Calculating the Value of Your Backdoor Roth Contributions

I recently published a detailed article questioning the Marginal Value of the Backdoor Roth. I wanted to answer a simple question. “Is it worth doing?”

The answer I came up with? Probably, yes. Unless you’ve got significant obstacles, namely a tax-deferred IRA in your name that you can’t easily roll over into an employer’s 401(k) or individual 401(k). Then, it’s not that big of a deal if you don’t.

The thing is, in the first year that you do the Backdoor Roth, your tax savings is probably going to be somewhere in the range of $10 to $40.

We’re comparing investing $6,000 in a Roth account versus investing the same $6,000 in a relatively tax-efficient taxable account with a tax drag on the order of 0.3% to 0.7%. In year one, the savings won’t even buy you an Instapot.

If you’re not familiar with the Backdoor Roth, it’s an indirect and perfectly legal way for high-income earners to contribute to a Roth IRA annually. Read my updated Vanguard Backdoor Roth 2019: A Step-by-Step Guide for the background and instructions.

Once you’ve read that and the Marginal Value post, you’ll be up to speed.

 

Calculating the Value of Your Backdoor Roth Contributions

 

How valuable is the Backdoor Roth to you, specifically? That depends on many factors, some of which are under your control, others which are at the whims of our policy-makers.

The sooner you start making backdoor Roth contributions, the more benefit you’ll see. You have until mid-April to make a contribution for the prior calendar year. First-timers are now making both 2018 and 2019 Backdoor Roth contributions.

The longer you can make Backdoor Roth contributions, the more valuable they’ll be to you. You must have earned income (capital gains, dividends, and withdrawals from tax-deferred accounts do not count) to contribute to an IRA via the front or back door.

The longer you leave the Roth balance alone, the more advantageous the Roth contributions will be for you.

The higher your taxable income, now and in retirement, the more it helps to make Backdoor Roth contributions.

Accordingly, those living in high-income tax states will benefit the most.

 

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Someone Who Will Not Benefit Much from the Backdoor Roth

 

Knowing what we know, let’s profile someone who will not benefit much at all from the Backdoor Roth. Someone who might frequent this site.

Mr. Rothschild is 35 years old. He and his wife earn a combined $240,000 a year. It’s a respectable sum and even after taking into account the $24,400 standard deduction in 2019, their MAGI will be too high to contribute directly to a Roth IRA.

The Rothschilds found this website after they started down the rabbit hole that is the FIRE blogosphere. They realized, like me, that they could afford to retire soon, and came up with a five-year plan to exit the workforce and start living their dream.

Having been living on half their take-home pay since completing their education 10 to 12 years ago after they met in a quantum mechanics class, they’re in good shape to be financially independent after a total of about fifteen years in the workforce. By age 40, they plan to pull the trigger.

That gives them five years to make Backdoor Roth contributions.

Each year for five years, Mr. Rothschild will make a $6,000 Backdoor Roth contribution. His wife, who has a rollover IRA from a previous job’s 401(k) and a current 401(k) with poor investment options, opts not to make Roth contributions. She understands she’s probably worse off rolling over her current tax-deferred IRA into the expensive 401(k) plan just to do the Backdoor Roth for five years.

They live in Texas, a tax-free state. In their taxable investment account that, like mine, contains mostly passive index funds, they endure a tax drag of 0.3% by virtue of paying 15% long-term capital gains rates on qualified dividends of about 2% in that taxable account.

Therefore, each year, the tax savings of investing via the Backdoor Roth instead of the taxable account will be 0.3% of the Roth IRA balance generated by the Backdoor Roth contributions.

For purposes of this exercise, the invested money will grow at 6%.

 

Backdoor_Roth_Value_1

 

Over five years, Mr. Rothschild contributed $30,000. His tax savings that first year was a paltry $18, but that improved to a tax savings of $101 in year five as the balance grew.

Will he continue to benefit from his prior contributions once he starts drawing down the account? He knows his Roth conversions (I have called them contributions, but step two of the Backdoor Roth is technically a conversion)  are available for withdrawal penalty-free at any time five years later, and he starts taking prior conversions out annually starting in his first year of early retirement. He has, in essence, built a “Roth ladder.”

With a taxable income well under $78,750 as early retirees, living primarily off of a taxable account, a 457(b), and the $6,000 a year in Roth money, they are easily in the 0% long-term capital gains bracket.

Therefore, his taxable account works pretty much the same as the Roth account. The qualified dividends and long-term capital gains are tax-free.

There are no tax savings in the years in which he withdraws his contributions.

 

Backdoor_Roth_Value_2

 

Over the course of ten years with a Roth IRA that peaked at a balance of $33,823, the earnings at 6% left him with nearly $9,000 in the account after withdrawing all of his contributions. He’ll let that grow until he can access it easily without penalty at age 59 1/2. We’ll call it 60.

 

 

Throughout these years, the Rothschilds remained in the 0% capital gains tax bracket. Living in a no-income tax state, they didn’t see a dime of tax benefit from the money being in a Roth account during these years. The money would not have behaved any differently in a taxable account.

The total savings for this couple occurred in the five years in which they were working and the grand total of his tax savings for doing the Backdoor Roth was $293, or just under $60 a year for those five years.

 

A Couple That Would Benefit Greatly from the Backdoor Roth

 

On the opposite end of the spectrum, we’ll look at the Rothmans, a dual-income couple earning greater than a half-a-million dollars a year in the lovely high-tax state of Minnesota.

The Rothmans met at a curling league fundraiser while earning their MBAs and were married at The Basilica shortly thereafter.

To make the Roth contributions as beneficial as possible, we’ll assume this power couple was at peak earning power from age 25 to 65, at which they finally retire and continue to enjoy a fatFI lifestyle.

We’ll assume that the Backdoor remains open for each of these 41 years and that they turned 25 in 2010, the very first year Roth conversions were allowed in their income tax bracket, and that they knew one of the few accountants who was advising clients to do this back then.

With income placing them in the top federal income tax bracket, they pay 20% + 3.8% in taxes on qualified dividends, and 9.85% in Minnesota state income tax on those same dividends. That’s nearly 35% of about a 2% dividend yield in their taxable account for a tax drag rounded up to 0.7%.

 

 

After 41 pairs of $6,000 contributions, the Rothmans have contributed $492,000, but the magic of compound interest at 6% over 41 years gives them over $1.6 Million dollars of earnings in the account when they’re ready to retire to their 6 bedroom, 9 bath estate on Lake Minnetonka.

The tax savings was only $84 between the two Roth accounts in year one, but by the time they’re making their 10th pair of contributions, they’re saving over $1,000 in taxes between the two of them.

When they’re sextagenarians and making their 36th pair of Backdoor Roth contributions, the annual tax savings reaches $10,000 per year. The total tax savings over these 41 years is $187,531.

At this point, the size of their earnings eclipses the contributions by a 3:1 ratio with a balance in the accounts of nearly $2 Million.

The Rothmans don’t need to touch this money, as the $12,000 a year contributed to the Roth accounts represents between 5% and 10% of their annual investments. With a large eight-figure portfolio, they let the accounts grow until they romantically pass away just days apart after celebrating their 100th birthday.

 

Backdoor_Roth_Value_update

 

At age 100, a full 75 years after they started these accounts, the value of the Roth accounts alone is $15,222,850 and is growing by over $900,000 a year with those with 6% returns.

By now, the tax savings over a lifetime of investing were over $1.6 Million.

 

How Much Tax Will Backdoor Roth Contributions Save You?

 

If the tax code persists in its current form for awhile, and you’ll be earning a solid income throughout, it’s certainly somewhere between the $300 that the Rothschild family saved, and the $1.6 Million saved by the Rothmans.

Again, it comes down to the following factors:

  • How early you start your Roth IRA
  • How many years you contribute
  • How long you delay withdrawals
  • Your tax drag in a comparable taxable account

 

The examples given aren’t perfect, and they don’t need to be. They exist to demonstrate two extremes.

In real life, returns are far from constant from year to year, and compounding occurs continually. The contribution limits will rise over the years to keep up with inflation. By not accounting for either inflation or the associated increase in the amount one can contribute, we’ve essentially given the Rothschilds and Rothmans a 6% real return, which is generous, but not out of line with past stock returns.

In my last Backdoor Roth post, I gave a number of examples of ways you could make up for the difference of not making annual Backdoor Roth contributions.

A lifestyle change worth $1,000 per year from something like a better, lower cost cell phone plan or one to two new reward credit cards each year were a couple of examples. Cutting expenses or increasing after-tax income by $1,000 in any way, shape, or form would make a difference.

How much of a difference?

I’m glad you asked. Do you smell a spreadsheet? I do!

We don’t need to do the math for the Rothschilds, who only saved $300 in taxes by doing the Backdoor Roth for five years. The answer here doesn’t require a spreadsheet or anything beyond second grade arithmetic.

They’re better off earning a little more money or spending a bit less. They could make up that difference in one month.

For the Rothmans, the answer is not so obvious.

We can compare investing $1,000 a year in a taxable account, with the relatively high 0.7% tax drag, to the growth of the tax savings in the Roth account. Let’s look at what spending $1,000 less or having an extra $1,000 in after-tax income will do with the same annual 6% return

 

Backdoor_Roth_Value_7

 

After 41 years of investing an extra $1,000 a year in a taxable acccount, and assuming they remain in the highest (current) capital gains bracket in a high-tax state throughout, the account grows to $138,329. That’s nearly $50,000 shy of the $187,531 of tax savings over 41 years of Roth contributions.

However, if we tweak the assumptions just a bit, and change the tax drag to a more typical (but still high) 0.5% per year, guess which is the better strategy?

In this case, with a tax drag of 0.5% instead of 0.7%, the tax savings of 41 years of backdoor Roth contributions are $133,951, whereas the taxable account with $1,000 a year contributed grows to $145,587.

Saving $1,000 extra per year can be as valuable as doing the backdoor Roth over many decades.

It’s true that the IRA can become a stretch IRA for heirs, but it will be subject to Required Minimum Distributions (RMDs) when inherited. A taxable account benefits from a stepped-up cost basis when inherited, and will not be subject to RMDs.

 

Should You Backdoor Roth?

 

As much fun as I’ve had with these spreadsheets, my answer hasn’t changed. If you’ve got no barriers to doing this, and you earn too much to contribute directly, you should go ahead and do the Backdoor Roth.

If this workaround remains viable for decades, doing so will probably save you a few hundred dollars a year on average, and perhaps up to about $1,000 a year over the course of a long working career.

On the other hand, if you haven’t done this due to a pro-rata rule issue (pre-tax IRA in the way), or simply weren’t aware of it or were afraid of goofing it up (which is easy to do), you’re not missing out on the investment trick of a lifetime.

Despite the 7-figure benefit I was able to produce over an extreme example and a 75-year time frame, for the typical high-income investor, I believe the benefits of the Backdoor Roth are truly marginal. If you’re a do-it-yourself investor whose investing horizon may resemble the ultra-wealthy Rothmans, the benefit can be big. But in relation to the rest of your portfolio, that $1.4 Million will pale in comparison to a high 8-figure or low 9-figure net worth on your 100th birthday.

It is also true that a Roth IRA offers better asset protection than a taxable account.

Conversely, consider the advantages of a taxable account:

  • 100% liquid and available without penalty at any age
  • The foreign tax credit is realized only in a taxable account
  • Tax Loss Harvesting alone is worth $1,000 or more per year for most high-income professionals. You can’t do that in a Roth account.
  • With a taxable account, you or your CPA won’t have to worry about fouling up form 8606, potentially costing you thousands of dollars.

 

From commenter Luis on the marginal value post:

“Please read this and learn from a fool (being the fool myself). We (my wife and me) have been doing Backdoor Roth since 2012, although we have an idea about taxes, we use the services of an accountant and trust him.

So, being busy as I was until my retirement, mostly accepted for being good what my tax preparer did. I rarely questioned his job, except a couple of times.

So far so good: Recently I received from the IRS a note saying that we owed almost $5,000 in past taxes and penalties!!!!!!!! How this happened? In all this years, from 2012 to 2017 never a form 8606 was produced. Not only this back taxes were due, also I discovered that $780 was paid for “excess contribution to Roth Ira”!!!!!!!! every year: $780 time 6 years equal to $ 4680 (I am the one that discovered the imbroglio).

We share the responsibility with the accountant, for not supervising his job, but he was supposed to be the expert after all. Right now we are in the middle of trying to somehow fix this mess, but my guess is I going to bite the bullet anyway.”

 

What’s Worse Than Not Doing the Backdoor Roth?

 

Since we’ve established that it’s value is in the range of dozens to hundreds of dollars per year, anything that costs you many hundreds of dollars or thousands of dollars per year is more harmful to your bottom line. Let’s review some common ones.

 

Paying AUM fees to a financial advisor.

What do you suppose is worse? Tax drag of about 0.5% on 5% to 15% of your portfolio or paying 1% to 2% in “assets under management” fees on all of your portfolio? The latter will cost you 20 times as much or more per year.

If you need a financial advisor, and there is no alternative to paying those fees, I suppose it could be excused. But the fact is, there are flat-fee and hourly rate fiduciary advisors that won’t cost you $10,000 to $20,000 annually per million dollars invested.

Remember, investment fees will cost you millions.

 

Student Loan Mismanagement

The average indebted medical student graduates with about $200,000 in student loan debt. Most will make mistakes worth tens of thousands of dollars in managing the payback of their student loans. Six-figure mistakes are not uncommon when you start to look at two-physician couples with a half-million or more in debt.

If not pursuing PSLF or another loan forgiveness program, there’s a good chance you can lower your interest rate and/or payment by refinancing. View current rates and cashback bonuses on The Student Loan Resource Page.

The Student Loan Planner has consulted on over $400 Million in student loan debt, creating plans that have saved their clients over $80 Million, or an average of $62,000 per client. Check out their services here.

 

Ignoring Tax Loss Harvesting

At a marginal tax rate of 33% to 50%, a high-income professional can easily deduct $3,000 per year from ordinary income with occasional TLH, resulting in $1,000 to $1,500 per year in savings with a few well-timed mouse clicks.

This is almost certainly a greater benefit than the backdoor Roth. If you’re a Vanguard or Fidelity User, I’ve made tutorials complete with screenshots for you.

 

Ignoring Travel Rewards

If you’re in a position where you can always pay off a credit card balance monthly, but opt to spend via cash, check, or debit card, you’re missing out on valuable rewards.

In the four or five years that I’ve been earning welcome bonuses on a variety of reward cards, my family and I have averaged well over $5,000 a year in free travel. One card alone, obtained by both my wife and I, got our family of four to Honduras for a medical mission, saving us over $3,000 in airfare on one trip last year.

I highlight my simple strategies and some of the top cards to target in the following:

 

So many other decisions will be much more impactful on your finances than the Backdoor Roth. What kind of car you drive. Public versus private school. Where you live. How well you negotiate. Your choice in beer, wine, or liquor. Honestly, anything that has an impact of at least a thousand dollars a year is bigger.

 

In summary, I remain a fan of the backdoor Roth because I like to optimize my finances in every way that I can, and with no barriers to doing this, it has benefited me to the tune of at least $1,000 by now. In 2019, we made our seventh pair of contributions.

I just don’t see it as the panacea it’s sometimes made out to be.

 

For more information, be sure to check out additional articles on the Backdoor Roth:

 

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Have you taken advantage of the Backdoor Roth? How many times? How do you value the benefit of your Backdoor Roth efforts?

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16 comments

  • PKB

    Would your analysis and conclusion also apply to the Mega Backdoor Roth IRA? Thanks!

    • You can do the math in a similar manner, but you’re able to set aside as much as $37,000 a year that way, so the benefit could be > 6x larger.

      Unfortunately, it’s not an option in my current retirement plan.

      Cheers!
      -PoF

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  • I have taken advantage of the Roth IRA since I first became a resident. Once I finished residency in 2012, I started making back door contributions.

    I value the benefit of my backdoor Roth efforts highly because like the Rothmans, I have a long time horizon and live in a high income state. In the long run, I think the tax savings will be substantial for me.

    Btw, if the Rothschilds are related to THE Rothschilds… who needs backdoor Roth money when you’re old money rich!

    • If your ability to contribute to Roth remains, either via the backdoor or front door, you’re going to enjoy a sizable Roth balance someday. I did some mental math with mine, which is nearly 30% of our net worth, and realized it will likely be an 8-figure account if I can leave it untouched ’til I’m in my eighties. And that’s if I never made another contribution.

      Whenever I hear the name Rothschild, I think of the Pentaverate, the secret society that runs everything in the world.

      Cheers!
      -PoF

  • Yeah it’s a no-brainer, and your numbers show it. It’s not going to hurt you, unless you mess up something. I can now do front door Roth contributions being that I’m part time and my salary is cut in half!

  • Because of my financial circumstances I had been contributing to a traditional IRA for years as a non-deductible contribution. So it makes perfect sense to do the backdoor ROTH method as these contributions were not saving any money for me on the front end. Although I knew the conversion was a no-brainer but did not do it because of the perceived pain it would be to avoid the pro-rata rule (I finally did it last year by transferring the balance into my 401k and it was quite easy to do so). This year the conversion was piece of cake and followed your guideline to a “T”.

    One of the benefits of having ROTH money is that you are not forced to take out money via RMDs. If you have a high RMD you can be bumped up in the tax bracket and get taxed higher on social security benefits.

  • We’ve been doing it to hide wealth from future college financial aid decisions.

    • That’s a good point — I’ve got way too much in taxable investments at this point to have any hope for need-based aid. But it is true that money in retirement accounts will not count against you on the FAFSA.

      Holdings outside of retirement accounts, income, and even contributions to or from retirement accounts, will be a negative when determining your financial need.

      Cheers!
      -PoF

  • Sara

    We started doing the Backdoor Roth last year after reading about it on Whitecoat Investor. Because we are relatively young, we didn’t have any other IRAs to worry about. My question is – going forward, do we always have to do the conversion? Or can we at some point opt to just leave money in the regular IRA? If we did, could we also leave the prior contributions in the Roth, or would we need to roll them over?
    Hoping someone might now the answer :).

    • You want the money in the Roth IRA. In the traditional IRA, you’d have to pay ordinary income tax on withdrawal of the earnings from any non-deductible contributions.

      Investing in a taxable brokerage account is superior in many ways to making non-deductible contributions to a traditional IRA (unless, of course, you then convert to Roth).

      Cheers!
      -PoF

  • What an epic post, PoF! Really helpful, too.

    I filled up the backdoor Roth in 2017, but then opted to just keep it open with a paltry amount in 2018 so that we could pay down our student loans faster. We will fill it up again in 2019 to the 6K max for both of us.

    I LOVE Roth dollars. So much so that I often have internal debates about doing a Roth contribution in our 403B despite being in our theoretical “peak earning years.” The benefits of having no RMD’s and leaving a stretch roth IRA are the real deal.

    Thanks for providing a very level-headed discussion on an important topic.

    TPP

  • JB

    What if the Rothschilds are that wealthy family in Minnesota in their income-earning years, let’s say 30-60 years of age, but then they retire to FL or TX? that would diminish the value of the Roth, right? And taxable would be better?

  • Gasem

    The advantage is always there despite the tax savings or no savings. The advantage derives from how you use the Roth in retirement. My Roth which will have about 1M at age 70 will act as self insurance. It is not part of my WR. Eventually we all die and death is not always short and sweet and cheap, sometimes it is protracted and chaotic and expensive and that can decimate WR money. A Roth funded over several decades is just the ticket since it’s mostly interest. A protracted illness say a cancer diagnosis requiring fancy schmancy treatment or 12 years of 24/7 Alzheimer’s care can hit the expense jack pot and even though medical expense is deductible. Yanking a wad out of brokerage or TIRA is a pay me now proposition as far as the government is concerned. I like the idea of already been taxed money sitting around just in case. You get care and your wife doesn’t get hosed paying a huge tax bill. Nor does she get hosed if it becomes her turn late in her life and she’s filing as a single.

    If you plug in 500K to start and it’s 1.5M by 70, it’s 3M by age 90. 3M buys a lot of best quality nursing home care along the way for you or your wife or both and probably leaves a chunk to the kids to boot. You can also at 70 start a small withdrawals say 2% on the Roth and it will give you some extra pin money to spend and self insurance to boot. My retirement is set up so SS + a small TIRA (600K) which I will allow to go to RMD is the core. I stay in the 12% bracket for 15+ years with this start, which takes me to 85. I augment yearly with some brokerage money and TLH to supply the remainder of my yearly WR at 12% tax rates even though my budget is in the 22% bracket. My Roth is insurance and legacy and pin money. If I want a Tesla I’ll just save up a couple years of 2% pin money and get me a Tesla. The value in Roth conversion is not only in tax efficiency but in how you expect to use the money to CYA in your dotage.

    Good article

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  • EnjoyIt

    I think you are missing one more benefit of a Roth account. In the withdrawal phase of your life, having a sizable Roth account allows one to minimize other taxes as well. By taking Roth withdrawals you decrease your earned income and then will have the capability of selling appreciated shares and not pay any taxes if one is in the 12% tax bracket.

    You may have options to sell from a taxable account and still be in the 12% tax bracket making those withdrawals untaxed from capital gains otherwise many physicians will find themselves paying capital gains tax of 15% on the appreciated portion of those withdrawals.

    For example lets use a couple that lives on $80k/yr. Where they take that money from makes a big difference on how much they pay in taxes. If all the money comes from a 401k/IRA they will pay a decent amount in taxes hitting the 22% tax bracket. But lets look at it closer with a different option.

    The couple will have the $24,400 standard deduction so they can comfortable pull that from their 401k and pay no taxes. Next they can withdraw another $25,600 from the Roth. They still need another $30k of which they can sell shares from their taxable account. As long as they stay under $39,375 in capital gains, they will pay $0 taxes which also means this couple can likely tax gain harvest some funds to avoid taxes in the future.

    The following year this same couple can take all $80k from their taxable account and then do a Roth conversion at $0 tax for $24,400k to be used the following year.

    In the end, the Roth account when well funded is just another tool/location to be able to help minimize taxes during the withdrawal phase of your life and I think it is very well worth utilizing during the accumulation phase. Just as an HSA that is well funded over many years will help in the distribution phase of our lives.

    Sure it adds complexity, but we all seam to enjoy this kind of stuff anyways. I know I do.

    • Excellent points all around. I’ve touched on some of this in a post from the early days of the site — The Taxman Leaveth — but you outline some specifics very well. I do believe in the benefit of tax diversification in a portfolio, and we personally have a nice chunk in Roth — nearly 30% of our nest egg.

      Cheers!
      -PoF

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