Not a fan of Backdoor Roth IRA

[sakowitzm]

I'm a keep-it-simple-person; 58 and just recently FIRE'd.

I have a basic understanding of the financial benefit of doing the backdoor Roth... but it seems like a fairly small benefit gleaned many years down the road. In my case, probably just kicking in in about 12 years, and then continuing from there.

Is the Roth conversion akin to paying off your mortgage early? ie, there are pros and cons, but mostly it's about sleeping well at night? Or personal preference? Or am I just dense, and should wake up and smell the coffee? Appreciate your feedback.

 

[OverThinkMuch]

The backdoor Roth helps people who earn incomes above the normal limits. You mentioned being retired ("recently FIRE'd"), which would imply you don't have a huge earned income. And if it's closer to $0 earned income, you can't contribute to an IRA (let alone setting up a backdoor Roth).

You might convert existing Traditional (pre-tax) IRAs to Roth over time, and take advantage of the low tax bracket. But that's separate from backdoor Roth - that's just a Roth conversion.

 

[Sunset]

If you don't have a ROTH, and you have LOTS of money in regular IRA/401K's then conversions from IRA to ROTH while staying in the 15% tax bracket will cut down on your taxes you pay when you hit 70.5 as you will have less RMD's taken out, which will add to your SS income pushing you into a higher tax rate.

If you have only a small amount in IRA's say about $300,000 or less then it's probably not worth it unless you get a nice fat pension. (I picked 300K as a very approx number).

 

[gauss]

For us it turned after-tax savings into tax-free growth. Our 401ks allowed after tax contributions of up to 50k/year or so each. Since our plans allowed in-service withdrawals we were able to take a distribution of these assets, pay any tax on that years growth, and then roll over to a Roth IRA which hopefully will be allowed to continue to grow tax-free (as under current law). Please beware that if you have existing assets in the 401k that they will be distributed as taxable/non-taxable amounts in a pro-rata fashion -- you can't request a distribution of just the after-tax funds for contributions after 1986. Google "isolating the basis" over at fairmark.com for further details on how to address this problem without incurring a huge tax bill.

There is a very tangible tax-benefit for us in doing this. I would think a similar benefit would go to those who cannot contribute directly to a Roth IRA due to high income and also cannot contribute to a deductible IRA due to availability of employer pension plans and income.

-gauss

 

[GrayHare]

Backdoor Roth is like the employer match on a 401k: free money that costs nothing. The backdoor implies quick conversion of a non-deductible tIRA contrib to Roth and that you have no other tIRA balance. If you do have other tIRA dollars, this step is not a backdoor but merely a standard conversion to Roth that can incur tax.

 

[sakowitzm]

I stand corrected. I should not have used the term backdoor. Simply a tIRA to Roth conversion. And yes, our income is and will remain rather low for many years to come... will be drawing from/selling assets from a taxable account with little or no capital gains.

 

[gauss]

I stand corrected. I should not have used the term backdoor. Simply a tIRA to Roth conversion. And yes, our income is and will remain rather low for many years to come... will be drawing from/selling assets from a taxable account with little or no capital gains.

Ahh.. in that case (a tIRA to Roth conversion) it can be a bit more of a wash -- especially if will be in the same tax bracket down the road.

One thing to keep in mind, and not many people talk about this, is that you are married now, there may be a benefit to doing the conversion sooner rather than later.

Tax filing married filing jointly has very different brackets and standard deductions compared to filing single.

God forbid that something should happen to one of you that would prevent filing as married in the future, you may want to kick yourself for not converting sooner while the MFJ rates applied to you. Never pleasant to think about, but having the single filing rates apply to 401k/IRA distributions/conversions after the loss of spouse would just add more misery to the surviving spouse IMHO.

-gauss

 

[travelover]

...........One thing to keep in mind, and not many people talk about this, is that you are married now, there may be a benefit to doing the conversion sooner rather than later.

Tax filing married filing jointly has very different brackets and standard deductions compared to filing single..........-gauss

Good point - one I had not considered.

 

[B0bL0blaw]

Ahh.. in that case (a tIRA to Roth conversion) it can be a bit more of a wash -- especially if will be in the same tax bracket down the road.

One thing to keep in mind, and not many people talk about this, is that you are married now, there may be a benefit to doing the conversion sooner rather than later.

Tax filing married filing jointly has very different brackets and standard deductions compared to filing single.

God forbid that something should happen to one of you that would prevent filing as married in the future, you may want to kick yourself for not converting sooner while the MFJ rates applied to you. Never pleasant to think about, but having the single filing rates apply to 401k/IRA distributions/conversions after the loss of spouse would just add more misery to the surviving spouse IMHO.

-gauss

I generally agree with gauss. However, one unmentioned benefit (which may or may not be relevant to your situation) is that while RMDs are required for tIRAs, they are not required for Roth IRAs. This could be a significant benefit for some people.

 

[Perryinva]

What I find interesting is how some people consider the above mentioned benefits as "minor"! If something is a wash, tax wise, (typical tIRA to Roth conversion) BUT also has all those benefits (plus not mentioned, the advantages to heirs vs an inherited IRA and the ability to pull a large sum if needed with no tax consequences) then it is not "almost the same", it's a no brainer. I don't get it.

 

[Sunset]

I stand corrected. I should not have used the term backdoor. Simply a tIRA to Roth conversion. And yes, our income is and will remain rather low for many years to come... will be drawing from/selling assets from a taxable account with little or no capital gains.

In low tax rates your LTCG (Long Term Capital Gain) is taxed at 0% as long as your overall income range is within the 15% limit (about 75K + your deductions).

So you certainly can harvest LTCGs, meaning you can sell stock that went up in value, and repurchase that same stock immediately.
Then you claim in income tax the LTCG which is taxed at 0%.
What does this do, well it protects you from tax increases, because maybe the gov't makes these gains taxable again, but your basis is now much higher so you would pay less compared to the fellow who didn't do it.

The other thing it buys you, is suppose you decided to go on a world cruise and needed $100K extra, you could now sell some of those stocks you previously harvested and the actual tax due would be very tiny compared to if you didn't harvest them.

The only trick in doing this is:
It only makes sense to do if you are making a "profit" on the sale of the stocks. You must make a profit LTCG on the stock then wash sale rules do not apply.
You should not exceed the top of the 15% tax rate category, or you will pay tax on the LTCG for the amount over the 15% income range.

 

[Sunset]

What I find interesting is how some people consider the above mentioned benefits as "minor"! If something is a wash, tax wise, (typical tIRA to Roth conversion) BUT also has all those benefits (plus not mentioned, the advantages to heirs vs an inherited IRA and the ability to pull a large sum if needed with no tax consequences) then it is not "almost the same", it's a no brainer. I don't get it.

Perhaps some of those benefits are tempered by the the paying of the tax immediately instead of in 10 years.

Also if one already has a ROTH of some size, say 100K, then probably this could cover all emergency needs of pulling out extra in 1 year for most folks.

 

[kaneohe]

................................... BUT also has all those benefits (plus not mentioned, the advantages to heirs vs an inherited IRA .............................

What advantage?

 

[Perryinva]

Heirs have to pay taxes on inherited IRAs as immediate RMDs, regardless of age. They then get added to their own RMDs at age 70. Roths are always tax free, even inherited, though the same age requirements for earnings exist.

I qualified my statement "if the conversion is a wash tax wise". Naturally, if your taxes are indeed lower in retirement then contributions to a Roth make little sense. And to really benefit from a conversion, the taxes need to be paid out of non converted funds, which is essentially adding more to the Roth without penalty.

 

[sakowitzm]

Perhaps some of those benefits are tempered by the the paying of the tax immediately instead of in 10 years.

And to be more accurate, paid not "in 10 years", but just starting in 10 years. Possibly spread out over 20+ years.

 

[Animorph]

If your income is very low now you might have a chance to take money out of your tIRA for 0% or 10% tax rate now. That's better than paying 15% or 25% when RMD's start and you're receiving SS. If you don't need the tIRA withdrawal, then do it as a Roth conversion.

You may have no capital gains now, but you better have some significant gains after 12 years, right? Might be nice to some of those in a Roth instead of a taxable account.

 

[Perryinva]

Exactly. IF there is no taxable benefit to a Roth before age 70, which is easily possible, then it is prudent for one to consider taxes post 70 as well. It really depends on your tax brackets and income sources. If all your income is after tax generated and you are under the top of the 15% bracket for life, then it really makes little to no sense to use a Roth.

Very early REers also tend to be great at low income survival and tax minimalism but may not understand or estimate correctly the tax and cost scenarios in old age. To a 40 or 45 year old, a 15 year payback starting at 70 seems far fetched. To a 65 year old, it is an essential game plan, because IF you DO live to 85, it is MUCH less likely that you will be generating your income...it must generate itself. A 65 male today has a life expectancy of 85. And a married couple at 65 have an almost 50% chance one will see 90.

So where a Roth can be very valuable is for intermediate and higher income couples where they are solidly in the 25/28% tax brackets for life, due to high pensions and SS, that also have significant savings. A $750k Roth is more valuable than a $1MM tIRA after 70 1/2, even though tax wise they are equal, even with the taxes paid up front. As mentioned, the desire to spend a large sum, or for the very possible need to spend a large sum in old age, is a game changer. It would be quite foolish to actually PLAN on ones tax bracket, if you have say a $150k and up income you want to maintain for life, and you have considerable assets and fixed incomes, to drop in the future. We will be lucky if they stay the same, and if one dies before the other, a guarantee of a rate increase in old age when the survivor may afford it the least.