Big thanks to David for the smart question. Keep em coming!
David asked “Is a back door Roth IRA a good approach to consider if your maxing out 401K?”
Backdoor Roth’s are a “financial gotcha”. They seem like a really smart way around the system until you
get into the details.
And then you realize that Backdoor Roths are pretty much NEVER a good idea. Here’s what you need to
know…WHAT IS A “BACKDOOR ROTH IRA”?
TRADITIONAL IRA: you pay taxes on all of the money when you take it out in retirement.
ROTH IRA: you pay the taxes NOW and then you don’t pay any taxes ever again.
A “Backdoor Roth” is when you convert your Traditional IRA into a Roth IRA which means you pay the
taxes NOW.
It’s technically called a “Roth Conversion”.
WHY IT’S CALLED A BACKDOOR ROTH
To contribute to a Roth IRA (aka use the front door), you can’t make over $208,000 as a couple (or
$140,000 for an individual).
A backdoor Roth gets around the income limits. (As in it uses the backdoor.
And that must be a good thing, right? It’s gotta be better to pay a smaller tax on just the principal now
and never pay taxes on the gains.
THE MATH OF A BACKDOOR ROTHMany people mistakenly think paying taxes NOW and never again is
better than paying taxes on everything later
But that’s not true.
Here’s the simple math:
Traditional IRACurrent Value: $100,000+60% Growth: $160,000-25% taxes: -$40,000Post-Tax Total: $120,000
Roth IRACurrent Value: $100,000-25% taxes: -$25,000Post-Tax Total: $75,000+60% Growth: $120,000
So regardless if you take the taxes out NOW and grow from there or if you keep it all in and tax
everything including the gains later you’ll end up with the same amount.
THE ONLY FACTOR TO CONSIDER
The only factor that can make a Backdoor Roth good or bad is whether your tax rate will be more or
less when you take the money out.
That’s the set up.
Tomorrow I’ll show you when a Backdoor Roth actually makes sense.
