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The backdoor roth point / Counterpoint: A must-do or meh?

By Jimmy Turner, MD
The Physician Philosopher

Editor: As you may know, I am definitely in the “Must Do” court of this argument, and have even put together a step-by-step guide to set up a Backdoor Roth. But it’s always good to consider different viewpoints because as we say “Personal finance is personal.” Enjoy this dual guest post in today’s Saturday Selection, originally posted on Physician on Fire.

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Is the Backdoor Roth one of those moves that every high-income earner should be making? Or is it a marginally beneficial play that you can take or leave as an investor?

I made an argument that suggested the latter, showing that the marginal benefits of doing the backdoor Roth paled in comparison to other smart money plays like taking advantage of travel rewards.

However, when I later ran the numbers over many decades, I was able to show that the additive and compounded effects of making the effort time and time again could lead to a substantial benefit that was anything but marginal.

I reached the conclusion that, like many things optimizers tend to do, the backdoor Roth is something that ought to be done if there are no major obstacles, but that it’s certainly not a requirement to be financially successful.

What is the backdoor Roth? I’ve written about it in detail in this step-by-step guide. Essentially, it’s a two-step process to make annual Roth IRA contributions for people who earn “too much” money to be able to make direct contributions to a Roth IRA.

In this post, the FI Physician David Graham will go first, singing the praises of the backdoor Roth while running some numbers under a realistic scenario he set up.

Justin Harvey, the husband of an anesthesia resident and financial advisor with Quantifi Planning, steps on the brakes and shows us how the backdoor Roth isn’t all it’s cracked up to be.

The Backdoor Roth Point / Counterpoint: A Must-Do or Meh?

The Scenario

A 30-year old couple has two children and earn $400,000 a year. They will FIRE at 50 with a goal 3.5% withdrawal rate from their assets. They have a 36% saving rate on gross salary which is a 50% saving rate after tax.

They max out a single 401(k) with 5% match and can either invest $6,000 x 2 = $12,000 a year in a backdoor Roth or leave that amount in a brokerage account. Let’s see what their net worth is doing when they FIRE and again at age 60, a full 30 years (though they only fund the backdoor Roths the first 20).

Inflation is 2% a year. Salary will grow by the same amount. Healthcare inflation is 5% and will start at $10,000 a year when they FIRE. Stocks return 7% (2% dividends) and bonds 3.5%. Pre-retirement expenses are currently $13,333 a month and $10,000 (prior to inflation) when they FIRE.

Point: In Support of Backdoor Roth IRAs

Why are backdoor Roth contributions good for the high-income earner? One word—math.

Sure, they won’t rock your world, but any chance at tax diversification is a good thing. That is, tax-deferred growth now and tax-freedom later.

What are the advantages of having money grow tax-deferred? Many. I’ll discuss those later.

But the main advantage of Roth accounts and tax diversification is the ability to control your income in retirement. Tax-freedom!

Advantages of INCOME CONTROL in Retirement

If you can control how much income you have in retirement, you can control the taxes you pay. That is, you choose when and how much taxes you owe. Of course, this is limited by sources of income.

For instance, you will pay taxes on annuity payments (including social security) and other sources of ordinary income. You will pay (at least) long term capital gain taxes on sales from your brokerage account. But from your Roth—no taxes!

What does this control give you?

  • No tax drag
  • No Required Minimum Distributions from Roth IRAs
  • Ability to control your provisional income for Social Security taxation (though I will grant you that a high-income earner should just assume that they will pay maximum taxes on their social security).
  • Get ACA healthcare premium tax credits prior to age 65 by keeping income low with Roth withdrawals
  • Fight off IRMAA. Surcharges on your Medicare B and D plans (that is, taxation of the wealthy) are a cliff penalty resulting from your adjusted gross income from 2 years prior
  • Control your capital gains tax rate. Why not do some capital gain harvesting at zero or 15% rather than at 18.8 or 23.8%?
  • Tax diversification is always good to have. Who knows what future tax rates will be or what legislative risk the future holds?
  • Roth money is the best money to leave your heirs. If the stretch (inherited) IRA is killed by congress via the SECURE Act, this becomes even more important
  • Finally, even a little tax diversification may help you fend off salesmen pitching variable annuities or cash value life insurance for “tax avoidance”

Let’s look more closely at the case at hand and see what we can learn about other advantages of backdoor Roth IRAs.

Results for the Case

Roth 1
Figure 1 – Investment portfolio for Brokerage (green) and backdoor Roth (blue)

As you can see above, they start young with very few assets, but given the amazing savings rate quite quickly build up sizeable assets.

For the first 20 years, they either invest fully in a brokerage account (green), or do $12,000 yearly in a backdoor Roth IRA (blue). You can see the blue sliver just on the top after about 20 years.

It’s a sliver, however, it is real money!

The Roth plan end up with more than $212,000 more in assets than without doing the Roth. If we divide that by 30 years, that is and extra $7000 A YEAR return. Sure, they have $6M in assets, but if I saw $7000 laying on the side walk, I’d bend over and pick it up!

Why do they have this extra money? Tax-deferral avoids tax drag!

Tax Avoidance with Roth IRAs

Roth 2
Figure 2 – Yearly taxes paid for both plans

Here you can see their tax liability. Starting out over $100k in taxes a year, there is a bump up in 2026 when the Tax Cut and Jobs Act is due to expire. You see they peek out almost at $250k in taxes before early retirement (yikes). Taxes at retirement are purely capital gains as they are selling from their brokerage account to pay bills.

As a quick aside, FIRE leads to an amazing Tax Planning Window with the ability to do all sorts of amazing tax tricks. Here, they are just doing some capital gain harvesting.

Back to the figure. You can see the backdoor Roth plan in the dark green, and if you squint, you can see the light green where they are paying additional taxes every year without the backdoor Roths.

In the end, over 30 years they pay more than $112k in taxes (or $3,746 a year) by not funding backdoor Roths. Here you go, uncle! Take my money.

When you are paying $250k a year in taxes, an extra $3k or 4k doesn’t seem like much, but again, I’ll pay less in taxes whenever I get the chance.

So, why do they pay less in taxes every year? Tax Drag.

Understanding Tax Drag

When you contribute your after tax money to a backdoor Roth, you will never pay taxes on it again. Including when it is growing! You avoid tax drag.

That $6 or 12k you take out of your brokerage account and deposit into your Roth now grows tax-free.

In a brokerage account, even passive index funds pay about 2% dividends a year. On qualified dividends, you pay yearly capital gains rate taxes.

What about bonds and REITS? There you pay ordinary income.

Other tax-inefficient funds (such as active funds, small cap value funds, target date funds, etc) also have tax drag in the brokerage account with a mixture of ordinary and capital gains taxes.Related: Tax Drag: What a Drag it is Getting Taxed

Asset location is beyond the scope of our discussion today, though I will grant you folks usually invest most aggressively (and tax-inefficiently) in their Roth accounts. The above example is with an 80/20 stocks/bonds portfolio, so your tax drag could be more or less depending on your asset location.

Summary Table

Figure 3 – Asset total from each account over 30 years

Above you can see in 2030, 2040, and 2050 what your account totals are for the Backdoor plan and for the Brokerage plan.

Note that after a decade of backdoor Roth contributions, you have $10k extra to show for your work, which is almost a 0.5% increase in your total amount.

After twenty years (and the end of backdoor Roth funding), you have an extra $72k and 1.3% more for you efforts!

As you are living off your brokerage account at that point, the percentage increase in account value doesn’t increase in the next decade (there is less tax drag since you don’t have salary kicking up your ordinary income) but your Roth IRA total continues to grow. After 30 years (and 20 years of backdoor Roth contributions), you have over $1M in your Roth IRA and $212k more money than without backdoor Roth contributions.

Sign me up!

What is Your Hourly Rate for doing Backdoor Roths?

So, in conclusion, backdoor Roths offer a high income earner a chance at some tax diversification and more money in the end.

How much do you save? Not very much in year one.  I bet you save about $60 the first year in tax payments. Not too shabby, after all backdoor Roths are not that complicated and likely will take you less than an hour to figure out how to accomplish.

You may have to teach your CPA what an 8606 is and how to report backdoor Roths to the IRS as I did, but that was honestly pretty fun to teach my tax guy about taxes. But not worth 60 bucks…

However, as we saw above, your 20 or 30 hours of work before retirement pays more than $3,700 an hour in avoided taxes. Does your day job pay that well?

While backdoor Roth contributions won’t rock your world, they save you money, you pay less in taxes, and you are 1% more efficient.

FIRE means you strive to be 1% better in everything you do (if you value it, that is). I value tax diversity, paying less in taxes, and having more money to leave behind as an important part of my FIRE plan. I hope you do, too.

[PoF: The slivers of extra money from doing the backdoor Roth don’t look like much, and the gains are relatively small on a percentage basis. However, when looking simply at dollar amounts, over a long investing timeframe, the monetary reward can be substantial.

Let’s see what Justin Harvey has to say. I do have to give him credit for taking the more difficult side in this point / counterpoint. It’s tough to argue against “free money,” but he does a good job.]

Counterpoint: The Backdoor Roth is Overrated

There are a lot of reasons that the positive impact of the Back Door Roth IRA contribution may be overstated.

I would present the Back Door Roth IRA contribution (henceforth called BDR) as a potential option if it’s easy/convenient for you to do (read: if you have an advisor and a good CPA who can execute it for you at no marginal cost to you in terms of time or money).

But if you have pretax IRAs, if you are doing paperwork yourself, or if your CPA makes a mistake (there are many ways to go wrong, as WCI has pointed out) then you can quickly more than offset the modest benefits here.

Furthermore, there are a handful of qualitative and difficult-to-put-a-dollar-figure-on reasons that I think the BDR benefit is overestimated.  In the context of a high-savings-rate physician’s finances, it’s my opinion that real-world benefits of the BDR are situationally dependent at best, and in many cases effectively nonexistent.

Note: I’m going to ignore the impact of taxable account tax drag for now, since that’s dependent on too many variables and is covered above (and was previously estimated at $30-50/yr on this blog).

Here are five reasons that the BDR is overrated, but which can’t be captured in a straight-line financial projection:

Dollar-Cost-Average Flexibility

A physician with a high savings rate will necessarily have a large sum invested in taxable assets each year.  Buying into assets afresh in a taxable account will create “tax lots” where the basis is equal to current market prices.

In the event that you need to liquidate some assets in this account, it allows for both 1.) selectively selling the highest-basis assets to maintain tax efficiency and 2.) tax loss harvesting to offset any gains.  If I spend ten years investing $10k/mo in a taxable investment account, I can cherry-pick the highest basis assets to sell, choosing the high-water-mark in any time in the last ten years.

Unless the market is literally at all-time highs across any purchased asset class in my moment of need (which we must admit is a pretty desirable worst-case scenario), there will likely be some assets accessible with smaller negative tax impact in the taxable account.  It’s also nice to know that if I need to access these assets before age 59.5, I won’t be subject to tax + penalty on gains, as I would be with a Roth IRA.

Spending Floor In Retirement

Since investors who will have an interest in BDR’s are high earners who will likely have plenty of future assets to meet their needs, they may not ever spend much of their Roth or taxable assets after age 70.5, since they will have RMDs, social security, and other incomes which must also be taxed in most of the retirement years.

A physician with $3mm in qualified assets and two social security incomes could have +$170k/yr of income from RMDs and SS alone (i.e. ~$110k/yr RMD + $40k/yr for earning spouse + $20k/yr for non-earning spouse).

This floor grows meaningfully over time to an RMD of ~190k/yr at age 80, and Social Security benefits which grow with cost of living adjustments.  In order for Roth assets to be relevant, you would need to:

  1. Be older than age 59.5
  2. Spend more than this floor in retirement, and
  3. Have no taxable assets accessible at little tax impact.

There are some for whom this would be true, but many for whom it would not. Note: charitable expenditures don’t count toward total spend, since you can gift your most appreciated in-kind assets from a taxable account without negative tax consequence.

Roth IRAs and Estate Taxes

Per the above, it’s unlikely to matter much after age 70 whether or not you have Roth assets.  Another thing that generally happens after age 70 is that you die, so we should consider Roth vs. Taxable benefits at death.

Both a taxable account and a Roth IRA are equally taxable from a “death tax” standpoint in a person’s estate (i.e. neither can avoid estate/inheritance tax).  To be clear, I’m not talking about the federal estate tax in this instance since (as of now) it only impacts estates >$11.4mm.

However, state death taxes will vary (fourteen states + DC have an estate tax, and six have an inheritance tax, per the Tax Foundation.  Also, don’t die in NJ or MD, they have both!), and they have much lower thresholds and greater taxability.

A Roth IRA will still be subject to estate/inheritance taxes, just like a taxable account, since both accounts are included as part of the taxable estate.  A better estate tax reduction strategy would be to get money out of your estate prior to death by using an irrevocable trust and/or gifting assets directly up to the tax-free gifting threshold ($15,000 per year as of 2019).

Roth IRAs and Avoiding Probate

It’s true that one of the benefits of Roth IRAs is that these assets avoid probate (i.e. the beneficiaries receive the assets upon death rather than waiting for probate courts to divide up the assets).  Keeping money out of probate is a good way to love your loved ones after you die, since it will save time, cost, and headache in settling your estate.

Taxable assets in a regular taxable account would generally be subject to probate.  However, a good estate planning attorney would be able to advise on an estate to minimize probate headaches, including putting most taxable investment assets into a revocable trust.  A less flexible but free option would be using a TOD account.

With the revocable trust strategy, assets are still functionally available for whatever the grantor (the person who creates the trust) needs, but then assets will be outside probate upon the death of the grantor.

Inheriting a Roth IRA vs. Taxable Assets

Receiving a Roth IRA from an estate isn’t markedly better than receiving taxable assets outright, since both are subject to the same taxes per the above.

Additionally, taxable assets are not subject to the RMD rules that a Roth would be (this doesn’t add cost but it does add some administrative burden) and taxable assets receive a “step-up” in basis at death.

This means that any gains during the life of the decedent are erased and are not taxable once assets pass to heirs.  So if you inherit a taxable account from your grandfather who purchased $3k of AAPL in 1980 and he bequeathed it to you in a taxable account at a final value of $300,000, you could immediately sell all these shares and pay zero taxes on the gains, and have no RMD obligations.

Whether or not you receive assets in a taxable account or Roth IRA is irrelevant for tax savings at time of receipt.

In Conclusion

At the end of the day, I’m not anti-BDR, because it certainly might help from a tax diversification standpoint.  If you offered me $1mm in a Roth IRA or $1mm in a taxable account, I’d take it in the Roth eleven times out of ten.

I just find that busy physicians have such limited time and so many other important financial considerations that really do move the needle, that their attention is generally better focused on higher-impact items.

[PoF: A big thank you to David Graham, MD and Justin Harvey, CFP®, ChFC®, RICP® for sharing their thoughts. I think both guest authors made valid points on this surprisingly controversial topic, giving us ample food for thought.]

Are you a backdoor Roth enthusiast? Or do you think of it as an optional maneuver that might give you marginal gains? Have you done the backdoor Roth before?

POF

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