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Financial Freedom => Taxes => Topic started by: david123 on November 29, 2018, 05:56:38 AM

Title: ROTH IRA Misunderstandings
Post by: david123 on November 29, 2018, 05:56:38 AM
I think a lot of people don't understand ROTH IRAs, even financial professionals.  I've seen a lot of people make the argument about pre-tax vs post-tax, and will taxes be higher in the future or now.... and to all those arguments, I say "I don't care".  My situation is that both me and my wife work.  We max out our 401Ks every year (pre-tax money, but when we retire and begin to withdraw it will be taxed as ordinary income).

We make over the limit to contribute to a ROTH IRA, so we do backdoor conversions to the max allowed ($5,500 each in 2018).  It is post-tax money, but when we retire the withdraws are tax free. 

Why is this good?  We've already taken advantage of all the pre-tax investing (401Ks) we can, so the ROTHs are the next best thing from a tax advantage standpoint.

The ROTHs won't amount to all that much in retirement given the low yearly limits, but tax free withdraws might let me leave my other investments to increase for a few years.

Any thoughts, or am I wrong in any of this? 
Title: Re: ROTH IRA Misunderstandings
Post by: ManInAVan on November 29, 2018, 03:24:06 PM
Can you elaborate on the backdoor conversions to Roth from your 401k because you're over the limit?  That sounds like something that could be useful for my situation.
Title: Re: ROTH IRA Misunderstandings
Post by: IzzyEsq on November 30, 2018, 08:11:04 AM
I'm sure David123 will have more info, but I found this article useful when I had the same question:  https://www.irahelp.com/slottreport/backdoor-roth-conversion
Title: Re: ROTH IRA Misunderstandings
Post by: david123 on November 30, 2018, 12:15:54 PM
Google "backdoor roth IRA" and you will find a lot of information that is probably better than what I can describe.

The short explanation is that there are fairly low income limits on who can contribute directly to a ROTH IRA.  There are not income limits on who can contribute post-tax money to a regular IRA.  The backdoor conversion is you contribute to the regular post tax IRA, then convert it to a ROTH IRA.  Any gains would be taxable, but since you do it fairly quickly, typically there are no tax consequences. 

You can also google "Mega backdoor roth IRA" which gets a little more complicated, but you can contribute more by putting money in a post-tax 401k, then rolling that into a ROTH IRA.

For me at least, I like to max out traditional pre-tax 401k first, but after that, there are not a lot of tax savings accounts when you are not self employed and have a higher income.

Good luck.  Although there is a lot of information on backdoor ROTH conversions, some people still don't get it.
Title: Re: ROTH IRA Misunderstandings
Post by: mbb_boy on November 30, 2018, 02:11:36 PM
Quote from: david123 on November 29, 2018, 05:56:38 AM
I think a lot of people don't understand ROTH IRAs, even financial professionals.  I've seen a lot of people make the argument about pre-tax vs post-tax, and will taxes be higher in the future or now.... and to all those arguments, I say "I don't care".  My situation is that both me and my wife work.  We max out our 401Ks every year (pre-tax money, but when we retire and begin to withdraw it will be taxed as ordinary income).

We make over the limit to contribute to a ROTH IRA, so we do backdoor conversions to the max allowed ($5,500 each in 2018).  It is post-tax money, but when we retire the withdraws are tax free. 

Why is this good?  We've already taken advantage of all the pre-tax investing (401Ks) we can, so the ROTHs are the next best thing from a tax advantage standpoint.

The ROTHs won't amount to all that much in retirement given the low yearly limits, but tax free withdraws might let me leave my other investments to increase for a few years.

Any thoughts, or am I wrong in any of this?

You're not wrong, but it's a really easy decision to make when you literally have no other option than to do backdoor roth.

What people actually misunderstand is that when they discuss taxes now vs in the future, they should be comparing marginal rate now vs EFFECTIVE rate in the future. They often due marginal vs marginal, which incorrectly results in a Roth bias. I submit that default for everyone should be traditional, because scenarios where your future effective rate is higher than your current marginal are limited.
Title: Re: ROTH IRA Misunderstandings
Post by: ManInAVan on November 30, 2018, 10:34:02 PM
Thanks everyone for the input!  I have a bit of weekend homework to do!
Title: Re: ROTH IRA Misunderstandings
Post by: david123 on December 03, 2018, 10:25:06 AM
One thing I didn't mention since it doesn't apply to me - be careful of doing a partial IRA rollover to a ROTH.  So in the case you have an IRA already (401k rollover or other IRA) and you only roll part of your IRA into a ROTH IRA, there are tax implications.
Title: Re: ROTH IRA Misunderstandings
Post by: Fat Tony on December 29, 2018, 05:48:34 PM
@david123, completely agree - if your income is over the traditional IRA limit (barely $60K for individuals) and you've maxed out your 401k, clearly Roth IRA (or backdoor Roth) is the best and most logical next step for your tax-sheltered investments. The only other tax-sheltered possibility worth doing next is the HSA. However, if you're not yet maxing out your 401k, then the argument gets fuzzier, with current vs. future tax rates and tax diversification being the questions. I find that Backdoor Roths are a relatively new thing, since it wasn't possible until 2010, and many people who had been working for a while accumulated regular IRAs (for which the pro rata conversion rule would nuke the tax benefits).

Quote from: mbb_boy on November 30, 2018, 02:11:36 PM
What people actually misunderstand is that when they discuss taxes now vs in the future, they should be comparing marginal rate now vs EFFECTIVE rate in the future. They often due marginal vs marginal, which incorrectly results in a Roth bias. I submit that default for everyone should be traditional, because scenarios where your future effective rate is higher than your current marginal are limited.

Can you explain why you should compare marginal rate now vs effective in the future? Let's say you're already saving $10K/year in your pretax traditional 401k, and you have to decide whether to put $5K into a Roth IRA or $5K more into the 401k. Your 401k is already accounted for and will build up a nice nest egg (let's say $500K at retirement), potentially allowing you to withdraw $20K/year at retirement - now you should consider where your additional marginal savings and withdrawal are coming from. Am I missing something here?

Additionally, some tax diversification may be exaggerated, because one can perform traditional to Roth conversions in low tax nears during and near retirement as well. You also aren't required to take distributions on your Roth IRA, and can pass them on tax-sheltered (after which withdrawals may be forced for the next generation - but from my understanding, without tax penalties)