Backdoor ROTH IRA strategy may not last

[pjigar]

The two main problems most folks miss when they compare pre-tax 401k to Roths is

1) You have to add in the value from your tax savings in pre-tax 401k in a taxable account to the value of your 401k. Me putting in $19,500 into a pre-tax 401k allows me to save $8,190 in taxes, which I can and will use to invest elsewhere. So I have to compare the value of both the 401k ($19.5k) + investments in a taxable account ($8.2k) in 25-45 years after taxes to the Roth in the same time period. You can't ignore the value of the tax savings up front and only compare on the back end.

2) Roths can and likely will be changed in the future - look at the current proposals. It's very likely Roth accounts over just a couple million will have taxes at some point IMO. Just like SS was not taxed for a long time but now 85% of it is taxed for anyone with other assets. I'd much rather have the guaranteed tax savings today than the hope that it'll be tax free in 25-45 years.

The only people I think roth's really make sense for are very young folks not making any money that have family that will contribute to Roth OR folks who are going to inherit a ton of money OR will make a fortune with company they started or startup that made it huge.

#1. Yes, I understand this but this exercise is to equalize "tax rates" across working year vs pre-SS years vs RMD years.
#2. Yes, and that why the goal is to equalize "balances" across all 3 buckets: Pretax, Roth and post-tax.

 

[EastWest Gal]

The two main problems most folks miss when they compare pre-tax 401k to Roths is

1) You have to add in the value from your tax savings in pre-tax 401k in a taxable account to the value of your 401k. Me putting in $19,500 into a pre-tax 401k allows me to save $8,190 in taxes, which I can and will use to invest elsewhere. So I have to compare the value of both the 401k ($19.5k) + investments in a taxable account ($8.2k) in 25-45 years after taxes to the Roth in the same time period. You can't ignore the value of the tax savings up front and only compare on the back end.

2) Roths can and likely will be changed in the future - look at the current proposals. It's very likely Roth accounts over just a couple million will have taxes at some point IMO. Just like SS was not taxed for a long time but now 85% of it is taxed for anyone with other assets. I'd much rather have the guaranteed tax savings today than the hope that it'll be tax free in 25-45 years.

The only people I think roth's really make sense for are very young folks not making any money that have family that will contribute to Roth OR folks who are going to inherit a ton of money OR will make a fortune with company they started or startup that made it huge.

You can’t make a Roth contribution without income. We gifted DS his Roth contribution for 4 years so he could keep his earned income for current needs, and build his cash on hand to allow a home purchase in the future. He now has a Roth 401K and his income is low enough that it makes sense.

I never started a Roth until we started doing conversions last year. Any excess $$ got plowed into our regular after tax brokerage account. Simpler than co-mingling pre-tax and after tax dollars. We have a twice as much in the regular brokerage as we do in the rollover IRA.

 

[Magus]

#1. Yes, I understand this but this exercise is to equalize "tax rates" across working year vs pre-SS years vs RMD years.
#2. Yes, and that why the goal is to equalize "balances" across all 3 buckets: Pretax, Roth and post-tax.

The tax rate is irrelevent - the goal is to maximize your value net of taxes. Equilizing all 3 buckets is helpful in general but irrelevent to my argument. Most Roth fanatics do not count the value from the tax savings and grow it over the same period to add to the value of the 401k/IRA. In the excel link above, you'd need to value the tax savings over the same time period invested in a post-tax fund and add that to the 401k and compare the two combined after tax to the Roth. 98%+ of the time you're better off with the tax deduction.

 

[Magus]

You can’t make a Roth contribution without income. We gifted DS his Roth contribution for 4 years so he could keep his earned income for current needs, and build his cash on hand to allow a home purchase in the future. He now has a Roth 401K and his income is low enough that it makes sense.

I never started a Roth until we started doing conversions last year. Any excess $$ got plowed into our regular after tax brokerage account. Simpler than co-mingling pre-tax and after tax dollars. We have a twice as much in the regular brokerage as we do in the rollover IRA.

Yeah, it's not hard to make $6000 a year in income - that's roughly 430 hours a year of working at $14/hr. I wish more parents would do the Roth's for their young adult kids when they have small income - 5 years of that you let that grow for 40-50 years is worth more than the after tax value of college (which is 5x the cost) (roughly $1MM in incremental earnings pre-tax from college over a lifetime)

 

[pjigar]

The tax rate is irrelevent - the goal is to maximize your value net of taxes. Equilizing all 3 buckets is helpful in general but irrelevent to my argument. Most Roth fanatics do not count the value from the tax savings and grow it over the same period to add to the value of the 401k/IRA. In the excel link above, you'd need to value the tax savings over the same time period invested in a post-tax fund and add that to the 401k and compare the two combined after tax to the Roth. 98%+ of the time you're better off with the tax deduction.

You are right again for 90% of people. I am highly compensated individual so in my case, if I contribute in pre-tax 401k then my RMD will push me into much higher tax bracket than today. And secondary reason is to weather future changes to the tax laws by keeping assets distributed across pretax, Roth and post-tax buckets. I have met people with modest income but good savings rate (like a lot of folks here) in their 70s and they have been hit with much higher tax rate than they ever paid in their lifetime, simply because of RMDs. There is nothing wrong with running the numbers for anyone and see what they might be up against in the future. It is better to adjust your sail when you are mid-way to the journey rather than near the end of it.

 

[ncbill]

Yeah, it's not hard to make $6000 a year in income - that's roughly 430 hours a year of working at $14/hr. I wish more parents would do the Roth's for their young adult kids when they have small income - 5 years of that you let that grow for 40-50 years is worth more than the after tax value of college (which is 5x the cost) (roughly $1MM in incremental earnings pre-tax from college over a lifetime)

Yep, that's what I did for our oldest who obtained their undergraduate via a military academy...at the time their pay was ~$1,000/month (35% of base O-1 salary)...though they only got to keep a fraction.

 

[Ed_The_Gypsy]

We set up and funded Roths for both of our kids when they were starting out. Neither one seems to have continued to fund on their own but both have IRAs through work. DD also has a good pension program but DS does not and doesn't earn much. I hope to review the subject with him from time to time. It took me a long time to wake up but I had the advantage of a better income, making up for my early stupidity.

 

[BradC]

I'm in a catch-22 with this:

I turn 59-1/2 in 2022, so any taxable distributions I have in 2021 will incur the 10% penalty.

I have after-tax contributions that I would like to move to a Roth IRA. I am retired, and my company 401(k) does NOT allow conversions within the plan, so to do the after-tax to Roth move, I need to distribute to an IRA. I know there is no tax or penalty involved in this part.

However, I also have company shares that will benefit greatly from NUA. If I want to do the NUA in the same distribution, I will need to pay the 10% early-withdrawal penalty for the cost-basis of the company shares.

My math says that the benefit of the after-tax conversion is greater than the NUA penalty, so I think I'll make the move this year.

But I sure wish this could have been delayed until the end of 2022!!

 

[pastoral]

It's almost November, when will the Congress discuss this? Is it likely to pass?

And why they only go after the post-tax conversions and not pre-tax conversions? (I hope the latter is not on the agenda)

 

[SecondCor521]

It's almost November, when will the Congress discuss this? Is it likely to pass?

And why they only go after the post-tax conversions and not pre-tax conversions? (I hope the latter is not on the agenda)

Discussions are ongoing.

My crystal ball is broken.

The change you reference is to raise tax revenue to help fund the proposed additional spending.

 

[pastoral]

I see, thanks. Thank God I don't have post-tax plans and no tIRA. I just liked the simplicity of Roth

 

[USGrant1962]

It looks like the death of the back door Roth is off the table, for now.

https://finance.yahoo.com/news/lucrative-retirement-tactic-just-dodged-190904009.html

 

[optimist2]

As of November 3, they put it back again into the proposed law:


The legislative provisions also seek to close what has been termed the “back-door” Roth by prohibiting all employee after-tax contributions in qualified plans and after-tax IRA contributions from being converted to Roth—regardless of income level, effective for distributions, transfers, and contributions made after Dec. 31, 2021.

 

[TheWizard]

As of November 3, they put it back again into the proposed law:


The legislative provisions also seek to close what has been termed the “back-door” Roth by prohibiting all employee after-tax contributions in qualified plans and after-tax IRA contributions from being converted to Roth—regardless of income level, effective for distributions, transfers, and contributions made after Dec. 31, 2021.

Welcome, optimist2!

 

[Exchme]

So the key language from page 1917 is:
'A qualified rollover contribution shall not include any rollover contribution from any eligible retirement plan described in subparagraph (B) (other than from a designated Roth account (within the meaning of section 402A)) if any portion of the distribution from which such contribution is made would (without regard to such contribution) be treated as not includible in gross income.’

Years ago, I made few thousand $ after tax contribution to my IRA and have since rolled my much larger 401k into it and retired. So if this ridiculous thing becomes law I will be hurt badly. Working folks may be able to roll everything but the offending contributions back to their company's 401k, isolating the after tax money in the IRA and then do Roth conversions from the 401k, but I don't see how I could get access to the 401k of a company I don't work for anymore.

My amounts of after tax contributions are so small that I wonder if I can abandon any claim to them being after tax contributions and just pay tax on them again, but that seems very dangerous as the language doesn't say it "is" non-taxable, it says "would be", so they might reject the whole conversion and hit me with penalties.

I knew they were going to raise taxes on billionaires, there just seems to be a lot fewer zeros in a billion than there used to be.

 

[gauss]

Years ago, I made few thousand $ after tax contribution to my IRA and have since rolled my much larger 401k into it and retired. So if this ridiculous thing becomes law I will be hurt badly. Working folks may be able to roll everything but the offending contributions back to their company's 401k, isolating the after tax money in the IRA and then do Roth conversions from the 401k, but I don't see how I could get access to the 401k of a company I don't work for anymore.

Two thoughts on this:

#1) You could become self-employed and thus open a 401k for your new business. If you get the terms of your newly minted 401k correct, you in theory could "isolate the basis" with this new tool in hand.

#2) Just wait and see a) if this actually passes and assuming that it does b) see what the regulations look like that implement it. I truly believe that the treasury regulations that implement this law will not let $1 of after-tax contibution posion the whole IRA.

-gauss

 

[corn18]

I guess they are targeting folks like me. From 2015-2021, I did backdoor Roth and mega-backdoor Roth and managed to get $196,781 into Roth accounts while making $700k / year. As of last Friday, those Roth accounts have $141k of growth that I will be able to withdraw tax free. My plan is to let this all ride and pass it on to my heirs, at which time they should be able to withdraw everything tax free. Can you imagine how big that will be in 30 years? At 5% real growth, it would be $22M in today's dollars. Holy crap! The government wants someone to pay taxes on that.

 

[Exchme]

I guess they are targeting folks like me. From 2015-2021, I did backdoor Roth and mega-backdoor Roth and managed to get $196,781 into Roth accounts while making $700k / year. As of last Friday, those Roth accounts have $141k of growth that I will be able to withdraw tax free. My plan is to let this all ride and pass it on to my heirs, at which time they should be able to withdraw everything tax free. Can you imagine how big that will be in 30 years? At 5% real growth, it would be $22M in today's dollars. Holy crap! The government wants someone to pay taxes on that.

When you did those Roth conversions you were in a very high tax bracket, so they did get a chunk. And although it's deviating from the thread topic, remember that the estate tax exemption gets cut in half in 2026 when TCJA expires to $5.85M each, $11.7M together, so the government will get 40% of everything above that exempt amount anyway. Somehow I think you will end up paying your "fair share".

 

[Exchme]

Two thoughts on this:

#1) You could become self-employed and thus open a 401k for your new business. If you get the terms of your newly minted 401k correct, you in theory could "isolate the basis" with this new tool in hand.

#2) Just wait and see a) if this actually passes and assuming that it does b) see what the regulations look like that implement it. I truly believe that the treasury regulations that implement this law will not let $1 of after-tax contibution posion the whole IRA.

-gauss

I hope you are right, contributing after tax money to IRAs was specifically in the law to encourage retirement savings. If they end up poisoning my whole account, I would have been better off to light the money on fire rather than save it. Talk about perverse incentives.

 

[camfused]

...At 5% real growth, it would be $22M in today's dollars. Holy crap!...

I am not good at math, but I get $847K for $196K that compounds for 30 years.

 

[corn18]

I am not good at math, but I get $847K for $196K that compounds for 30 years.

Oops, I put the wrong variables in the Excel FV formula. It's actually $1.459M

 

[youbet]

Oops, I put the wrong variables in the Excel FV formula. It's actually $1.459M

$22M ----- $1.459M .......... Same thing. Yawn. No big deal.

 

[pjigar]

I guess they are targeting folks like me. From 2015-2021, I did backdoor Roth and mega-backdoor Roth and managed to get $196,781 into Roth accounts while making $700k / year. As of last Friday, those Roth accounts have $141k of growth that I will be able to withdraw tax free. My plan is to let this all ride and pass it on to my heirs, at which time they should be able to withdraw everything tax free. Can you imagine how big that will be in 30 years? At 5% real growth, it would be $22M in today's dollars. Holy crap! The government wants someone to pay taxes on that.

You may have misread a zero in compounding! $350K compounded at 5% for 30 years is $1.5M. May be you assumed future contributions. By the way, the Roth conversion rule is an unintended goof up by congress while trying to stop people who held start up shares in Roth IRA which were funded by mega-backdoor contributions channeled from 401K. They want to stop future funding of Roth for everyone because the startup C-suite employees can have artificially low income for years because they are awarded huge RSUs/Options which will vest in the future. Lot of these C-suite guys can fly under the radar of "middle class" paper income for years while building up the shares in IRAs. That is how they can end up with million/billion dollar IRAs in couple of decades down the road. Unfortunately the proposed change will affect all highly compensated individuals who are just the worker bees without RSUs/Options.

 

[thefinancebuff]

Years ago, I made few thousand $ after tax contribution to my IRA and have since rolled my much larger 401k into it and retired. So if this ridiculous thing becomes law I will be hurt badly.

It won't hurt you. If your IRA is 99% pre-tax 1% after-tax, when you take $10,000 out, you convert $9,900 to Roth and put $100 in your checking account.

 

[Exchme]

It won't hurt you. If your IRA is 99% pre-tax 1% after-tax, when you take $10,000 out, you convert $9,900 to Roth and put $100 in your checking account.

Your interpretation would certainly be make it a non-event for me and I admit I am in over my head trying to understand the bill. But reading the text of the bill I quoted above seemed to prohibit the entire transaction? Is there an expert analysis somewhere on this point (just occurred to me that you are thefinancebuff.com proprietor - I read that site regularly and thanks for the feedback! )