The Back Door

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Not to be redundant, but if you want to retire young you’ve got to save a large proportion of your income. That’s rule number one, two, and three.

I shouldn’t say it like that because saving money is actually quite fun once you get started. Investing your savings is even more fun.

And you will be surprised at all the fat you can trim from your life without losing any happiness at all.

But I digress.

The purpose of this post is to discuss what vehicles you should put your valuable savings into and in what order.

Step one: Pay down any high-interest debt. We’re talking credit card bills, floating-rate subprime mortgages, anything with an interest rate above 6%.

If you got any of these: emergency!! You shouldn’t even be thinking about retirement until you stop financing your banker’s retirement.

Pay That stuff down. Then come back and read the rest of this post. You will essentially be getting a guaranteed 6-20% return on that money in the form of interest rates that you will not have to pay in the future.

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It would be advisable to ignore step number 1, just trust us on this one

Step two: Max out your employer-based retirement plan. If you think your tax rate will be higher in retirement than it is now then contribute to a Roth (after tax) plan. If not then contribute to a standard  tax deductible plan.

Either way this money will grow tax-free and this is a huge advantage. All of your dividends and fixed income interest will grow without a 15 to 35% hit in the form of taxes. If a 1% increase in mutual fund expense ratios means a loss of 33% of your portfolio in 40 years, then imagine how much this tax savings will mean to your future portfolio growth.

Step three: You’re not done yet. If you’re serious about saving, you will likely have more money to save.

So where do you put this?

You put it in an IRA. After maxing out your employer plan you can contribute an additional $5500 per person or $11,000 per married couple into an IRA. You’ll not get to put in pre-tax dollars, and you’ll pay income tax when you pull out the money in retirement, but this money will still grow tax-free. Very valuable.

Step four: hold on a sec….

Time for a major “I’m only a doctor,” disclaimer.

Do not do this step without consulting with your tax advisor.

As I understand it, through a quirk in the tax code, although high income earners are not able to contribute to Roth IRAs, they are able to roll over post-tax IRA contributions into Roth IRAs accounts.

This means that the day after contributing your $11,000 to your IRA, you can roll it over into a Roth IRA with no tax penalty!

This is called a “backdoor Roth.”

Not only will this money now grow tax-free but it can be pulled out tax-free in retirement. Talk about free money.

The major caveat here is that if you already have an IRA, then the IRS sees all of your IRA money as one lump sum.

So if your other IRA money is worth $90,000 pretax dollars, and your recent post-tax contribution is worth $10,000, then when you try to rollover the $10,000, the IRS will count it as only 10% post-tax dollars allowing you to rollover only $1000 tax-free, while paying taxes on the other $9000.

The way around this is to roll over your IRA money into your employment based retirement accounts so that all you have are post tax (Roth) IRA accounts.

Now we can talk about the morality of this another time.

I’m as progressive as they come.

But when it comes to planning for retirement it’s best to think like a tax dodging venture capitalist.

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Once we’ve retired we’ll have plenty of time to pen letters to our congressman advocating for a less labyrinthine, and inequitable tax code.

Step five: consider enrolling in a high deductible health care plan, and investing money in a health care savings account.

This is known as a “stealth IRA.” But that’s seriously a topic for another day.

Step Six: open a taxable investment account. And invest in tax efficient funds.

I’m sure I’m missing about a hundred steps, but I think this is a pretty good blueprint for simpletons like me!

If you have any other angles, please fire off a comment.

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13 Responses to “The Back Door”

  1. Meghan January 17, 2014 at 12:22 pm #

    Can you explain the backdoor IRA a little bit more? I’m confused on the part:
    “The major caveat here is that if you already have an IRA, then the IRS sees all of your IRA money as one lump sum.

    So if your other IRA money is worth $90,000 pretax dollars, and your recent post-tax contribution is worth $10,000, then when you try to rollover the $10,000, the IRS will count it as only 10% post-tax dollars allowing you to rollover only $1000 tax-free, while paying taxes on the other $9000.” I don’t even know what questions to ask specifically but any clarification on this piece would be great!

  2. Miles Dividend M.D. January 17, 2014 at 9:34 pm #

    Meghan,

    Thank you so much for visiting the site and asking this question.

    To explain this further I should probably talk about The run-of-the-mill Roth IRA conversion.

    As you may know the difference between a traditional IRA and Roth IRA is that with a traditional IRA you pay your taxes when you pull money out during retirement in the form of income tax. (The benefit being that you originally put in pretax money.)

    With Roth IRAs, on the other hand, you put in after-tax money but when you pull it out, you pull it out completely tax-free.

    At any time you may convert a traditional IRA into a Roth IRA, by paying taxes on the amount of money your principal has earned.

    So if you originally put $5000 into a Traditional IRA and it is now worth $6000, if you want to convert it into a Roth IRA you must pay income taxes on the $1000 that you made.

    The crucial point in the post is that the IRS sees all of your IRA money as one pot.

    So if you try to execute a $5000 backdoor IRA , but you’ve got $45,000 in another IRA account, The IRS will just say $5000 is one 10th of your total IRA money, and tax you on one 10th of all of the money that all of your IRA accounts have made.

    If you have no other IRA money, however, this is not an issue and you end up paying for your Roth IRA with after-tax money , which is otherwise an impossibility for high income earners.

    Does that help?

    Alexi

  3. Robert January 19, 2014 at 6:09 am #

    Just discovered this site from the link on Million Mille Secrets. Some good stuff here! The investment advice is basic but sound.

    No offense, Doc, but on this response I think even your clarification is still confusing. It would help if you more clearly distinguish between the two types of traditional IRAs. They aren’t really two different types, but they are treated differently. I’ll call them “deductible traditional IRAs” and “non-deductible traditional IRAs”.

    By “deductible traditional IRA” I mean that the money that was put into the IRA was deductible (and deducted!) on the taxpayer’s return and thus in effect was paid with pretax dollars. Money in a deductible IRA, because it was paid with pretax dollars, is fully taxable when it is withdrawn upon retirement–that includes both the contributions and the investment gain on those contributions.

    By contrast, money paid into a “non-deductible traditional IRA” is not deducted on the taxpayer’s return, and thus is paid with money that has already been taxed (i.e., income tax). Because that money is already taxed, it can be withdrawn upon retirement without paying taxes on it. However, the investment income earned in the non-deductible IRA has not yet been taxed (that being one of the principle advantages of any kind of IRA, that income grows tax-deferred), so when you retire, you have to pay taxes on the investment gain in the account. For this kind of IRA, you have to track your “basis” in the account, meaning that you track the amount of after-tax dollars that you invested in the account over the years. The difference between what the account is worth (when you are withdrawing funds) and your basis is your gain, and that gain is taxable when withdrawn.

    The trick here (and it really isn’t a trick) is how you apportion the withdrawals between taxable and non-taxable money when an IRA contains both. What the Doc is saying is that if you are withdrawing from an account that has a mixture of taxed and non-taxed contributions, the IRS requires that you treat these as proportional withdrawals; you can’t just say, “I’m withdrawing the basis first, then later the investment income”. But there are several rules on this and some tax strategies. If memory serves me right, the IRS looks at ALL your IRA accounts, not just the particular one you are withdrawing from, so even if the account you are withdrawing from was funded entirely with after-tax dollars, if you have another IRA that was funded with pre-tax dollars (i.e., a deductible IRA), then this proportionality will still be applied. But I may be wrong on that. Consult IRS publications or your tax advisor.

    If you are asking why someone would invest in a non-deductible IRA in the first place, it is because you cannot invest in a deductible IRA if your taxable income in that year is above a defined maximum. And you can’t invest in a ROTH IRA if your income is above a defined maximum. That would probably include many doctors. If your income is not so large, then investing in a deductible IRA and/or ROTH IRA is the better deal.

    That said, some financial advisors–i.e., Ric Edelman–advise diversifying your retirement accounts between taxable and non-taxable accounts as a way to hedge against future tax law changes. Imagine, for example, that the US implements a VAT in exchange for reducing income tax rates. Now, if you have all your money in a ROTH, for which you paid taxes upfront, you are the loser compared to someone who put it in an IRA and deferred their taxes. You’ll both pay the VAT on your purchases, but you’ll effectively be taxed twice).

    I heartily second the Doc’s suggestion to look into HSAs, especially if you are a high income individual and can’t contribute to a deductible traditional IRA.

    Hopefully this helps. Like the Doc, I comment with the caveat that I’m not a financial expert either! I’m a scientist.

  4. Miles Dividend M.D. January 19, 2014 at 10:14 am #

    Robert,

    Robert,

    Thank you for your detailed comment. I agree with it (almost) in its entirety. Well done!

    The one point I would make is that for high income individuals who have already maxed out their 401K/403B for the year, Ric Edelman’s advise is not particularly relevant. Since you can only contribute to a traditional IRA with post tax dollars (at that point) and it costs nothing to convert to a Roth IRA (assuming you have no other IRA accounts) it is truly a no brainer to do the backdoor at that point. After all pulling money out tax free is better than being taxed on withdrawl’s all else being equal.

  5. Miles Dividend M.D. January 19, 2014 at 10:28 am #

    Meghan,

    I think Robert is right, the farther in to the weeds you get in explaining this manover, the more confusing it gets.

    Let me try again in simple english.

    A back door Roth is a good idea if you are

    1. A high income individual.
    2. You have maxed out your employer pre-tax retirement accounts (401K, 403B, etc) for the year.
    3. You do not have any IRA accounts already in addition to your 401K, 403B etc.
    3.***If you do have IRA accounts it may make sense to role them into your 401K open up the possibility of a backdoor IRA.
    4. Talk to your accountant to review your particulars.

    Hope that helps!

  6. Robert January 19, 2014 at 11:12 am #

    Doc, I agree with your comment for high income individuals, and ROTH is indeed a no-brainer vs. non-deductible traditional IRA. One other point to keep in mind is that if married, sometimes the spouse qualifies for a deductible IRA even if the other partner does not. You’d have to check the rules on conversion then, as I haven’t read up on if the existence of a spousal IRA would trigger the proportionality rule on a conversion of your own IRA to a ROTH.

  7. Sebas February 11, 2014 at 11:50 am #

    Thank you Doc and Robert for your insights.
    I thought I had this topic under control but now I understand there are “deductible” and “non-deductible” Traditional IRAs. It took me a while to understand this whole dilemma and I had to read other articles to fully get it. I recommend the link at the bottom of my comments for extra and clear explanation.

    I guess the Doc is over $188K (married filing jointly) and contributing directly to a Roth IRA is not an option. Therefore, he MUST use the backdoor to a Roth IRA to get the tax-free growth and retirement withdraw benefits on a Roth IRA. Then he has to make “non-deductible” contribution (up to the $5,500 limit… I guess the Doc is young at heart) to a Traditional IRA and immediately convert it to a Roth IRA to avoid the complication of paying taxes on whatever growth was there. Do I have it right?

    Now, my personal situation is that I am a little behind $178K (married filing jointly) and I am slowly converting my pre-tax Traditional IRAs (a little every year) to a Roth IRA so when the time comes (over $188K), I can use the backdoor IRA method to continue the Roth IRA benefits. In the meantime, I maximize the Roth IRA contributions every year for my wife and me. Does this sound a good plan to you?

    http://www.nerdwallet.com/blog/investing/2013/high-income-roth-ira-backdoor/

    • Miles Dividend M.D. February 11, 2014 at 12:19 pm #

      Sebas,

      Thank you for your comments, and thank you for the link.

      Your assumptions about my income level are spot on. My post may have been clearer had I disclosed them.

      As to whether or not it makes sense to convert your current IRAs to Roth IRAs, the main questions here are,

      1. Do you think you will be in a higher tax bracket in retirement? (If not, you might be better off paying the taxes then when you’re marginal tax rate is lower and avoiding the taxes now by keeping your funds in a traditional IRA.)

      2. Do you have an employer-based retirement plan? Like a 401(k) or 403b? If so all you will need to do to be able to do the back door IRA when you are making more money, is to roll your IRA monies into your employer-based retirement account. This is what I did.

      Not to be Pollyanna-ish, but one advantage of having less income now, is that you can save a tremendous percentage of your income tax-free which is a huge value proposition!

      Thanks again for reading and great job saving and investing.

      Alexi

      • Sebas February 11, 2014 at 7:17 pm #

        Thanks Alexi.
        My belief is that my taxes at retirement will be the same or higher and that is why I prefer to pay taxes now, with all the deductions I have (4 children + house, etc).
        I do maximize my employer’s 401K (10% and they match 4%) and I also fund four 529 for my children’s education since the day they were born.

        In regards to the back door, are you saying when your salary is over $188K, you roll over any the pre-tax Traditional IRA you may have to your employer’s 401K to keep it pre-tax? I didn’t know you could do that.
        After doing this, your “non-deductabe” contributions to a traditional IRA from their own are not negatively affected by the pro-rata rule right?

  8. Miles Dividend M.D. February 11, 2014 at 9:39 pm #

    Sebas

    Consult your tax professional before doing anything. But…

    If you roll over all of your current IRA money into your 401(k), The pro rata rule ceases to be in effect.

    This is because the IRS sees 401(k)s and IRAs as completely separate buckets.

    Once you’ve done this you and your wife should be able to contribute $5500 each a year to a traditional IRA and immediately roll it over into a Roth with zero tax penalty, regardless of your income.

    If you’re able to keep your spending down in retirement, you might be able to get away with paying zero taxes at all, which would make it a shame to pay taxes now converting your IRAs into a Roth IRA, and missing out on the compounding magic of your money lost to Taxes.

    For more on that please see this excellent post from go Curry cracker.

    http://www.gocurrycracker.com/never-pay-taxes-again/

    (I’ll probably do a meta-post on this in the future.)

    Enjoy!

    • Robert February 12, 2014 at 6:24 am #

      I’m really foggy on this one, but just a caution to check out. If your 401(k) includes only before-tax contributions and employee match, then you may not want to mix it with after-tax accounts such as non-deductible IRAs. Otherwise, I think there are some unfavorable treatments for proration that take place on ROTH conversion or distributions. Check it out for yourself, or better, consult a tax professional.

  9. mike October 17, 2014 at 6:14 pm #

    Question: what if there’s nothing left by the time you get to six and you don’t want to wait till you’re 60 to retire?
    Intuitively, and financially, this approach is spot on. But if your tapped before you get to the after-tax part, how are you not ensuring a “normal” retirement?

    • Miles Dividend M.D. October 17, 2014 at 9:02 pm #

      Mike,

      Thanks for your question.

      Everyone’s tax situation is different. If youre taxed at the 15% marginal income tax bracket, and will continue to be taxed at the 15% income bracket (Or below) in retirement, then you will not ever have to pay capital gains taxes or dividends under current tax laws. Under such a scenario a Roth offers little advantage, as your taxable account effectively is a Roth. A backdoor Roth is unnecessary in such a circumstance because your income is not high enough to require the back door maneuver.

      But if you are a high income earner, it always makes sense to defer and avoid taxes whenever possible.

      There are many ways to tap retirement accounts in early retirement without penalty, such as removing principle from Roth accounts after five years without penalty, SEPP distributions or Roth IRA ladders.

      I wrote about those here.

      http://www.milesdividendmd.com/whitecoat-faceoff-unballing-your-yarn/

      Hope that helps.

      AZ

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