[Editor's Note: This is Physician on FIRE's follow-up post to the one we republished here a few weeks ago with a rebuttal. I love that it discusses which folks will get the most value from doing Backdoor Roth IRAs.]
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 in the spring of 2020 can now be making both 2019 and 2020 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.
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 $24,800 standard deduction in 2020, 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%.
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.
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. As such, their qualified dividends were not taxed at the federal level. 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. Well, that's not entirely true. They would miss out on the opportunity to harvest losses for beneficial tax treatment with money in the Roth IRA. There are some ways that a taxable account can be as good or better than a Roth IRA.
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.
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 a while, 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
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 an extra $1,000 per year can be as valuable as doing the backdoor Roth over many decades.Required Minimum Distributions (RMDs) when inherited, and the SECURE Act dictates that it must be completely withdrawn after 10 years. 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 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 the years, from 2012 to 2017 never a form 8606 was produced. Not only were these back taxes were due, I also 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 High 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 you need personalized comprehensive advice for your specific situation, consult with an expert at StudentLoanAdvice.com.
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.
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.
- Tax Loss Harvesting with Vanguard: A Step by Step Guide
- Tax Loss Harvesting with Fidelity: A Step by Step Guide
Ignoring Credit Card 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:
- Credit Cards for People Who Love Free Travel and Money
- The Best Business Credit Cards for Small Business or Private Practice
- Rewards Made Easy: The Best Cash Back Credit Cards
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:
- Vanguard Backdoor Roth 2019: a Step by Step Guide
- The White Coat Investor Backdoor Roth Tutorial
- 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?
Have you taken advantage of the Backdoor Roth? How many times? How do you value the benefit of your Backdoor Roth efforts?