The White Coat Investor Network[Editor's Note: Today's post is from Physician on FIRE. I don't like it. I didn't like it when it was published and I like it even less now as I republish it. It contains no completely false statements, but it demands a rebuttal because of what it does not include as well as the misleading nature of its most important sentence. I am pleased to provide that rebuttal at the end of this post. Read the whole thing, then let us know who got this one right in the poll at the end.]

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.

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.

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)). [And numerous other exceptions noted here-ed] 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 nondeductible 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)?

backdoor roth — worth less than 50 cents a 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 2020 is $7,100 for a family or $3,550 for an individual.

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.

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:

student loan refinancingThe Rebuttal

All right, my turn. You suffered through that long-winded attempt to tell you not to bother with a Backdoor Roth IRA. Despite its length, it left out some pretty important information and minimized the most important point in it by calling it a “mere $20-50 a year.” First, the important information in five strong points.

# 1 A Roth IRA is Asset-Protected in Most States

That's right. If you get sued for millions above policy limits (admittedly unlikely), and have to declare bankruptcy, in most states you get to keep your retirement accounts, including a Roth IRA. If that is the case in your state, that's an awfully good reason to bother with the “hassle” (a single IRA rollover for some, simply opening an account and making a couple of transactions a year for most) of doing a Backdoor Roth IRA each year.

# 2 A Roth IRA Facilitates Estate Planning

You get to designate beneficiaries for a retirement account, and when you die, that Roth IRA money goes immediately to your heir just as soon as they can get their hands on a death certificate. No expensive and time-consuming probate. Nobody else gets to know what you were worth. Plus, if that heir is smart, they don't have to take a single dime out of that Roth IRA for 10 years, allowing another decade for it to compound tax-free, essentially doubling the value of what you left behind.

# 3 Most People Don't Invest Tax-efficiently

Guess what? Most people (and their heirs) don't invest tax efficiently. They buy and sell too much and they own stuff in taxable besides a total stock market or total international stock market fund. For those people, a Roth IRA is much more valuable than a taxable account, not just 0.5% per year more valuable.

# 4 Most People Don't Tax Loss Harvest Well, Donate to Charity, and Take Advantage of the Step-Up in Basis

While one can invest very tax-efficiently in a taxable account by only using total market funds, tax loss harvesting, donating appreciated shares to charity, and leaving low basis shares for an inheritance, let's not kid ourselves that most people do that. Most people sell their assets for spending money in retirement. And when they do, they pay capital gains taxes on their gains. That tax is not due on Roth IRA withdrawals, further boosting the benefit of a Roth IRA.

# 5 Capital Gains Rates May Go Up

While it is impossible to predict future tax rates, it is entirely possible that capital gains rates may go up. Imagine if the long-term capital gains rate brackets are simply eliminated. Not so tax-efficient now. That Roth IRA is looking better and better all the time.

The Most Important Point

[This section adjusted after publication due to a calculation error, which actually strengthened my point.]

Those are five strong reasons to use a Backdoor Roth IRA. But they pale in comparison to the dear Dr. POF's false assertion that a Backdoor Roth IRA is only worth $20 a year. As you will soon see, doing a Backdoor Roth IRA each year instead of investing in taxable is worth far, far more than $20 a year. Let's do some math. First, let's just give him his assumption that  Roth IRA grows at only 0.5% more than a taxable account. That's certainly plenty of additional return to make my point. Let's say you start doing Backdoor Roth IRAs at age 30 and continue them to age 65. You then let the money ride another 30 years and then give it to your heir, who lets it ride another 10 years before withdrawing and spending it all. You contribute $6K a year for 35 years. We'll compare it to a taxable account that gets a step-up in basis at death, but only grows at 7.5% instead of 8%. Your heir will pay 15% on his gains after letting it ride for 10 years.

Roth IRA: =FV(8%,35,-6000,0,1) = $1,116,613 at retirement, =FV(8%,30,0,-1116613) = $11,236,094 at death, and =FV(8%,10,0,-11236094) = $24,257,884 after the heir has had it ten years

Taxable account: =FV(7.5%,35,-6000,0,1) = $994,923 at retirement, =FV(7.5%,30,0,-994923) = $8,710,506 at death, and =((FV(7.5%,10,0,-8710506))-8710506)*0.85+8710506 = $18,805,329 after the heir has had it ten years

The difference, $24,257,884 – $18,805,329, is $5,452,555

We're talking about a 70 year period. So let's divide $5,452,555 by 70. We get $77,894 per year.

Does that sound like $20 per year? It sounds to me like POF missed this one by a factor of 3895. Does $77,894 per year sound like it might be worth possibly having to do a single rollover, one extra transaction a year, and one simple IRS form a year? I certainly think it does, but you be the judge. Maybe your time is worth more than mine.

[Update after publication: There is a criticism in the comments that I did not inflation adjust the numbers. That is true. Let's just go to the end of the calculationsand adjust the final difference ($77,894 per year) for an inflation rate of 3% over 70 years. 

=FV(-3%,70,0,-77894) = $9,237 per year Again, a far cry from $20-50.]

Who is right about the Backdoor Roth IRA?

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What do you think? 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? Comment below!