This post will look at the benefits of a backdoor Roth IRA. Long time readers know that I'm one of the biggest naysayers of the Roth IRA. The main reason is: most people will make less in retirement than during their working years. Therefore, taxes should be lower, all things being equal. However, what about the backdoor Roth IRA?
Despite being negative on the Roth IRA, 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.
Benefits Of A Backdoor Roth IRA For Retirement
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 $140,000 a year or a married couple who makes over $208,000 a year, you are not allowed to contribute to a Roth IRA for 2021.
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 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.
If you are an excellent stock picker or join an incredibly successful startup, a backdoor Roth IRA is attractive. 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 Is Good For Tax Diversification In Retirement
Take my situation as an example: I'm no longer in the highest tax bracket after retiring in 2012. Currently I'm happily in the 24% tax bracket. Now is probably as good a time as any to convert my IRA into a Roth IRA.
Nobody knows what taxes will be like in the future. But for someone who thinks taxes will go higher, is an investing genius, and hates being discriminated against, doing a backdoor Roth IRA makes sense.
As for me, although I believe a backdoor Roth IRA is a good idea, I will likely never do a backdoor Roth IRA. 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 home run investments in my retirement portfolio because I'm focused on capital preservation.
Recommendations To Build Wealth
The best way to become financially independent and protect yourself is to get a handle on your finances by signing up with Empower. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize.
Before Empower, I had to log into eight different systems to track 25+ difference accounts. Now, I can just log into Empower to see how my net worth is doing. I can also see how much I’m spending every month.
The best tool is their Portfolio Fee Analyzer. It runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! Empower also recently launched the best Retirement Planning Calculator around.
Once you register, simply click the Advisor Tolls and Investing tab on the top right and then click Retirement Planner. There's no better free tool online to help you track your net worth, minimize investment expenses, and manage your wealth. Why gamble with your future?
Invest In Private Growth Companies
Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.
About the Author:
Sam began investing his own money ever since he opened an online brokerage account online in 1995. Sam loved investing so much that he decided to make a career out of investing by spending the next 13 years after college working at Goldman Sachs and Credit Suisse Group. During this time, Sam received his MBA from UC Berkeley with a focus on finance and real estate.
In 2012, Sam was able to retire at the age of 34 largely due to his investments. They now generate roughly $250,000 a year in passive income. His main passive income investment is in real estate crowdfunding. He spends time playing tennis and taking care of his two children.