How do mega (and regular) backdoor Roth conversions benefit individuals with high MAGI?

Submitted by Complete-Smoke9368 t3_10qbcmf in personalfinance

Currently I'm still below the Roth IRA contribution limit but my MAGI is too high to be able to benefit from any contributions to a Traditional IRA. I was following the flowchart for the Prime Directive and saw that in Step 5 and also in the "Advanced" section it mentioned performing backdoor Roths as an option.

My confusion spawns from my understanding that Roth IRAs are only beneficial if you plan to be in a higher tax bracket when you retire (therefore no taxes on withdrawal). I'm currently in the second highest tax bracket and don't expect to be needing this much money in retirement, therefore my thought process would dictate maximizing contributions to employer trad 401k to minimize taxes would benefit me the best.

The problem is that when performing mega/regular backdoor roth conversions I would still be taxed at my high effective tax bracket and lose out on all the savings from putting it into a traditional IRA (401k). Is the basic idea that tax free gains outweigh the upfront cost of having to pay high taxes on contributions now?

EDIT: I'm actually in the third highest tax bracket. I can't math.

1

Comments

You must log in or register to comment.

BouncyEgg t1_j6ozes3 wrote

Your mistake is in believing that non-deductible contributions to tax deferred assets (ie traditional/Aftertax) result in a taxable liability.

The net effect of the Backdoor strategies is that it effectively increases Roth space without additional tax liability.

6

Complete-Smoke9368 OP t1_j6p30bv wrote

I think I misunderstood how taxes work with the backdoor conversions. That's my bad! That totally changes everything!!

1

nothlit t1_j6ozc2c wrote

You should be maxing traditional 401k and then pursuing one or both of the backdoor options in addition to that. In which case the comparison is not traditional vs. (backdoor) Roth, it's backdoor Roth vs. taxable brokerage.

Also, you aren't taxed on the conversion step of backdoor Roth because the traditional IRA contribution is nondeductible (unless you have lots of existing pre-tax IRA money, in which case there are other considerations).

5

Complete-Smoke9368 OP t1_j6p2wbe wrote

Great point. I was thinking about it a little wonky. Additionally, I believe I missed the part where (mega) backdoor Roths aren't required to pay tax on the conversion. I always figured that since taxes weren't paid going into the Trad 401k that they would get their taxes when I performed the conversion....

1

Complete-Smoke9368 OP t1_j6p4yuc wrote

According to this link backdoor Roth conversions are taxable?

1

sciguyCO t1_j6p90hk wrote

Key detail you may have missed:

>you still need to pay taxes on any money in your traditional IRA that hasn’t been taxed.

So only any pre-tax money (deducted when contributed or growth after contribution) involved in the conversion incurs owing tax.

The "clean" backdoor Roth goes like this:

  • You have a $0 Traditional IRA balance, so no pre-tax dollars already exist in it.
  • You contribute money into a Traditional IRA. You claim this as a "non-deductible contribution" on your return to report that these are "after tax" dollars. So they get included in your taxable income on your return and taxes are owed and paid on them as part of that. There is no income limitation on this contribution.
  • You convert your Traditional IRA balance into your Roth IRA. There is no income limitation on this conversion. That used to be different, but the income restriction's removal back in the 90s(?) was the change that opened up the backdoor.
  • The amount converted is taxable based on a "pro rata" calculation. You take the $pre-tax / ($pre-tax + $afterTax) of your IRA balance to get a percentage. If the $pre-tax is $0 (because you didn't claim the deduction and earned no interest/growth), then 0% is taxable.

There's some wiggle room around timing of things. You don't have to wait to file your return for those contributed dollars to count as after-tax, everything gets lumped together on your tax return.

2

nothlit t1_j6p7uwu wrote

It depends on whether you have any pre-existing pre-tax money in your IRA(s). If there is none, then the conversion is 100% nontaxable because it consists of 100% nondeductible basis from your traditional IRA. If you have existing pre-tax IRA money, then the conversion has to be a proportional mixture of pre-tax and after-tax (nondeductible) amounts, and is taxable in the same proportion.

1

sciguyCO t1_j6p1kjq wrote

When you have high income, it is true that "pre-tax" retirement savings almost always results in lower overall taxes paid (today's + during retirement). So at that level, you should focus your retirement dollars into either a pre-tax work plan or (if you have no retirement option through an employer) a Traditional IRA. The income restriction on deducting tIRA contributions only applies when you also have a work plan.

But there's a limit to how much pre-tax "space" you're allowed to use. Some people want to put away a lot for their retirement each year, more than they're allowed with regular 401k contributions. Maybe they're behind for their age, maybe they want a fancier lifestyle, maybe they just have no better use for those dollars. So while the tax cost from saving in a Roth may not be ideal, it still could be the best option compared to some non-tax-advantaged account. But again, only after "using up" all your available pre-tax options.

>Currently I'm still below the Roth IRA contribution limit
>
>...
>
>I'm currently in the second highest tax bracket

These two statements are not compatible. The income cutoff where your allowed direct Roth IRA contributions becomes $0 is roughly 1/3rd of the way into 24% tax bracket (give or take a bit between the filing statuses). If you're in the 35% bracket, then you make way too much to use a Roth IRA without the backdoor.

3

Complete-Smoke9368 OP t1_j6p2i5f wrote

You caught me :P! My math was bad, I am the third highest tax bracket.

I think I understand what you're saying, I have been making contributions to my employers Roth 401k for the past few years when I should have been making my contributions to the trad 401k this whole time.

1

meamemg t1_j6ozzm3 wrote

You are comparing a traditional IRA/401k to a Roth IRA/401k. For high income individuals, the traditional will be better, yes.

Where the backdoor Roth comes in is once you have maxed out the traditional IRA/401k. If you have additional money that you want to contribute but exceed the limits for a traditional 401k, and make too much for a deductible traditional IRA contribution. Then you need to compare to putting it into a regular taxable investment account. And a Roth IRA will come out better than that.

2

Complete-Smoke9368 OP t1_j6p2pmr wrote

Is there a reason that it only comes once you have maximized contributions? Why wouldn't you perform a mega backdoor Roth even if you were contributing say 80% of the federal limit?

1

meamemg t1_j6p3m6c wrote

For the reasons you outlined: A traditional contribution is better than a Roth contribution for people with relatively high incomes.

2

Complete-Smoke9368 OP t1_j6p55y0 wrote

Right, but I guess the part that confused me was the implication that because I had not hit the yearly maximum for 401k contributions I would not perform a backdoor roth conversion. Wouldn't the interest accrued in the trad 401k be growing and taxable?

1

meamemg t1_j6p5orf wrote

It would. But if you are in a higher tax bracket, the tax deduction is more valuable.

2

DaemonTargaryen2024 t1_j6p4wx6 wrote

It’s basically that you’re forced to choose between a non deductible Trad IRA, or a Roth conversion of a non deductible Trad IRA contribution, which assumes you have no other Trad IRA funds.

Same for MBDR: once you’ve maxed the pretax 401k space the only thing left (if your plan even offers) is after tax. And since after tax earnings are pretax, you may as well convert to Roth to make the earnings (eventually) tax free.

1