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 $137,000 a year or a married couple who makes over $203,000 a year, you are not allowed to contribute to a Roth IRA for 2019.
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.
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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. He also became Series 7 and Series 63 registered. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $215,000 a year in passive income. He spends time playing tennis, hanging out with family, consulting for leading fintech companies, and writing online to help others achieve financial freedom.
Updated for 2019 and beyond.
Obama is actually looking to add RMDs to roths, or at least it is on the potential budget plan. So that advantage is already at risk.
They are also looking at putting a cap on additional retirement contributions and capping the maximum tax deduction you can get if you are in upper brackets. Both of these two likely won’t hit most people but would affect high income or high savings individuals.
Sam, great article. However, I do think you’re missing one other big discussion. If you have access to a 401(k) or other retirement plan at work, you cannot take a tax deduction on a traditional IRA contribution if you make more than $69K (deduction is phased out between $59K and $69K).
Therefore, if your income > $69K, unless you convert to a Roth IRA, you would be making a traditional IRA contribution post-tax and only tax-deferring your earnings. By contrast, a Roth IRA lets you distribute your earnings tax free. This is (potentially) a big advantage for people who make more than $129K and have already maxed out their pre-tax advantaged investment options. While as you have noted in the past, the Roth IRA may not be as beneficial as a pre-tax 401(k) or a traditional (deductible) IRA, if those options are not available a backdoor Roth allows at least some additional tax benefits.
There are also the simple advantages of contributing to an IRA, even after maximizing your 401k: (i) somewhat of a forced savings program, (ii) the money is not easily accessible – sure you can tap it, but it isn’t that easy, so psychologically people won’t tap it, (iii) creditor protection, and (iv) tax-deferred growth. So even if the back-door option wasn’t available, there are still some reasons why a high-earner may want to contribute to an IRA along with a 401k. The back-door option just gives you one additional benefit, the tax diversification.
The downside is that if you have a separate IRA (e.g., a rollover IRA), doing a conversion means you will be converting that too. But there are some strategies around that. You could rollover your rollover IRA into your current 401k plan (if allowed by your plan).
Anyway, I’m glad to see you have come around to this option.
I posted before reading the article you linked to. The author does discuss the pro rata rule. However, as I stated above, there is a potential way around the pro rata rule, particularly if your only other deductible IRA is a rollover IRA. Simply, roll that into your current 401k (if allowed by your plan). You may not want to do this if your existing 401k has high costs or limited investment choices, but I think most plans now have low cost index funds to choose from, so for many people, there wouldn’t be much downside risk.
S makes some good points with regard to the pro rata rule. As she/he mentions, be aware of the costs of your 401k funds versus Roth IRA funds. For example, the 500 index fund offered by my 401k has a 0.7% expense ratio (ridiculous) while a vanguard 500 fund has 0.05%. For a 100k rollover, that’s almost ~$650 more per year in fees in the 401k for the exact same investment. As such, for rather large ira to 401k rollovers, check the fund prices first.
Probably the best option, though not always possible, is to make an after tax 401k contribution (up to the $51k limit) and then do an in service withdrawal/conversion to move this money to your roth. A person could potentially roll over ~$30k ($51k limit – 17.5k pretax max contribution – employer contribution) or more per year to his/her roth for tax free growth. In this scenario, this person could contribute $5.5k to roth via backdoor, 17.5k to 401k, an employer contribution to 401k (assume $3.5k in this example) and another $30k to roth via after tax 401k withdrawal/conversion to roth…each year!!
Sam, Very nice continuation on my Backdoor Roth IRA article on Personal Capital. I’m going to include this in my big “tax tips post” on March 31st!! Very comprehensive treatment.
Under current law: unlike withdrawals from a traditional IRA, withdrawals from a Roth do not figure in the formulas used to compute taxes on social security benefits or premiums for Medicare Part B. These could be substantial tax breaks for people who both have a portfolio and also rely on SS benefits as part of their retirement income.
Great addition! Thanks for sharing Larry.
It is a great time to convert if you are in a very low tax bracket and expect your future tax bracket to be higher. My stumbling block is paying the taxes which is substantial.
Glad you are opening up to the Roth IRA :) We have been contributing to our Traditional IRA’s and then immediately converting to Roth IRA’s for a couple years because we can’t take the tax deduction. If we can’t get the deduction, which is one of the main benefits of the Traditional IRA in my mind, we might as well grow our accounts tax free and not pay taxes on the earnings with the Roth.
Never ceases to amaze me how complicated all of this is and therefore how easy it is to make sub-optimal decisions. I can sympathize with a lot of the arguments for/against traditional vs. Roth, marginal vs. average tax rates on contributions vs. withdrawals, etc. I try to visualize what those choices mean for me economically now and in the future, but the problem is the overwhelming majority of the population cannot or will not take the time to do so. Acting in one’s own self-interest is the fundamental assumption of Adam Smith’s invisible hand, yet time and again people have proven to do the opposite.
I believe that the system is deliberately complicated and that there is a positive relationship between the amount of complication and magnitude of sub-optimal decisions. All the “waste” from not acting rationale economically has to go somewhere (it’s a zero sum game after all), and where do you think it goes? To benefit the ones who made the system complicated in the first place! It it were easy, everyone would act rationally and there wouldn’t be any waste to siphon off.
Okay, I’ll take off my tinfoil hat now. FWIW, here’s how I play the tax arbitrage game:
1. Pre-tax 401k contribution up to limit of company match
2. Max out HSA
3. Max out traditional IRA, then convert to Roth IRA (traditional IRA contributions are non-deductible at my current income level)
4. Max out remainder of 401k
5. Any other tax advantaged vehicles (529s, life insurance, etc.) as needed
6. Taxable savings for any remainder
I feel comfortable that I’m not leaving any money on the table with my savings regardless of how much I can contribute in any year and have good tax diversification for whatever Uncle Sam throws at us down the road.
I definitely agree with you on the complications of taxes and retirement savings.
The government makes things absolutely stupid. If you’re not really into personal finance, it is very hard to figure everything out on your own and that’s a shame.
Wow! You are really working at this. I’d say optimizing is probably not possible; the goal is satisficing.
The rules are dynamic and you have no idea what the game will be by the time you hit retirement age.
No doubt! To be completely right you’re going to have to make a major bet on future events, but the cost of picking wrong is just too high for me. If you’re going to do that you might as well cash out, go to the nearest casino and put it all on black. At least you’d have more fun and get some drinks comped.
Without the benefit of some major hindsight, you’re never going to know if you picked the right answer or not. You’ll always be wrong on some level, the best you really can do is try to minimize how much you’ll be wrong across a range of potential outcomes.
Hi Sam,
I enjoyed reading both articles about Roth IRA. I did learn more about this retirement tool.
In your case will be very difficult or not worth to do a backdoor IRA conversion because you already have significant amount of IRA and the tax burden, at conversion will be very high.
You can transfer your IRA in a 401k then consider Roth conversion but why would you do that?
Al
Thanks Sam. You just opened up a can of worms for us, which is actually a great thing. Backdoor Roth IRA’s are not something we need to necessarily deal with right now, so I am glad we can learn from people like you that are going through the process and can offer real world insight.
I have no plans to open a back door Roth IRA. I still have a Roth I opened a long time ago, but I’m not doing anything with it anymore. That’s a good call about moving to a state with no income tax before retirement.
I appreciate all your advice etc but maybe I misunderstand some basic principles of IRA’s / Roth / 401k etc.
I don’t have a 401k at my current job. I’m 32 years old.
If I contribute $5,500 to a ROTH IRA and think of it as putting pretax income of $7500 (estimate).
In 30 years when I draw from the ROTH, and it continues to grow at 4% (just a safe estimate). That means in 30 years I will have $18000 from my $5500 and since I put in “pretax income” of $7500 means that I will pay $2000 in taxes for $12,500 in income.
If I do the same in a standard IRA and put in $5500, it really only costs me $4300. Now after 30 years with the same assumptions – Becomes $18000. Now I have to pay taxes on $18,000 in income. Even at the lowest income tax bracket 15% you will have to pay 15% on the FULL $18,000 which is $2,700.
Am I missing a fundamental point somewhere? It seems too simple to me.
I think of our government a lot like kids and people. You can tell people “I’ll give you $1000 cash right now OR I’ll give you 20% interest each year and keep the $1000 in an account”. Most people want the $1000 right now and don’t want to wait. i think that’s like our government. They want the tax money now, even though they will probably get much more in the future with the 401k and the IRA plans.
I read Barbara’s post on Personal Capital and I agree, it’s well-written article explaining a strategy I was completely unaware of. I had to ready it slowly to ensure I was truly understanding!
I don’t think a Backdoor IRA will ever apply to my situation although I kind of wish it did because it’s a savvy strategy. Plus, that’s a cool name…kind of sounds dirty.
I do a back door IRA because my husband and I already max out our allowable 401k contributions and its the next logical step for tax sheltered retirement savings.
I have no idea, as a 28%er, if my taxes will be lower or higher in retirement. The smart guess is it will be lower, but that’s far from a guarantee. I feel like its a sort of hedge against my pre-tax 401k contributions for future rates. And again, after maxing out the 401k, it was the next logical savings vehicle for us.
It’ a good hedge if you guys are already maxing out the 401k and can afford the disposable income. Good situation to be in.
Question: If a high wage earner deposits $5,500 into a nondeductible IRA on January 1 are they then able to grow the account over the course of the calendar year, roll the growth and earnings portion only to their work place 401k befire year end, leaving only the original contribution amount to be converted to ROTH? They have no other IRA accounts.