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Understanding the benefits of a backdoor Roth

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  • Avatar Hockeydoc 
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    Hi all, long time lurker, listened to most of the podcast library… just had one question that I haven’t been able to fully grasp yet.

    Why should I want to do a backdoor Roth as opposed to a traditional Roth [edit: IRA. oops.]? The answer I got from the blog post was for “tax-diversification” in retirement but I don’t really understand that. An example: lets say I make $350k per year and in retirement my goal would be to live on ~$150k per year.  If I use a traditional IRA, I’m taking income taxed at 32% and delaying the tax until i would only have to pay 22%. I’ve saved money! With a backdoor Roth, I feel like I’m arbitraging those tax rates against myself… pay 32% up front to save 22% later. Doesn’t make sense to me unless I were to plan to retire with more income than I have now, I suppose.

    The backdoor Roth seems like a hassle: separate forms to file, rolling stuff over, waiting a day, pro-rata stuff. Obviously that hassle must be worth it otherwise informed investors such as yourselves wouldn’t be so gung-ho for it, but I feel like there’s something I’m missing here. I’ve tried searching but I’m just not getting it. Can anyone point me in the right direction? Did I miss a blog post or something?

    #237626 Reply
    jfoxcpacfp jfoxcpacfp 
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    You got the wrong answer from the blog post, not sure whose fault it is, not laying any blame.

    The reason you want to do a backdoor Roth as opposed to a TIRA is that the TIRA is nondeductible and all of the income and growth are taxed at your top marginal tax bracket when you you take it out to spend. A nondeductible TIRA is the worst way to save for retirement.

    A backdoor Roth, otoh, grows 100% tax free. So the income and growth is taxed, not at your top marginal tax bracket when you you take it out to spend, but at 0%. All you have to do is make a nondeductible contribution to a TIRA and convert it to a Roth with no tax consequences on the conversion (assuming you do it almost immediately).

    If you were able to deduct your contributions to a TIRA, that would change things. You would have to choose between taking a deduction today or taking no deduction today but getting free growth and income. As a HIP who (presumably) already participates in a retirement plan at work, that is not an option available to you.

     

    Johanna Fox Turner, CPA, CFP, Fox Wealth Mgmt & Fox CPAs ~
    http://www.fox-cpas.com/for-doctors-only ~ [email protected]

    #237737 Reply
    Liked by Lordosis, MaxPower, G
    Avatar Peds 
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    but I feel like there’s something I’m missing here

    Click to expand…

    you missed the qualifications you need to actually contribute to a traditional vs rIRA.

    #237740 Reply
    Avatar G 
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    as jfox said.

    also, POF took a stab at the assumed value of a backdoor.  google the topic on his site.  once you do it a couple times, it is pretty straightforward.  yes, there is a little wealth value there, but is also a kick-arse vehicle to leave to your kids (until they change the law) and it is another place that creditors can’t come after (contrast that with taxable).

    #237743 Reply
    Liked by Tim, jfoxcpacfp
    Avatar ZZZ 
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    “Did I miss a blog post or something?” Apparently you missed several things.

    – So, tell me how big much of a tax deduction you’ll be getting on your traditional IRA contribution while making $350k?

    “backdoor Roth seems like a hassle”

    Totally. It takes me at least 5 minutes a year to make $12k post tax dollars tax free forever every year.

    https://www.physicianonfire.com/value-of-backdoor-roth/

    Give that a gander, hopefully it will clear some things up for you.

     

    #237744 Reply
    Liked by childay
    Avatar CornTeeth 
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    I think you meant a backdoor Roth IRA vs Traditional IRA.  There is no such thing as a Traditional Roth unless you mean contributing to a Roth IRA directly without converting it from a Traditional in which case I don’t believe anyone reading this blog should have the ability to do that since their income is too high.

    In terms of tax diversification you need to thinking about all of your investment accounts instead of just your IRA accounts.  IRA invetments should be a small piece of your overall portfolio since in 2019 you can only contribute a total of $12,000 between you and your spouse.  Many people elect to defer tax by electing to contribute to a 401k plan so they would have some tax diversification by contributing to a Roth IRA instead of a Traditional IRA

    Roth IRAs have other benefits when compared to a Traditional such as no penalty on qualified early withdraw on your contributions, no minimum distribution requirement.  Roth IRA is arguably better for estate planning purposes since your heirs inherit your Roth account tax free.

    I believe the general consensus is to contribute to Roth 401ks and Roth IRAs during low earning years such as residency and then diversify by contributing to a tax deferred 401k as well as a Roth IRA.

    There are plenty of examples where people calculate out projected growth of same amount of money invested in Roth vs Traditional IRA accounts and as I look over them it’s always been six of one and half dozen of the other since no one can perfectly predict your tax bracket during retirement.  It’s nice having some money in a account that doesn’t force you to take distributions from.

    Back door IRAs aren’t much of a hassle.  It’s one extra step vs contributing to a Traditional IRA which takes a few minutes.

    #237746 Reply
    Avatar jhwkr542 
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    I think pof even understates the value of the backdoor Roth. He assumes capital gains taxes can be made to be 0% in his calculation. This seems like a stretch for most people. If you have 30 years of contributions for husband and wife, it’s going to be hard to get that to zero without giving the money to someone else.

    #237765 Reply
    Avatar Hockeydoc 
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    I think you meant a backdoor Roth IRA vs Traditional IRA.

    Click to expand…

    I did. Sorry, typo. Great, I look more clueless

    Back door IRAs aren’t much of a hassle.  It’s one extra step vs contributing to a Traditional IRA which takes a few minutes.

    Click to expand…

    I’m sure it’s probably easy to do once you do it the first time. I was getting at the idea that there are additional steps as compared to just a traditional IRA. Even though I’m sure its not much once you figure it out, nobody would fill out an extra form unless there was a good reason.

    Looking through all the replies, I think JFox found the flaw in my logic. I was assuming that the traditional IRA was tax deductible. I didn’t realize there was an income limit to deducting contributions. I just figured it was like a 401k and you could just contribute pre-tax dollars up to the maximum contribution limit.

    So, to confirm: traditional IRAs are non-deductible on a physician’s income and get taxed on distribution. Roth IRAs are non-deductible for everyone, but by rolling into a Roth, you can avoid the taxes on distribution. Plus, you get other benefits like estate planning, no RMDs, tax diversification, etc. Does that sound right? It seems to make more sense now.

    #237785 Reply
    Liked by childay
    Avatar jhwkr542 
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    So, to confirm: traditional IRAs are non-deductible on a physician’s income and get taxed on distribution. Roth IRAs are non-deductible for everyone, but by rolling into a Roth, you can avoid the taxes on distribution. Plus, you get other benefits like estate planning, no RMDs, tax diversification, etc. Does that sound right? It seems to make more sense now.

    Click to expand…

    Correct, you’ve got the basic understanding of the benefits. Minor point to clarify terminology: moving money from a traditional IRA to a Roth IRA is a conversion step, not a rollover, which is a like conversion of money without creating a taxable event (i.e. traditional 401k contributions to IRA, old 401k to new 401k, etc).

    When you do the backdoor Roth maneuver (it’s not really a unique account), often you have to wait a few days for the funds to settle, so you can convert. Many times, this may create $1 of income. You’ll convert all of it and will pay taxes on this $1. If this were a rollover, this would not create the $1 for taxes.

    #237818 Reply
    Avatar ZZZ 
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    “Traditional IRAs are non-deductible on a physician’s income ”

    No, they’re nondeductible above a specific income limit, physician or not. Hopefully a doc makes above the limit, but a resident or part timer may not

    “Roth IRAs are non-deductible for everyone”

    Yeah, they’re post tax dollars

    #237819 Reply
    jfoxcpacfp jfoxcpacfp 
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    Traditional IRAs are non-deductible on a physician’s income ” No, they’re nondeductible above a specific income limit, physician or not

    Click to expand…

    Close, but still not quite right. TIRAs are actually deductible at any income level (if you have enough income, of course) and don’t participate in another retirement plan. If your spouse does, there is, again, an income limit imposed.

    It feels really strange to take a TIRA deduction for an attending but we actually have one who is a high-income W2 employee with no retirement plan at his employer, pretty rare. I remember reviewing his return and automatically starting to type up a note on the review point sheet to correct the preparer, then realizing that I was wrong, not the preparer.

    Johanna Fox Turner, CPA, CFP, Fox Wealth Mgmt & Fox CPAs ~
    http://www.fox-cpas.com/for-doctors-only ~ [email protected]

    #237822 Reply
    Avatar KT 
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    So I made the mistake of combining nondeductible IRAs with deductible IRA when I finished my fellowship.  No one told me about the form 8606 and conversion to ROTH. I have been told to file all those 8606s now and when I retire, the nondectuctible IRAs which I have already paid taxes on will have to be converted to ROTHs.  Is that correct?

    #237870 Reply
    jfoxcpacfp jfoxcpacfp 
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    So I made the mistake of combining nondeductible IRAs with deductible IRA when I finished my fellowship.  No one told me about the form 8606 and conversion to ROTH. I have been told to file all those 8606s now and when I retire, the nondectuctible IRAs which I have already paid taxes on will have to be converted to ROTHs.  Is that correct?

    Click to expand…

    Yes, you need to file the 8606’s now – that was the only mistake you made, not combining the TIRAs. The 8606 simply allocates the growth in the return and the “basis” in the TIRA so that you’ll be able to determine the tax treatment when you take out the funds.

    Most likely (without knowing how much $$ we’re talking about here), you need to go ahead and convert to a Roth now. Definitely don’t want to wait until you retire!

    Johanna Fox Turner, CPA, CFP, Fox Wealth Mgmt & Fox CPAs ~
    http://www.fox-cpas.com/for-doctors-only ~ [email protected]

    #237912 Reply
    Liked by Tim
    Avatar saildawg 
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    In essence, you make too much money to do a traditional IRA, so what you are comparing is the benefit of taxable account investing vs roth account investing

    The finance buff has a calculator, check it out and decide for yourself

    https://docs.zoho.com/sheet/published.do?rid=b6wwv1d611964d92c49f491b3b7f9cc578207

    #238307 Reply
    Liked by childay

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