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Do you earn too much to contribute directly to a Roth IRA? Well then, you, my friend, must use the backdoor. And I say “must” not because it’s your only option to legally contribute to a Roth IRA, but also because you would be a damned fool to leave all that juicy Roth money on the table. Right?
You’re not going to tiptoe around those $100 bills lying all over the place, are you? Are you?!?
That’s the impression I get when I read thread after thread in the forums and facebook groups including my Physicians on FIRE and fatFIRE groups, as well as in blog posts written by my friends and me. Yes, me.
I’ve been making these backdoor Roth contributions for six years now, and I’ve shown thousands of people how to do it with my step-by-step Backdoor Roth Tutorial for Vanguard investors. My cardiologist friend EJ made a tutorial for Fidelity users, and the White Coat Investor has a popular tutorial and a great post on all the ways to goof it up (and how to avoid those mistakes).
While I love Roth money for the tax-free growth and tax-free withdrawals, there are some limitations on Roth money that don’t exist when you invest instead in a taxable account. Today, I’d like to quantify the actual dollar value of making Backdoor Roth contributions and discuss some of the disadvantages of Roth IRA investments.
The Marginal Value of the Backdoor Roth. Is it Worth the Trouble?
First, we must acknowledge that the answer is going to vary by the comparison investment we choose. A number of times, I’ve had people question why one would make Backdoor Roth investments instead of tax-advantaged retirement accounts like a 403(b) or individual 401(k) and perhaps an HSA. That’s not the right question to ask.
Since the Backdoor Roth is a tool used only by high-income households, I believe in first maxing out all other tax-advantaged space available to you (perhaps with the exception of a non-governmental 457(b) in a facility with financial troubles or poor investment or withdrawal options).
When I say first, I mean that more in terms of priority rather than temporally. I typically make my Backdoor Roth contribution and conversion in a one-two punch the first few days in January. I do so knowing that I’ll be maxing out all of my tax-advantaged space in due time.
The Backdoor Roth is what you do with $6,000 per spouse with money that would otherwise be destined for a taxable brokerage account. It’s not done in lieu of filling other tax-advantaged space. There is the question of whether to make Roth or traditional tax-deferred investments in those accounts, but that’s a different question.
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What About Student Loans?
You might be in a situation where you’re deciding between paying down student loan debt or mortgage debt or investing in a Backdoor Roth. In that case, you’re deciding between a known return by eliminating debt and an unknown return by investing in the stock market.
While this is a real conundrum for some, it’s tough for me to compare the apple to the orange, particularly when the orange may carry some emotional baggage. Every discussion of paying down debt versus investing invokes the psychological benefit of being debt-free, which is difficult to quantify, but real. It’s one reason that I chose to become debt-free by forty.
For this exercise, we’ll compare investing in a taxable brokerage account versus investing that some money in a Roth IRA via the back door. We’ll also look at similar comparisons in the investing world, including the way one handles an HSA.
The Taxable Account
The “taxable account,” also known as a non-qualified brokerage account, has been given an unfortunate nickname. “Penalty-free, highly-liquid, barely taxed account” just doesn’t roll off the tongue the same way.
There is some truth to the longer version, though. A taxable account (or accounts) is just a collection of assets you’ve bought. In my case, I’ve got a taxable account with Vanguard holding mutual funds and a little bit of Berkshire Hathaway stock.
These investments can be sold at any time and I’ll have cash in my bank account within a couple of business days. If they were any more liquid, I’d have to store them in kegs.
How exactly is a taxable account taxed? There are two primary ways. One is the tax on dividends. I buy funds that distribute mostly qualified dividends, which are taxed at a favorable long-term capital gains rate. The other tax is on the earnings when sold, the capital gains tax, which you may or may not have to pay, depending on your total taxable income.
Calculating Taxes on a Taxable Account
Depending on how much taxable income you have and where you live, that rate can be anywhere from 0% (taxable income under $80,000 for married couples filing jointly (MFJ) in 2020 in a no-income tax state) to 38.1% (taxable income over $1,000,000 in California). For most families earning a typical physician’s income, it will be between 15% and 23.8% plus state and local income tax).
At the federal level, taxable income above $80,000 (after deducting a $24,800 standard deduction) gets you the 15% tax on qualified dividends in 2020. Halve those income and deduction numbers for a single filer.
If your Modified Adjusted Gross Income (MAGI) is more than $200,000 (single) or $250,000 (MFJ), you’ll pay the additional 3.8% NIIT (a.k.a. ACA surcharge) that helps fund the Affordable Care Act. Finally, earners in the top federal income tax bracket have another 5% tacked on.
It’s important to understand that this tax is levied only on the dividends. Qualified dividends will be taxed at the favorable rates outlined above and ordinary, non-qualified dividends will be taxed just like interest at your marginal tax rate.
I have stated before that I am not a fan of receiving dividends, particularly during the accumulation phase while I occupy higher tax brackets.
The funds in my taxable account kick out about 2% in dividends annually. After paying state income tax and the 3.8% NIIT (but not the final 5% as I’m not in the top federal income tax bracket), those dividends are subject to about a 25% tax. This results in a tax drag of 0.25 x 2% or 0.5% because of the dividends.
A pediatrician in a no-income tax state invested in a tax-efficient manner might only have tax drag of 0.3%. A cosmetic surgeon in L.A. could have a tax drag of about 0.75% with the same tax-efficient investments.
On average, most of us will fall somewhere in between. Let’s go with 0.5% as a typical annual cost of holding funds in a taxable account as opposed to a Roth account where no taxes would be due on the dividends.
Capital gains in a taxable account can also be taxed. If you invest in passive index funds in a buy-and-hold manner, you are unlikely to incur any tax drag from capital gains while you’re working and continually adding to the fund.
If you have significant taxable income in retirement and you sell shares from the taxable account to fund your lifestyle, you can expect to pay the same taxes on those gains (the difference between the price you paid for the asset and the price you sold) at the relatively favorable tax rates outlined above.
Of course, capital gains taxes can be avoided in a number of ways, including a low enough taxable income, donating appreciated assets directly to charity or indirectly via a donor advised fund, or by passing assets along at death (at which the cost basis is reset to the current value).
This was a long-winded way of explaining that we can expect an average tax drag of about 0.5% on a taxable account holding popular index funds like Total Stock Market, S&P 500, Total International stock (which would be a touch higher but partially offset by the foreign tax credit), etc…
The Advantages of a Roth Account
Roth money is a bit easier to explain. Like the money in a taxable account, it’s already been taxed once. Unlike money in a taxable account, barring any drastic and unpopular changes in the tax code, Roth money will not be subject to further taxation.
This fact alone will give the Roth dollars about a half-percent boost in tax-adjusted returns annually when compared to dollars invested in a taxable account.
Additionally, Roth dollars are not subject to capital gains when sold.
Finally, assets in a Roth IRA are better protected from creditors than assets in a taxable account, so there is that asset protection advantage.
Clearly, it’s better to have money in a Roth account as compared to a taxable account. But… what are we giving up for this tax-free treatment?
The Disadvantages of a Roth Account Versus a Taxable Account
You can’t dine in the Roth Cafe and expect a free lunch. Those tax advantages do come at a price compared to investing in a taxable account. The costs may very well be worth it, but it’s important to understand the limitations.
1. Earnings in a Roth IRA cannot be accessed without penalty before age 59 1/2 (with the exception of setting up Substantially Equal Periodic Payments (SEPP)). Earnings in a taxable account can be withdrawn at any time. Note: You may withdraw the value of your Roth contributions (but not earnings on them) penalty-free as long as you’ve owned a Roth IRA for five years.
2. Roth conversions are not accessible without penalty until five tax years after the conversion was made. Obviously, there are no such limitations with money invested in a taxable account.
3. International investments in a Roth account do not benefit from the Foreign Tax Credit. If you own international funds in a taxable account, as I do, those funds pay foreign taxes, resulting in a tax credit on your 1040. This isn’t a huge benefit, but it can be hundreds of dollars per year in a six-figure taxable account.
4. There is no tax loss harvesting in a Roth account. In a taxable account, you can swap funds to save yourself $1,000 or more in taxes year after year. Excess paper losses can be used to offset capital gains, eliminating capital gains taxes in future years.
5. Roth conversions of non-deductible traditional Roth contributions (the Backdoor Roth technique) can be subject to income tax via the pro rata rule if you have any tax-deferred IRA money in your name.
That last point deserves more attention. In plain English, even if the IRA contribution you made as Step 1 of a Backdoor Roth plan was made as a non-deductible contribution, a percentage of the $6,000 you convert will be taxed based on the relative size of any IRA balances.
If you hold a separate $6,000 tax-deferred IRA, 50% of the attempted Backdoor Roth will be subject to income tax at your marginal tax rate. If you have $54,000 in tax-deferred IRA dollars, 90% of the $6,000 will be taxed because only 10% of your IRA dollars were made as non-deductible contributions, and the IRS looks at all IRA money, not just the non-deductible contribution you just made.
This is where a lot of people get hung up. They want to do the Backdoor Roth. They really, really want to do it, but they’ve got roadblocks in the way. A rollover IRA from a prior employer’s 401(k). A self-directed IRA. A SEP IRA from self-employment income. A SIMPLE IRA.
A common recommendation — and one I’ve made numerous times — is to open an individual 401(k) in a plan that accepts rollovers (like mine with E*Trade does). In order to do so, one must have self-employment income. There is some controversy over what level of business activity justifies obtaining an EIN and opening such an account.
Can you walk a few dogs, mow a few lawns, fill out a few medical surveys, open an individual 401(k) and potentially roll over hundreds of thousands of dollars into it? Will the IRS be OK with that? Some well-informed people say “yes,” and some equally educated people say “no.”
I’ll ask a different question. In such a case, where you’re contemplating starting a business to make the Backdoor Roth an option, is it worth the hassle?
My answer is “No.”
The True Value of a $6,000 Backdoor Roth Contribution
Let me start by saying that if you are maxing out all other available tax-advantaged retirement accounts, are making investments in a taxable account, and have no traditional, tax-deferred investments in your name, I do recommend taking the extra time to make the two-step Backdoor Roth Contribution.
However, you may have an IRA account that should not or cannot be rolled over to a different account, such as a 401(k), that’s not subject to the pro rata rule.
You may have a self-directed IRA holding assets that cannot be rolled over into a 401(k).
You may not have access to a 401(k) or your 401(k) might not accept rollovers.
Your 401(k) might have crummy investment options with high fees that would more than negate the benefit of the Backdoor Roth.
What is the benefit of that Backdoor Roth contribution?
By tucking away $6,000 in a Roth account rather than a taxable account, you can save about 0.5% of $6,000 annually, or about $30 per year in taxes. Depending on where you live, what you invest in, and how much you earn, the value to you could be $0, but will probably be in the range of $20 to $50 a year.
That’s what we’re fretting over. We jump hoops to get this $20 to $50 annual benefit. We fill out page after page of paperwork to open a solo 401(k). We contemplate starting a business (or something that could be called a business) to be able to do this.
You might be paying a CPA just as much or more to properly fill out form 8606 each year to properly document the transaction(s), and if it’s done wrong, you might end up paying a lot more in taxes or deal with a major hassle to re-file properly.
While it’s true that the benefit recurs year after year and the tax savings can eventually grow by addition and compounding to a few thousand dollars over several decades. If you’re married and doing this with $12,000 per year, the savings could eventually reach a tidy sum — but at an initial rate of $40 to $100 per year.
What else could you do to save $40 to $100 per year (or per month)?
- Eat dinner out one less time
- Open one new credit card with a welcome bonus worth $500 to $1000
- Opt for a cheaper, better cell phone plan
- Let Trim or Truebill negotiate lower cable and internet rates for you or just Cut the Cord completely
- Absolutely anything that saves you at least 10 to 15 cents per day.
The savings do benefit from addition and compounding. You might save $30 the first year, $60 the next, $90 the next, then $120 and so on. Assuming your investments have positive returns, the savings will be a bit larger. I do cover the full implications of the time value of the backdoor Roth in a followup post.
The Roth money also benefits from easy avoidance of capital gains taxes. This is difficult to quantify, as you may very well be in a position not to pay them in retirement, anyway.
If you are married and filing taxes jointly, you can have over $100,000 in taxable retirement income and after the $24,800 standard deduction in 2020, you’re paying zero tax on long-term capital gains (and qualified dividends). There are also the other avoidance strategies involving charitable giving and passing assets to heirs mentioned earlier.
I don’t want to trivialize the benefit of tax-free withdrawals, though. If you are a fatFIRE type and anticipate a big retirement budget, or you do not have much saved outside of tax-deferred retirement accounts and expect most of your retirement spending money to be taxed upon withdrawal, your taxable income may be too high to avoid paying capital gains taxes if you’ll also be selling funds in a taxable account to support a six-figure spend.
Obviously, this particular benefit of Roth dollars will vary from non-existent to substantial, depending on your individual circumstances, drawdown strategy, and portfolio construction.
Spend or Save Your HSA Money?
In a number of ways, the benefit you see from taking advantage of the Backdoor Roth option is akin to the benefit of saving health care receipts and leaving money invested in an HSA.
Rather than spending from an HSA, some people will save receipts perpetually and leave the money in the HSA to grow for years tax-free until some much-later date at which they plan to cash out the sum of the receipts over the years.
If you pull money from the HSA to cover costs as you go (and you have a taxable account), you’re essentially shifting money from a tax-free HSA account to a taxable investment account. The shifted money will suffer from a bit of tax drag.
What do I do? I spend as I go. I don’t pay hospital or clinic bills directly from the HSA — I pay with solid rewards credit card and reimburse myself — but I do deplete my HSA one expense at a time. The benefit from the points alone is far greater than the detriment of the tax drag resulting from withdrawing funds from the HSA.
There are three more reasons I don’t allow my HSA balance to grow, despite the fact my choice could be considered suboptimal.
First, I don’t like tracking receipts. I did this for a while. I would scan the receipt, save it in the appropriate folder on my hard drive, and enter the details into a spreadsheet. I’m sure there are more streamlined ways to do this, but it was a pain. I still keep paper receipts just in case I’m audited, but that’s much simpler.
Second, a bird in hand is worth two in the bush. I’d rather get the money out tax-free now rather than rely on remembering to do it decades from now. If I were to lose my mental faculties or die prematurely, would my next of kin know to withdraw all this HSA money tax-free? A legacy binder could play a role here, but it’s a risk I’d rather not take.
Finally, like the Backdoor Roth, there is only a marginal gain from doing so. If my HSA-reimbursable out-of-pocket health care expenses average $4,000 a year, I gain $20 per year by saving receipts and leaving the $4,000 invested in the HSA. It’s not worth the bother or the small risk that the money might never be withdrawn tax-free.
I believe you should always fully fund an HSA to the maximum allowed for the tax deduction, of course. The max for 2019 is $7,000 for a family or $3,500 for an individual, up $100 and $50 from 2018, respectively.
Other Ways to Create Roth Money
This is not an anti-Roth rant. I like having Roth dollars as part of my portfolio and it’s one reason that my money may be worth more than yours. Now that we understand that the annual benefit of the backdoor Roth is measured in dozens of dollars, we don’t have to feel bad about not doing it if it’s not convenient given our situation.
There are still a number of ways to make Roth money a part of your portfolio.
After the most recent tax reform, the new 24% federal income tax bracket goes all the way up to $326,600 in taxable income (MFJ) or $168,400 (single) in 2020. I think this is a reasonable tax bracket into which to make direct Roth contributions to your tax-advantaged retirement accounts like a 401(k), 403(b), or 457(b).
24% is also a reasonable rate at which to make Roth conversions. You’ll likely have a large gap between your taxable income in retirement and the ceiling of the 24% tax bracket before it jumps to 32%.
While you would give up tax-free qualified dividends, it may be worthwhile to fill up the 24% bracket with conversions between now and 2025, after which the current tax brackets are scheduled to sunset. This may be an especially prudent strategy if you have an IRA or 401(k) balance in the upper six-figures to seven-figures.
Roth conversions can also be used as a clever strategy to access an IRA before 59 1/2 without setting up SEPP. Five years after converting, you can withdraw the converted dollars (but not earnings) without penalty at any age. Do this annually and you’ve built yourself a Roth ladder with money available every year after the initial five-year “seasoning period.”
The Verdict: Are Backdoor Roth Conversions Worth the Trouble?
The initial benefit of the Backdoor Roth, as compared to putting the same $6,000 in a taxable account, is worth maybe $20 to $50 per year, per person, and that money will compound over time. You also virtually guarantee you’ll never pay taxes on the withdrawals, which may or may not be true of the funds in a taxable account.
If you have no IRA money in your name and are comfortable accepting the minor disadvantages of the Roth account for $6,000 of your annual investments, I think it is worth the trouble. It takes a few minutes each of two different days, and perhaps some time to research it to make sure you get it right.
There’s also form 8606, and I’ve linked to several examples of how to do this on paper or with online tax preparing software here.
However, I would not go to great lengths to clear a path for the backdoor Roth just to save yourself maybe $28 a year. You could do financial harm if you roll over rollover money from an IRA into a 401(k) with even slightly higher fees than the IRA in which it currently resides.
There’s no reason to beat yourself up if you haven’t been contributing to a Roth IRA via the “backdoor.” It could save you a little money now and possibly some capital gains taxes later on, but I consider the true benefit to be marginal for most of us.
For more information, be sure to check out additional articles on the Backdoor Roth:
- Vanguard Backdoor Roth: a Step by Step Guide
- The Marginal Value of the Backdoor Roth. Is it Worth the Trouble?
- Calculating the Value of Your Backdoor Roth Contributions
- The Backdoor Roth Point / Counterpoint: A Must-Do or Meh?
- The Backdoor Roth FAQ
Do you make annual Backdoor Roth contributions? Did you have to move money to clear a path to make them? Do you feel it’s worth it?
69 thoughts on “The Marginal Value of the Backdoor Roth. Is it Worth the Trouble?”
Having read this I thought it was extremely informative.
I appreciate you spending some time and effort to put this article together.
I once again find myself personally spending a lot of time both reading and posting comments.
But so what, it was still worth it!
If you want to get a great deal from this piece of writing then you have
to apply such techniques to your won webpage.
What about QRPs? Do they cause the pro rata tax to trigger for converstions to a back door roth?
I’ve been told No by Damion Lupo. Should be OK.
Thanks. I just opened one last year by rolling over my 403B from residency. I like being able to invest in real estate for a little more variety in my portfolio.
Dear Physician on Fire, Have you ever thought of teaching a class in all of this? If not please consider, many of us would sign up.
I would like to prepare a course (or courses). I just need to find the time.
I think there’s a real psychological aspect that the Roth money is retirement money while the taxable accounts can be accessed. It seems like a lot of the barriers to wealth are discipline so having the backdoor roth provides that even if the pure dollar gains are minimal.
I think many here are wasting time discussing the bare financial implications of the Roth IRA while neglecting the equally important psychological concept of money held for retirement vs money sitting in your brokerage account. One of the greatest risks to the future financial security of high income individuals is overspending and “keeping up with the Jones” during the peak earning years. Moving even a small amount of money out of taxable accounts that make you feel flush and into retirement accounts for use later in life can have a positive impact on spending habits.
It should be easy for a couple to accumulate mid six figure balances in a Roth by retirement increasing your ability to diversify sources of income to avoid tax liabilities, control the costs you pay for Medicare part B, and broaden your ability to gift money tax free to heirs.
This seems to be worth the investment of five minutes or so annually.
This seems ridiculously misleading to me. You pretend dividends are the only thing you get taxed on. I’m not aware of any data on it, but I expect most physicians pay capita gains taxes in retirement. Those taxes matter.
Taxes do matter, which is why I like to get my readers to think outside the box and perhaps find a way to set themselves up to be in a position to pay a lot less. It would be misleading if I didn’t address capital gains taxes or mention several ways in which they can be avoided or minimized.
If you assume you’ll just pay taxes anyway, I believe you’re more likely to prove yourself right.
There are benefits that a Roth account has that a taxable account does not, and there are some very real advantages to the taxable account. My recommendation is to have money in both buckets, but not to beat yourself up if you can’t find a way to do the Backdoor Roth annually.
As you can see in the comments above, potentially serious harm can come from a fouled up transaction if the 8606 isn’t properly filled out or not filed at all.
Cheers!
-PoF
I think it’s more than just “assuming you’ll pay taxes anyway”.
While you lay out scenario’s where capital gains taxes can be avoided, I would submit that it is much more likely than not that capital gains will be taxed for someone who has to use the backdoor for Roth contributions in the first place (because their income exceeeds the cutoff). After all, we are talking about high(er) wage earners here.
Think about, for example, what will happen when these folks begin drawing RMD’s and taking SS (assume that happens when they turn 70). Between those to things alone, they may well be at or above the income cutoff for zero capital gains. Under current tax rules, this means their capital gains will be taxed at 15% (and if capital gains push their ordinary taxable income from the 12% to 22% tax brackets, that could well push their marginal tax rate on their capital gains to 25%).
I early retired at 53. Based upon my portfolio and using current tax rules, I fully expect this will happen to me when I turn 70. And I don’t think I am an outlier in the higher earner community.
I used the backdoor for Roth contributions for both me and my wife every year that the backdoor was open. Now I am doing partial systematic Roth conversions from my tIRA to the top of the 12% tax bracket (trying and shift as much of my tIRA to my Roth as possible).
The title to this article probably should have been more nuanced – something like “In some cases, the marginal value of the Backdoor Roth may not be worth the trouble”. Because in some/many (perhaps even most) cases it clearly is.
Unable to edit my recent post so calling out the error here.
When I said, “and if capital gains push their ordinary taxable income from the 12% to 22% tax brackets, that could well push their marginal tax rate on their capital gains to 25%” I misspoke. That only happens if incremental “ordinary income” causes more of your capital gains to be taxed.
The rest of my comment still stands though.
If I were in your shoes, MikeG, I would look at whether or not it makes sense to reduce or eliminate future RMDs by making Roth conversions of your tax-deferred 401(k) / IRA balance in the 12% to 24% federal income tax brackets.
If married, you can have up to $315,000 (and nearly $320,000 in 2019) in taxable income which means you may be able to convert >$200,000 a year at a historically attractive rate between now and 2025 when the TCJA brackets sunset.
Thank you for your comments.
-PoF
I never thought very much of backdoor Roth because of the tax drag. Color me not impressed, but Back door Roth is not Front door Roth conversion. If you plan correctly and don’t have a ton of ordinary income close to RMD you can do yourself a favor by converting IMHO. My initial thought was to convert to the top of the 24% bracket and convert over a period of time sufficient to virtually clean out my IRA. This over time results in the greatest tax saving far in the future, and an increase in end of life portfolio value. In m case my end of life value is 1M more, 30 years in the future with Roth conversion than without and letting RMD eat up the taxes. My chances of living 30 years is small but my younger wife has a 30% of being around then, and an extra million bucks may buy a nice chunk of assisted living. My feeling now after starting conversion is to convert only stocks and leave the bonds to RMD. A smaller IRA RMD’s less and a bond IRA RMD’s less, so you can tune the RMD to keep your income in the 12% bracket for quite a while. I wrote an article here .
HSA has a distinct advantage. You can pay for Medicare parts A B and D with it. Some HMO plans can also be paid out of HSA funds, indemnified plans can not. You and your wife can expect to spend $300K on medical care in your dotage sohaving a pile of tax free money available that is 50% compounded from years of growing isn’t a bad deal. In my case I have enough HSA to cover 16 years of tax free medicare expense and it doesn’t defray my cash flow. Better than a sharp stick in the eye.
One thing to worry about is when you pull a BoJangles dog trick and up and die, your spouses tax bill sky rockets. If you’re RMDing 150k/yr and your SS is say 50K/yr your tax bill is 30K/yr just touching 24%. If your wife becomes single her tax bill becomes about 35K per year. She loses your SS, loses one deduction, and advances one tax bracket. Good ol Uncle Sam has a plan for her. Since it’s RMD money there isn’t anything you can do about it, so by having taxable account, tax loss harvest, Roth, and a small RMD you retain some control over how to optimize taxes. I’ve spent a lot of time understanding how to optimize this and it requires optimization and a plan planned and implemented a long time before age 70. FIRE planning is different than Retire planning. This is another earlier article I wrote as I was working through this
Making Roth conversions of a couple hundred thousand dollars a year in the 24% federal income tax bracket will have a much more powerful impact than shifting $5,500 from one good account type to another. No doubt about it. That’s part of my plan if I find myself in a position to do so before the current rates sunset (and are likely replaced with substantially higher tax rates).
Good point about the tax rates going up substantially on a widow or widower. I hadn’t thought much about it, but that will be a drastic change if my wife and I don’t pass together or in short succession.
Best,
-PoF
This line confused me a bit. $20 on $4,000 is 0.5% tax drag, but with the HSA, isn’t there a further tax savings by not paying FICA?
Great post to put this all in perspective.
I’m still putting in all $6,950 in the HSA annually. The difference is whether I leave all the money in the HSA or take out the $4,000 to cover medical expenses now.
By using money from the HSA, I lose the tax-free growth on the $4,000 and will instead have that money invested in a taxable account. The 0.5% tax drag is $20 that first year. Over time, it does add up, but there are other risks to waiting as outlined above.
Best,
-PoF
I started investing before Roth and way before the backdoor Roth was possible. I never changed anything when they came up. I have no Roth products at all. I was FI at age 50 and retired from medicine at age 54. The Roth is another tool in the quiver. Whether you use it or not, will not really make much difference, as was pointed out. Your savings rate is what will be the defining factor. I sometimes think I missed the boat by not doing Roth or making Roth conversions, but then this article comes out and I don’t feel so bad now. The internet Roth police will be held at bay. There are many roads to Rome, don’t get hung up on which one you use. Just get to Rome.
Dr. Cory S. Fawcett
Prescription for Financial Success
LOL
I love this.
Can you elaborate more about what you mean with saving receipts for the HSA? I was considering switching to an HSA next year to lower my taxable income, but just using it as an investment vehicle to allow more money to grow tax free and just pay my medical bills with regular credit card money for points as you said. If I just wanted to let the money grow for 30 years tax free before either spending the money on future bills, or taking it out and paying the income tax after age 65 for a non-medical expense, why would I need to save 30 years of receipts?
Also, I’m starting to believe in your mind reading skills, PoF. I was also getting ready to get my ducks in a row for a backdoor Roth conversion and you put out a great write up for both the HSA and backdoor Roth. Perfect timing for me!
“If I just wanted to let the money grow for 30 years tax free before either spending the money on future bills, or taking it out and paying the income tax after age 65 for a non-medical expense, why would I need to save 30 years of receipts?”
Good question. The reason is that if you use it for non-medical expenses after age 65, you’ll pay ordinary income taxes on the withdrawals. You want to avoid that scenario (although it makes the HSA equivalent to an IRA or 401(k) which is not terrible). But you really want to use every dollar for medical expenses to avoid paying taxes on the back end.
You will probably have those medical expenses later on, but what if you die prematurely or the US adopts some form of universal health care?
Cheers!
-PoF
Please read this and learn from a fool(being the fool myself). We (my wife and me) have being 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 time. So far so good: Recently I received from the IRS a note saying that we owed almost $ 5000 in past taxes and penalties!!!!!!!! How this happened? In all this years, from 2012 to 2017 never a form 8606 was produced. No 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. Two observations:
– when in doubt in how to follow the proper procedure do not do a Backdoor Roth, a taxable account is perfectly fine.
-be very weary of the qualifications of your tax preparer: could be giving the wrong advice.
I really appreciated if anybody had’ve been in the same situation how the problem was solved.I hope some fixing will happen, but otherwise the contribution of Backdoor Ira for six years(13,000 x6) it would cost almost $ 10k,totally ridiculous!!!!!!!!
Is your accountant a CPA? I don’t believe a CPA would make that mistake. Don’t use a non-CPA to handle your money. And if you gave the accountant information regarding your Roth, there is some professional liability there.
Actually many CPAs have no idea what a Backdoor Roth is or that a idividual 401k is so much better than a SEPP IRA.
It’s a shame but I have went through a few accountants over the years. I have a few friends who have found the same lack of knowledge in their own accountants as well.
It’s headaches like this that are rare but demonstrate the risk of not getting it right. I’ll bet you wish you could go back in time and forget you ever heard about this trick we call the Backdoor Roth. I’m sorry for your troubles.
Best,
-PoF
I went through something similar. My accountant didn’t include an 8606 even though I expressly told them to. Shame on me for not double-checking. The IRS came calling several months later, looking for their cut. I made my accountant draft up the letter explaining the mistake and had them take care of submitting an amended return with all the proper documentation proving that this was indeed AFTER tax money that was part of a BD Roth conversion. In the end the IRS accepted the explanation and all was forgiven, but the hassle was not worth the very marginal gains that PoF points out!!
Good post. Yes, the initial benefit may not be that much per year. But when you’ve done it for 10 years, it’s now $500 per year and growing. The hassle is so tiny most of the time (MAYBE one IRA rollover, plus a contribution and conversion each year) I think it’s worth it for most.
Of course, there’s more than just a tax benefit there compared to a taxable account. There’s also an estate planning benefit and an asset protection benefit.
This exactly.
It isn’t just $20-$50 per year. It is compounded in itself with growth.
Year 1 $20-$50
Year 2 $40-$100
Year 3 $60-$150
After 20 years of investing this number becomes more substantial substantial. $400-$1000 per year every year. And, that doesn’t even include a reasonable 5% growth on that money.
POF, I really believe you need to amend your article to include such data because it is a big deal. Who wouldn’t want an extra $1k+ of tax free spending money in their retirement.
That’s true. But any money you set aside by spending a tiny bit less or earning a tiny bit more also benefits from addition and compounding. The only difference is the tax drag.
I do plan a follow-up in which I dive deeper into the numbers. I wanted to do that here, but at 3,300 words, it’s plenty long. There’s enough material in the math for a separate post, particularly when trying to factor in capital gains taxes for those that expect to pay full fare.
Best,
-PoF
Appreciate the in depth article on the pros and cons of the Backdoor Roth. I think sometimes the FIRE community is a little overzealous in doing something just because they can, without questioning if it’s really worth the time and anxiety.
Heresy! Somewhere an angry mob of personal finance enthusiasts is lighting their torches and sharpening their pitchforks.
I think the backdoor Roth is worth the minimal effort I exert 5 minutes a year to contribute. I like knowing that by age 60 we’ll have a million dollars in tax free money at our disposal.
Most of all I like that between taxable accounts, Roth and 401(k) I will essentially be able to pick and choose my marginal tax rate based on how I make withdrawals.
Having a dollar figure the Roth is worth ($50-$100/year) really puts into perspective how lucky physicians are to have their earning power. You have readers who would never dare to skip on their Backdoor Roth but would never consider working a physician side gig making $1,000-$3,000 a day. A little hustle goes a long way to fueling a fatFIRE.
This is such a great post that clearly explains the benefits of “taxable” account as well as the marginal added benefits of the back door Roth (after maximizing other tax-advantaged accounts of course).
I think another “marginal” benefit (and I say marginal because it’s not really a hard benefit) is that Roth money is a little bit less liquid. Psychologically, people think of money in a Roth IRA as money that shouldn’t be touched, thus giving it a better chance to grow into something substantial. Whereas money is a taxable account has the perception of being liquid so… people might be thinking “I can withdrawal money from this whenever I want”. This could be to their detriment as they could be selling at a loss without tax loss harvesting or selling at a gain and incurring taxes on those capital gains. Like I said, it’s a soft/marginal benefit, but I think human psychological behavior is powerful so I do think it’s still a “benefit”.
Hopefully I explained my thoughts somewhat clearly ;P
I started investing for retirement with an SEP IRA a few years ago. Recently I’ve been debating whether or not I should clear a path to make backdoor Roth contributions. I didn’t really want to go through the hassle. This article makes me feel better about not doing it. Thanks!
Great article. I had never done the math, but it is interesting to know that the incremental benefit of the back door Roth is relatively low.
It is worth having a solo 401(k), however if you have a significant side gig. That will help you deferred tax and accrue more assets for retirement.
Great point. I opened up a solo 401(k) in 2016 — not to shelter IRA money (I rolled some over into my employer’s 401(k) several years earlier) but to make more tax-deferred space for the income from this site.
Cheers!
-PoF
Thank you very much for sharing, I learned something new today!
Figuring out how to become as tax efficient as possible in retirement is something I and my advisor are constantly mulling over. I appreciate your thoughts and the math around this topic.
Keep it up!
I’m here to teach, my friend. Every day is a schoolday.
It’s true that if you’re not invested in a tax-efficient manner in taxable, the cost difference can be much greater, making the Roth contributions much more attractive.
Cheers!
-PoF
I like Roth because it is another goal to force my savings. I do not budget in the traditional sense but I just make sure my savings are high enough and not feel back about spending the rest. Filling the roth helps me keep that goal up there and avoid lifestyle creep. If I plop 11k down in january I cannot spend it later. If I plan to put 1K a month into my brokerage I would be more likely to tap that if needed funds. It is also easier to get that money out to spend. Now myself and most people on this site would not think about spending money designated for retirement but it is nice to decrease the temptation.
I also like Having roth as a place to re-balance without penalty. My 403b and 457 are limited and I do not want to move much around in taxable so that leaves the roth. It i puny now but it will give me a place to put a tilt on my AA or some not tax friendly alternative investments.
You could also just “plop” $11k into your brokerage account on January 2nd. I do like your idea of the free rebalancing. I do the same.
I do some rebalancing in Roth, too. It’s nice to have that space. Most of my Roth money comes from a big conversion of a SEP IRA I did 8 years ago. I have been adding $5,500 a year the last six years, but 90% of what I’ve got there is from what I call my Mega Roth conversion.
Cheers!
-PoF
This is a great write-up of a complex topic, so thanks for putting this together. Investigating the backdoor Roth has been on my to-do list for a while and I can now confidently cross it off!
I have a huge balance in a traditional IRA from a 401k I previously rolled-over. That plus the marginal benefit means no backdoor Roth for me! On to my next to do…
Yeah, I wouldn’t worry too much about it. Honestly, if you’re in a position to consider it, and you know why it may or may not be the best idea, you’re likely going to be just fine no matter what choice you make.
Cheers!
-PoF
The loss of recharacterization has made Roth conversions far less valuable. An early investment loss in a Roth account “stays on the books.”
A loss in a taxable account can be used to offset up to 3k of regular income if no other cap gains. LT gains in a taxable account can be gifted and have a step up basis at death. Give away your money with warm hands rather than cold.
If you understand tax loss harvesting, a taxable account beats a Roth account every time. The amounts that can be put into a Roth are really quite trivial.
For families with children growing up making under ~250k but more than the traditional limit, the backdoor Roth is a good way to hide wealth from college financial aid calculations. You can do the same with a no tax benefit traditional IRA, but once you have the IRA set up in Vanguard, converting it is literally the press of a button.
Good point, gals. The Roth IRA is ignored on the FAFSA.
I tend to assume that if you make too much to make a direct Roth contribution, you’re not likely to qualify for any need-based financial aid, but there will always be outliers.
Thanks for sharing the tip!
-PoF
The range between “not Roth eligible” and ~250K+ (this upper number has probably increased since we last checked) per year is the prime “your wealth matters” territory for financial aid at private schools (Forbes has a really good series of articles on this topic). A good percent of the upper-middle-class is in this category (including us for most of our working lives– though I see the “not Roth eligible” limit has increased along with our income), which is probably why there’s a whole series of Forbes articles on how to legally hide wealth from private colleges.
Roth Iras offer a great way for your heirs to get the option for a stretch Roth Ira which allows them to continue to have a tax protected account grow while only subject to the RMD (which if given to someone young like a grandchild can extend the tax favored compounding by decades).
As an heir I would much rather inherit Roth funds for that reason.
I procrastinated for a long time before finally doing a backdoor roth (thanks for your guide that finally helped me to do it) mainly because I had so many other accounts that would have been subject to the pro rata rule and I was lazy to roll them into my 401k. I finally did and last year was the first year I did a backdoor roth (to demonstrate how long I had put it off, I had over $65k basis that was converted).
I honestly think you don’t need to save receipts for HSA use. Most studies show that a couple who is 65 will spend $250k in out of pocket expenses which would deplete pretty much even the most heavily funded HSA accounts. So even if you don’t keep a single receipt I think it would be easy to just use it from day the first day you are 65 and figure I would have enough qualified ongoing expenses (medication, co-pay, Medicare premiums, etc) to use it all up without digging for decades old receipts.
Good points, particularly on the HSA bit. I’d hate to run the risk of having to pay tax on any HSA money, though. While scanning and spreadsheeting the receipts may be overkill, maybe a shoebox or file folder would be adequate. You do run the risk of losing them to flood or fire in that case, but you probably won’t need them, anyway.
It’s true that a Roth IRA is a great account to inherit, but so is a taxable account, as the cost basis is stepped up to current cost when inherited.
Cheers!
-PoF
I am glad you laid this out and quantified it. I think the original writing was for people who needed money to bridge their early retirement to when they could access traditional Roth and 401(k) money. Though FIRE is a popular concept compared to several years ago, most people will not retire early at all or early enough to need that bridge.
The conversion advice has gotten mixed up in the basic personal finance advice and this post provides clarity on the real dollar value and by doing so emphasizes that it is really for the early retirement folks who need that bridge.
Thanks!
Thanks for the comment, Drew.
That’s not exactly how I view the backdoor Roth — I see it more as a way to squeeze a little more money into a tax-advantaged account. And if you can easily do it, I still think it’s worthwhile. Just as not as valuable to me as I had assumed it was.
I think a Roth Ladder is a great tool for those who retire early without much of a taxable account to make some of their tax-deferred money available to them without penalty at an early age.
The terms are confusing and they’re mostly made up using household objects (back door, ladder).
Cheers!
-PoF
Got it! I have clearly meshed the conversion ladder and backdoor in my own mind. This article and comment helped me clarify it. Thank you!
I’ve been doing the backdoor Roth since it started and I agree with you, it’s too much hassle if you have a regular IRA. Good for me, I don’t 🙂
And every year I restrained from starting a regular IRA for just that reason, because it would make the BDR too cumbersome.
The good news for me is that now that I half-FIRE’d and went part time I don’t have to do the BDR. I’m doing a front door Roth 😉
When the front door is open, there’s no need to sneak around to the back.
One of the downsides of starting a self-directed IRA would be the loss of the Backdoor Roth ability. But now I see it wouldn’t be that big of a deal.
Cheers!
-PoF
I think this is a clearly explained review of the complex retirement fund laws. I don’t disagree with any of it.
I love having money in ROTH personally. I see the value as much more than a few dollars of credit card points.
The ROTH allows tax-free growth and tax-free withdrawals. If I don’t spend it all then my kids will get it without paying a tax or penalty.
It is also much more flexible than a 401k or traditional IRA especially since there is NO RMD on ROTH. My parents an in-laws are over 70.5 years old and are required to take money out of retirement funds and pay the tax. It is a big issue for them. ROTH wouldn’t require that.
I’m going to push back against the “few dollars of credit card points” remark, but agree with the rest. Roth has numerous advantages as compared to tax-deferred money. My preferred method is to defer tax with traditional contributions in peak earning years and converting to Roth in low-income, low-tax years (retirement).
Regarding the credit card points, last year my wife and I each picked up one card and spent the $3,000 minimum on each. That gave us enough Aadvantage Miles to fly our family of four to Honduras and back. By spending $6,000, we got over $3,000 in free flights. That’s a 50% return in a couple months.
Cheers!
-PoF
Just curious how many cards do you open each year? I think I went to fast and opened 3 cards in just 3-4 months and Chase denied the 4th credit card. I am trying to find out what the right “pace” is for opening cards, thanks
Chase has a 5/24 rule. If you’ve been approved for 5 cards from any bank in the last 24 months, they will likely deny you. That’s why I strongly suggest you start with Chase cards and then consider other banks’ cards once you’ve racked up a bunch of Ultimate Rewards points.
Note: Some business cards won’t count against you in the 5/25 rule. Citi and AmEx for example, but I’ve heard Capital One business cards do.
I usually get a new card every few months, but will have to slow that pace to go back to Chase cards (or alternate between personal and business cards).
Best,
-PoF
I was denied on my 4th Chase credit card (3 were approved, 4th was denied). Before these cards, the last time I applied for a credit card was 4 years ago. The Recon Chase associate I spoke to, cited too many cards in just a few months as the reason for the denial.
I am bringing this up because despite listening to 100% of Choose FI episodes and taking the tavelmiles101 email course, the only rule I remember ever hearing is the 5/24 rule.
Based on my experience I would wait at least 4 months in between cards. I asked the Recon Chase associated about the rules and she acted like there were no rules, just case by case considerations.
Thanks!
I’ve written my opinion on the dollar value of a Roth IRA. Using relatively conservative assumptions, I came up with $2,750 in capital gains tax savings over 30 years, or about $90 per year. I only included the capital gains tax benefit, which you assumed would be zero in your analysis because of methods to avoid paying the capital gains taxes. I did not include dividend tax drag in my analysis.
I think you are minimizing the power of compound interest on the tax drag of the dividends. While 0.5% a year may not seem like a lot, you are cutting 0.5% on your after-tax returns. It would never be acceptable to the index fund investor community to pay 0.55% for their index funds instead of 0.05%, but that’s essentially what you are doing by choosing to invest your index funds in taxable instead of a Roth.
The ability to stretch your Roth IRA should be noted, which extends the tax benefits of the Roth to potentially over 100 years.
Finally, in my opinion, you need absolutely optimal investment management in order to render the benefits of Roth IRA just “marginal.” As you describe, you need to completely avoid capital gains tax in the taxable account and never sell your investments for decades through index fund investing. This may not be possible for the typical investor, who may have difficulty staying the course during down markets or avoiding the new trendy investment.
-WSP
I hadn’t considered the behavioral aspect of leaving the money alone once it’s in the Roth IRA. There are some psychological benefits of illiquidity, I suppose. Of course, the money is available to withdraw five years after the conversion.
Regarding the 0.5% tax drag, if it were on the whole portfolio, that would be a huge problem. But in the case where you’re already maxing out other tax-advantaged space, the $5,500 we’re talking about should represent a small portion of your annual investments — under 10% for most and less than 5% for many.
Good things to think about, nonetheless.
Cheers!
-PoF
I agree that the backdoor is not a huge game-changer, but over an appropriate time period (and Roth accounts should be the last one you tap, so we are talking several decades here), the compounding growth is real money. I think you are low-balling it at 5-10%, I think more like 10-30%; I value it around 20% for myself. Not enough to justify pro rata taxes, but definitely worth the trouble to clean out tIRA into SE401k, regardless of whether you are high- or low- income in retirement (but for different reasons). I think it is misleading to just say it’s “$28” a year, and it’s misleading to compare it to other saving strategies (why not both? there is no real trade-off here).
Same applies to HSA; even if you find tracking your spending a pain, you can a) just wait and use it to fund your (higher) expenditures when you are old and gray , and b) withdraw the balance (if any) like an IRA after 65 per the rules. I doubt many people’s balance with outstrip their spending later in life (especially FIREers). I have a big envelope full of receipts, but if it burns up, no big deal (except for the fire that may have just burned down my house). I just don’t see any real reason to eschew tax deferred/exempt growth. Over time it’s real money.
The 5% to 10% I was referring to is the $5,500 you can contribute to Backdoor Roth compared to your annual investments — we’ve been doing $11,000 as a couple with one income (hooray for the spousal IRA), which in recent years, has been about 5% of our annual investments.
I do like Roth money — it is the most valuable money a person can own, and there are a number of ways to invest or convert in Roth, most of which give you a lot more than $5,500 a year. I converted hundreds of thousands of tax-deferred SEP IRA money to Roth in 2010 when it was supposedly going to be a one-time opportunity.
And you’re probably right about the HSA. One risk is the possibility of single payer or universal health care becoming the law of the land. Our out-of-pocket expenses might look a lot different in that scenario, and I’m 23 years away from Medicare eligibility.
Cheers!
-PoF
Ah, gotcha.
I imagine if some version of single payer come to pass, there will still be a large amount of cost sharing – there has to be, or it will be a fiscal disaster.
Regarding HSA’s, are you only contributing $4000 a year, and not the $6900 that you are allowed to contribute?
Not contributing those extra $2900, would translate into paying around $1000 more in taxes (assuming a marginal tax rate of 35%).
In the case of universal health care, you could still withdraw the money after age 65, hopefully at a much lower marginal tax rate. For example, withdrawing $2900 after 65 at a marginal tax rate of 17.5% would save you $500 a year.
Disregard my comment above. I read below that you do contribute the max to the HSA. Thanks
Good question (and good points). In the post, I’m only talking about how you choose to draw down an HSA. I would never turn down a tax deduction like that, especially when there’s a very high likelihood we’ll also withdraw the money tax-free, too. The HSA is triple tax-free, as they say.
I’ve added a line to make it clear I always recommend maxing out an HSA account.
Cheers!
-PoF
I was glad to hear this wasn’t an anti-roth rant at the end.
My three favorite features of a Roth IRA are the following:
1) the ability to use it in early retirement (if desired) in the way you described.
2) no RMD in retirement after age 70.5 unlike regular IRA money.
3) giving it to heirs as a stretch Roth IRA.
As a stretch Roth IRA, your heirs will be forced to take RMDs but they will be tax free and the money will continue to grow tax free. So, it’s basically a tax free gift to your heirs for as long as it lasts. That’s a huge advantage if you plan to leave money to those you love.
I do agree that it is extra work, but wanted to highlight some of the other reasons it may be “worth it” for people.
TPP
Those are great advantages that Roth has over traditional IRA dollars, but that’s not what we’re talking about today. I’m looking at taking $5,500 that would be invested in taxable and instead investing it in Roth via the Backdoor.
Similar and in some ways better than the Roth account, the taxable account can also be accessed at any age with no stipulations, is passed down to heirs at a stepped-up cost basis (no tax due if sold for cash) and without RMDs. The biggest downside to taxable is the potential for future capital gains taxes, which may or may not be an issue for us.
I think converting traditional, tax-deferred investments to Roth between retirement and age 70.5 is an excellent idea for the reasons you outlined.
Cheers!
-PoF