Is It Worth Doing a Backdoor Roth IRA? Pros and Cons

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Is It Worth Doing a Backdoor Roth IRA? Pros and Cons
By Financial Samurai/ financialsamurai.com

"I’m on record disliking a Roth IRA, especially for high income earners. The Roth IRA is a way for the government to tax citizens up front to pay for their bloated and wasteful spending.

I firmly believe that if you are in the 24% marginal federal tax bracket, it is not ideal to pay taxes up front in order to contribute to a Roth IRA. You are much better off maxing out your 401(k) and IRA first.

If you are in the 22% or under marginal federal income tax bracket, then you can contribute to a Roth IRA. Roth IRA money will grow tax-free, and you won’t pay a penny in taxes when you withdraw the money, either. Roth is simply a designation for post-tax money that will never be taxed again.

But what if you make over the Roth IRA income limit? This is where the backdoor Roth, a two-step process, comes in handy....."

Richard

 

[PigsDad]

From the article:

My advice on a Backdoor Roth IRA remains the same as contributing to a regular Roth IRA. If you are in the 22% federal marginal income tax bracket or under, I encourage you to do a Roth IRA and diversify your retirement funds.

But once your federal income tax bracket hits 24%, you’re at roughly a neutral state. If your federal income tax bracket is 32% or higher, doing a Backdoor Roth IRA is a terrible, terrible idea.

The author misses the point of why most people do back-door ROTH contributions. If we were doing this instead of contributing pre-tax money to a 401k or a deductible Traditional IRA, then yes, they are not a good idea if you are in one of the higher tax brackets. But the author never mentions that -- he just makes a blanket statement that they are bad. Total ignorance!

If, like most people who do back-door ROTHs, the contributions is after you max out your pre-tax options, then a back-door ROTH is a fantastic idea, no matter your current tax bracket. That is because that money is going to be taxed anyway, and if you put it into a back-door ROTH then all earnings from those contributions will be tax free.

Interesting article, but some terrible advice.

Kurt

 

[1Kflyerguy]

From the article:

The author misses the point of why most people do back-door ROTH contributions. If we were doing the instead of contributing pre-tax money to a 401k or a deductible Traditional IRA, then yes, they are not a good idea if you are in one of the higher tax brackets. But the author never mentions that -- he just makes a blanket statement that they are bad. Total ignorance!

If, like most people who do back-door ROTHs, the contributions is after you max out your pre-tax options, then a back-door ROTH is a fantastic idea, no matter your current tax bracket. That is because that money is going to be taxed anyway, and if you put it into a back-door ROTH then all earnings from those contributions will be tax free.

Interesting article, but some terrible advice.

Kurt

I agree, i do a backdoor only after i have maxed all my other pre-tax contributions out.

If nothing else its good to have some tax diversification.

 

[GetawaysRus]

I'm another backdoor guy. I max out my 401K and Keogh, then I do maximum backdoor contributions to both my and my wife's IRA plans.

The article misses a few things that I think are important:

1. There is absolutely no way of knowing what income tax brackets will be in the future. Politicians can't help themselves, and they piddle with the tax rules all the time. However, should tax rates go up, that retirement money coming out of your Roth IRA (or Roth 401K) will look better and better. With a Federal deficit of about $22 trillion and rising, it seems to me that at some point tax brackets may rise, especially for higher earners. I have difficulty imagining that tax brackets will go any lower in the future.

2. I don't see any analysis in this article regarding how many years an individual is from retirement. If money in a Roth account has more years to compound, it could reach a very nice tax-free sum. So even for a young worker who may be in a lower tax bracket now than when he's older, letting that money compound in a Roth could be attractive. But compounding in a traditional retirement account is going to be taxable when withdrawn.

The option to have a Roth 401K has only existed for a few years, so the vast majority of my 401K balance is going to be taxable when I withdraw it. That's going to create a large tax burden in retirement. I'm also fortunate that I still have a traditional pension. Looking ahead a few years to my retirement, I will soon have pension income (taxable) + Social Security income (taxable) + withdrawals from traditional 401K plan (taxable) + withdrawals from Keogh plan (taxable). I'm never going to be in a low tax bracket, and there are probably others here who are in a similar boat. Any funds coming out of a traditional IRA would just make my tax situation worse.

There are few financial vehicles available to generate tax free income in retirement. A Roth plan (whether a Roth IRA or a Roth 401K) is one of these. And tax free income is a great thing to have.

 

[PigsDad]

@GetawaysRus, great response. I also agree that no one knows for sure what the tax brackets will be in the future, and I can't help to think that they can only go up, especially for higher earners. Having some tax-free sources of income in retirement will give me more options without having to worry about all the tax implications.

We just got some great news at work last week. My company is now allowing after-tax contributions into our 401k above and beyond the current limits of $19K/year ($25K for those over 50). We can now contribute an additional $19K after-tax dollars, and this is the best part: those after-tax contributions can automatically be converted to ROTH funds! So now I can do my normal back-door ROTH IRA contribution, PLUS an additional $19K ROTH funds into my 401k each year. I believe I have heard this called the "mega back-door ROTH" on some financial forums I occasionally follow. Not sure what changed in the tax codes, but I have heard of companies starting to offer this option in the last few years. It is a good opportunity to boost my total ROTH funds and still be able to do the pre-tax contributions to my 401k to lower my taxable income.

Kurt

 

[zinger1457]

I do think some people confuse a 'backdoor ROTH IRA' with a regular IRA to ROTH IRA conversion but there are differences. The real benefit of a 'backdoor ROTH IRA' is if you only have after-tax money in your IRA, that is not typical for most people. If your IRA has both after-tax and pre-tax money you're not allowed to select just the after-tax money to convert over. If 90% of your IRA is pre-tax then 90% of any conversion will come from the pre-tax amount and you will pay taxes on it. It's also based on all your IRA accounts combined, not just the one you're converting. That in effect is more like a regular ROTH IRA conversion which anyone can do. That's where a 401K is a huge advantage because the rules are different than an IRA in that if your 401K tracks your pre and after tax balances separately you are allowed to select just the after-tax amount to convert over.

 

[CalGalTraveler]

I do think some people confuse a 'backdoor ROTH IRA' with a regular IRA to ROTH IRA conversion but there are differences. The real benefit of a 'backdoor ROTH IRA' is if you only have after-tax money in your IRA, that is not typical for most people. If your IRA has both after-tax and pre-tax money you're not allowed to select just the after-tax money to convert over. If 90% of your IRA is pre-tax then 90% of any conversion will come from the pre-tax amount and you will pay taxes on it. It's also based on all your IRA accounts combined, not just the one you're converting. That in effect is more like a regular ROTH IRA conversion which anyone can do. That's where a 401K is a huge advantage because the rules are different than an IRA in that if your 401K tracks your pre and after tax balances separately you are allowed to select just the after-tax amount to convert over.

Although we did not have the Roth 401k until recently, we made nondeductible IRA contributions for years. We just did a reverse rollover of the pre-tax earnings back into our company 401k and will now convert the nondeductible contributions into the Roth with zero gains. Its like we made a backdoor all these years except our earnings from the years will be taxed. ☹ However better than keeping it in IRA and being taxed every time we take a withdrawal ie keeps the funds separated and will now continue to grow tax free until we retire.