Tuesday, December 19, 2017

Backdoor and mega-backdoor Roth IRA

tldr: If you hold investments in a taxable account, but haven't maxed out your 401k, HSA, backdoor Roth, and mega-backdoor Roth, you are losing a lot of money to the tax man!

In "Taking advantage of tax advantaged accounts" part 1 and part 2, we saw that retirement accounts make a huge difference in growing your investments due to their tax advantages. However, many of these accounts such as the traditional IRA and Roth IRA contain several restrictions as far as who can partake in these advantages. This post goes into how to get around these restrictions to maximize your retirement contributions (100% legal).

First, a little background: for a traditional IRA, a single filer can only take a full deduction if you're modified adjusted gross income is $63,000 or less. Between $63,000 and $73,000, you can only take a partial deduction, and after $73,000 you can't take any deduction. A non-deductible traditional IRA is actually at a tax disadvantage compared to a regular taxable account because it can no longer claim the lower capital gains tax.

You can contribute to the Roth IRA up to $120,000 AGI. Between $120,000 and $135,000, your contribution limit starts phasing out. After $135,000, you can no longer contribute to a Roth IRA.

In any given year, the total contributions to all of your traditional and Roth IRA accounts cannot exceed $5,500. This puts yet another limit on how much you can take advantage of these accounts even if you meet the income thresholds.

The first technique is fairly well-known and is called the "Backdoor Roth IRA" or more officially as a "Roth IRA conversion". This uses a loophole where any traditional IRA can be converted to a Roth IRA, as long as you pay the requisite taxes. Remember, a traditional IRA may be deductible (i.e. tax deferred) whereas a Roth IRA is taxed immediately, thus when you do the conversion you must make sure you pay the taxes that a Roth IRA requires. However, you should only be using this technique if you're income is above $120,000 anyways (otherwise you should just contribute to a Roth IRA directly). This means your traditional IRA contribution was non-deductible and you already paid taxes on that amount, which means that you don't need to pay any additional taxes on the conversion. The conversion process is relatively simple with most brokerages (see your brokerage documentation for details).

Two things to keep in mind about the process
  • If you have taxable balances in any of your IRA accounts, you are subject to the associated pro-rata rules and must pay taxes on the conversion, even if you are converting an after-tax contribution.
  • You should do the conversion immediately after your traditional IRA contribution, otherwise you will have to pay taxes on the capital gains.
  • You are still subject to the $5,500 IRA contribution limit.
The second technique is called the "Mega-backdoor Roth IRA", and is much less well-known, but can increase your tax-advantaged contributions by tens of thousands of dollars. This technique requires your employer to offer after-tax 401k contributions. The background is the following: the IRS limits your traditional and Roth 401k contributions to $18,000 (+employer match) per year. Some employers will additionally offer an "after-tax" 401k plan that is normally not very useful since it doesn't have any tax benefits (the tax treatment is comparable to a non-deductible traditional IRA). However depending on your 401k plan, you can convert those after-tax 401k contributions to a Roth 401k or roll it over to a Roth IRA.

The process is more involved since you should do the conversion after every after-tax 401k contribution, which typically occurs every pay check. However, a few minutes of work every paycheck is a small price to pay for the associated tax-advantage. The total contribution limit for your 401k accounts is a whopping $55,000, which means (assuming a 50% employer match) you can put an additional $55,000 - $18,500 - $9,250 = $27,250 into a tax sheltered account every year. If you forget and do the conversion late and the account grows in the meantime, you'll just have to pay a small tax on the growth.

The mega-backdoor withdrawal does not count towards your IRA contributions, so you can (and should) take advantage of both the backdoor and mega-backdoor techniques. The combination of the two brings your tax-advantaged limits from ~$20,000 to ~$60,000 per year.

Sunday, December 10, 2017

Taking advantage of tax advantaged accounts (pt 2)

In part 1, we derived the growth rate of assets in various types of accounts. In this second part, we'll use this information to come up with some rules of thumb as to how you can optimally allocate your assets.

tldr: max out your 401k and HSA with stocks, then your Roth/deductible IRAs with stocks, put the rest in taxable accounts. Note, this is contrary to what many popular sources claim: that you should put tax-inefficient assets like bonds into tax advantaged accounts.

Since we're interested in maximizing our tax advantage, we'll look at the tax advantage of each of these account types, for both stocks and bonds, in absolute dollar terms.

We'll use the same illustrative example presented in part 1
  • $1,000 pre-tax contribution amount
  • 28% income tax bracket
  • 28% retirement income tax bracket
  • 15% capital gains tax rate
  • 8% stock growth
  • 3% fixed-income yield
  • 20 year investment horizon
  • 50% employer 401k match
Under these assumptions, we get the following account balances after the 20 year investment horizon for stocks
Account Type Withdrawal Amount Advantage
Regular $2961
HSA $4661 + $1700
Roth and Traditional 401k $5034 + $2073
Roth and Traditional+Deductible IRA $3356 + $395
Traditional, non-deductible IRA $2618 - $343

And similarly for bonds
Account Type Withdrawal Amount Advantage
Regular $1104
HSA $1806 + $702
Roth and Traditional 401k $1951 + $847
Roth and Traditional+Deductible IRA $1300 + $196
Traditional, non-deductible IRA $1138 + $34

The above table gives you a sense of how far $1000 (pretax) of stocks will go versus bonds. Once you have decided on a stock/bond allocation, you should allocate those dollars starting from the most advantaged places and moving to the least advantaged.

For example, let's say we plan on putting (in terms of pre-tax dollars) $50,000 into stocks and $50,000 into bonds. The above table would suggest maxing out our 401k first with stocks, so we put in $18,500 there. Then we should max out our HSA with stocks, so we put $3,400 there. Then (assuming we're eligible) we should max our our Roth/deductible IRA with stocks, so that's another $5,500. If we were not eligible for the Roth/deductible IRA, then we should max out our non-deductible IRA with bonds. Finally, once we've exhausted our tax-advantaged accounts, everything else should go into our taxable account. If we do this, our $100,000 investment will grow to $249,553 over the course of 20 years. If instead we had put bonds into our tax-advantaged accounts, it would only have grown to $222,384. In this scenario, this roughly corresponds to a 12% difference by simply putting assets in the right account.

The results are pretty robust to the input parameters chosen. I've made this spreadsheet (make a copy to edit) to play around with the parameters yourself if you don't believe me.

Obligatory Disclaimer

The author is not a financial adviser, tax accountant, or lawyer and disclaims any and all liability for the contents of this blog. The information reflects the author's personal research and experience, which may contain errata.