD for short.
The minimum withdrawal is calculated by taking the account balance and dividing by a factor related to your age. The account balance is what you had the previous Dec. 31. The age is your age at the end of the withdrawal year. Say your balance on Dec. 31, 2013 was $250,000, and your age on Dec. 31, 2014 will be 75. The minimum withdrawal for 2014 is $250,000 divided by the factor for someone who is 75 = $100,000 / 22.9 = $10,917 minimum withdrawal per year based on the chart to the right.
Roth IRAs are not subject to Required Minimum Distributions during the owner’s lifetime. If you so happen to grow so wealthy that you never need to tap your Roth IRA, you can pass on your Roth IRA to your heirs and allow the funds to continue to grow. Your heirs have the option to either roll their inheritance into their own Roth IRA or cash out the account without penalty regardless of their age. Another good thing is that a Roth IRA is not subject to probate court either, which could be a long a drawn out pain.
If you’re interested in learning more about RMDs, you can take a look at Publication 590 by the IRS.
3) A hedge against incredible investment success. One of the interesting discussions the community pointed out is what if you are an excellent stock picker or join an incredibly successful startup. Let’s say you contribute $55,000 to a traditional IRA tax free over the next 10 years and invest the money all in one stock that goes up 200X to $11 million 30 years later. When it comes time to withdraw at age 70, your RMD according to the chart is $11 million / 27.4 = $401,459. It’s more than likely you will be in the top tax bracket of 39.6% federal with this type of income.
If you were to contribute $5,500 in a Roth IRA for 10 years, it takes roughly a $74,000 gross salary ($19,000 more than what the traditional IRA person had to spend pre-tax at 25%), but at least your $11 million is now tax free upon withdrawal. The tax on $11 million at a 39.6% rate is $4,356,000. One can say the tax savings is therefore $4,356,000 – $19,000 = $4,337,000. Any of you eagle eye math geniuses out there please correct me if I’m wrong.
Clearly not many of us will have 200 baggers in our portfolios. But, you never know. Doing a backdoor Roth IRA is a hedge against runaway success. We can always dream right?
THE BACKDOOR ROTH IRA FOR TAX DIVERSIFICATION
Take my situation as an example: I’m no longer in the 39.6% tax bracket after removing myself from the workforce in 2012. Currently I’m happily in the 28% tax bracket, but could make moves to get down to the 25% marginal tax bracket or maybe even the 15% tax bracket (<$36,900) if I wanted to get aggressive. Now is probably as good a time as any to convert my IRA into a Roth IRA because if I pay taxes now, I am guaranteed to lock in the difference between 39.6% and 28% = 11.6% savings if I withdraw all at once by 70.5.
Nobody knows what taxes will be like in the future. But for someone who thinks taxes will go higher, who makes more than $121,000 as an individual or $191,000 as a married couple, is an investing genius, and hates being discriminated against, doing a backdoor Roth IRA makes sense.
As for me, although I’m accepting of the backdoor Roth IRA, I will likely never do a backdoor Roth IRA because I don’t want to ever give up my option of potentially reducing my taxes in retirement. I still plan to figure out a way to set up residency in a no income tax state such as Nevada, Florida, or Washington by the time RMD is required. Besides, I doubt I’ll ever have enough homerun investments in my retirement portfolio because I’m focused on capital preservation.
Recommendation: Run your ROTH IRA through Personal Capitals’ free Portfolio Fee Analyzer. The online program will quickly show you how much you’re paying in portfolio fees a year. The tool highlighted $1,700 a year in fees I had no idea I was paying. I ended up asset allocating out of a fund with a 1.6% expense ratio into a 0.2% expense ratio Vanguard fund with similar attributes as a result. Personal Capital also has a free Investment Checkup tool to show how your portfolio is weighted vs. a suggested weighting for your risk tolerance. Aggregate all your accounts in one place in order to track your net worth for free. I’ve been using the tool for over two years and am an advisor.