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The Front Door is Locked But I Want to Get Into the Roth Party. Can You Point Me To the Backdoor?

I am asked by clients about the backdoor Roth conversion on a somewhat regular basis.  It’s clear from the look on their face and tone of their voice that it is perceived as a strategy that well-to-do investors should be aware of if not already taking advantage of in their quest to stay one step ahead of those evil people at the IRS.  Similar to other personal finance topics where investors can be searching for a solution before even determining that they have a problem, there are important questions that should be asked first before diving into this particular strategy….namely, should I be contributing to a tax-deferred account or a Roth account, and if I decide on a Roth account, do I need to use the backdoor conversion to accomplish my goal?

Roth vs Tax-Deferred

At the heart of this decision is when you do want the income in question to pass through the tax toll booth, today or during your retirement years.  While there are scenarios that align with each account type, the folks that immediately gravitate to the Roth account typically come from one of the two following camps:

1)    Those that have a strong fear of significant increases in tax rates in the future

2)    Those that don’t have a very good understanding of how the tax brackets work

The general rule of thumb that I think makes very good sense is that investors are best served by using tax-deferred accounts during their peak earning years and Roth accounts during all other years.

Let’s look at a simple example to give some context to the discussion:

Single taxpayer with an adjusted gross income (AGI) of $250,000.  When she is deciding between a Roth and tax-deferred account for her $19,000 contribution toward retirement, her marginal tax rate (the rate applied to her last dollar earned) is 35%.  For this investor, barring any unique circumstances I would likely recommend that she take advantage of tax-deferral.  For now, I’ll assume that the current brackets and rates are constant throughout.  She has just one tax bracket above her current marginal rate, it’s a relatively small increase (35% to 37%), and her AGI would have to double to over $500k before she would start paying this higher rate.   On the other side of things, if her needs in retirement are lower than during her working years (hopefully no mortgage, no payroll taxes, no more contributing to retirement accounts, etc), she would likely find herself in a marginal bracket of perhaps 22-24%.  

While there are some categories that are expected to increase in retirement (healthcare being the elephant in the room), for the vast majority of cases it is reasonable to expect your monthly expenses to be lower in retirement.  

Let’s assume that she retires in her early 60’s and given that she’s had a solid financial plan in place for decades, she doesn’t expect to file for social security benefits until her full retirement age (let’s say 67) and might even wait until age 70 to get the maximum benefit.  So, her W2 income stops when she bids farewell to her employer, social security benefits won’t be starting for 8-10 years.  To complete the scenario, let’s say that she has rental or other passive income of $30,000 per year.  

What will her taxes look like in this first year of retirement?

Rental income:      $30k

401k withdrawal:  $50k 

Total income:  $80k

The first $12,200 is the standard deduction and therefore taxed at 0%.  Save at 35%, pay taxes at 0%.  Hard to argue with that.

The next $9,700 comes out at 10%. Save at 35%, pay at 10%. Still quite a bargain.

The next $29,775 ($39,475-$9,700) comes out at 12%.  Are you noticing a trend here?

The remaining $28,325 to get to her total $80,000 of income is taxed at 22%.

Her effective rate for this year is ($0+$970+$3,573+$6,231) = $10,774 / $80,000 = 13.5%

So, she defers at 35% and is ultimately taxed (perhaps decades later) at 13.5%....this ends up being quite the tax arbitrage.  Even if you assume that the rental income is first (a fair assumption) and the full $19,000 in question is assessed at 22%, this doesn’t change the verdict.

Here’s a simple illustration of a taxpayer deferring $56k (the maximum annual contribution from all sources) at the 35% marginal rate and then withdrawing $100k during retirement.   They say 401k since it is the most common qualified plan, but this math holds water regardless of which tax-deferred account is available to you at work.

Source:  whitecoatinvestor.com

OK….So what happens if tax rates do increase in the future?

It just takes a headline about the size of the national debt, the current year budget deficit, or perhaps the occasional arm wrestling match in D.C. over the debt ceiling to get people stirred up and predicting that at some point a major tax increase will be needed to cure these problems.   If deep down you firmly believe that rates will not just increase but perhaps increase dramatically during your lifetime, then without a doubt you should be fully committed to your Roth contribution or conversion strategy.

While making absolutely no predictions whatsoever on this topic, I hope we can all at least agree that tax increases are VERY unpopular politically.  The largest change in the Trump tax cuts, which were signed into law in late 2017, was to reduce the top tier from 39.6% to 37%….and reductions are a MUCH easier sell to the American voter.  

Since we can’t look into the crystal ball to resolve this debate, the next best option is to pick a number and run a scenario where rates do go up and then assess how that impacts the math and the winning strategy.  For this purpose, I propose that we increase all of the current brackets by 5% (i.e. 37% top tier becomes 42%).  This is effectively double the impact of the Trump tax cuts on a relative basis AND in the direction which is politically hazardous. 

Here’s how the numbers look:

First $12.2k x 0% = $0 (We didn’t say Congress was eliminating the standard deduction, so 0% holds here)

Next $9.7k x 15% = $1,455

Next $29.7k x 17% = $5,062

Last $28.3k x 27% = $7,648

Total tax = $14,165 / $80,000 = 17.7% effective rate

The gap narrows, as it would have to, but avoiding 35% to ultimately pay 18% still looks like a compelling strategy for this hypothetical high earner.  The other criteria that would cause the numbers to converge is if the expected income in retirement increases (i.e. pension).  

For those investors that are still attracted to the Roth account, before you start to map out the steps and process for the backdoor conversion, you should first review your 401k or qualified plan to see if Roth contributions are available.  This is very common in today’s qualified plans.  Not only do you avoid additional process steps and paperwork, but the contribution limit within your 401k is $19,000 (for 2019) versus the $6,000 that you can contribute to an IRA (Roth or Traditional).  There are also no income phaseout limits for the Roth 401k.  You might conclude that you don’t need to find your way in through the backdoor because the front door is wide open.  

It’s important to remember that while the Roth IRA does not have required minimum distributions (RMD’s) beginning at age 70.5, the Roth 401k does.  That’s the bad news.  The good news is you can rollover your Roth 401k to a Roth IRA once you retire or separate from service.  Problem solved.

Final Thoughts

The Roth IRA offers several attractive features, such as no RMD’s, tax-free distributions in retirement, and withdrawal of your contributions anytime without taxes or penalties.  That said, if you are in a high marginal tax bracket, odds are high that your best strategy is to first contribute on a pre-tax basis to your qualified plan or traditional IRA.  If you still have excess cash flow to invest after maxing out this deferral, THEN it becomes a great time to learn how the backdoor conversion works.  

So, without further delay, here’s a short video (less than 5 minutes) that does a good job explaining the process for high-income earners to convert money into a Roth.  If you find this leaves you with more unanswered questions, simply type in “backdoor roth ira conversion” in the YouTube search bar and you’ll be flooded with choices.

The Backdoor Roth in Simple Terms

While you have no control over or visibility into the direction of tax policy, the market, or the economy, you can and absolutely should have a comprehensive retirement plan in place well ahead of your last day on the job.  If you would like competent and objective help in developing your retirement plan (with all its moving pieces), please contact me using the form below.