Backdoor Roth rollover analysis and pitfalls

Let’s imagine that I make an after-tax contribution to a Traditional IRA in the amount of 3000 (perhaps a rollover from a previous employer or regular contribution if I am over the limit for a direct Roth IRA contribution).

Let’s further assume that I invest this in VTSAX and have a time horizon of 45 years that grows the investment to 63,000 dollars (21 times your money). When withdrawing this sum, I will thus be taxed on 60,000.

Reduce taxes?

However, I can actually save nearly the entire amount I will pay in tax by converting to a Roth IRA. When withdrawing from a Roth IRA, the withdrawls are tax-free (assuming I follow the guidelines for withdrawl).

All I need to do is rollover my traditional IRA to a Roth IRA. This is called a backdoor conversion. Vanguard’s IRA accounts make this very easy - I can request a rollover with the click of a button and even invest the money in the market before it hits the Roth IRA. In under 5 minutes, I was able to request the rollover and designate what funds they will be invested into the Roth IRA.

When I rollover my IRA to a Roth IRA, I am of course taxed on the capital gains I have incurred so far. Note that this isn’t the entire 3000 principal. If I roll over the day I contribute to the Traditional IRA, my tax liability will be a couple of cents at most. The longer I wait to roll over, the higher my potential tax liablity is, so the sooner I rollover, the better (this also relates to the caveat below).

How much do I actually save??

In this hypothetical scenario, let’s assume that I withdraw at a rate of 100,000 a year in retirement and live in CA. With nearly zero effort, I have saved my future self 29,000 in taxes according to this calculator by paying at most a couple of cents today.

Since I can make this move every year, it makes sense to extrapolate the total savings a Backdoor Roth can save over the years. Taking my mean time horizon until retirement as \(\frac{n(n+1)}{2n}\) with \(n = 45\), my mean time horizon is \(23\) which means I save 14,200 per year in expectation or a total of 639,000 in taxes (I didn’t do the math but my gut tells me this estimate is lower than the true value \(3000 \sum_{i=1}^{45}(1.07^i)) - 45*3000\).

One last thing…

The limit that you can rollover to a Roth IRA is actually 6000 (as of 2019), not 3000. Therefore using the same exact strategy, one can save a whopping 1.56 million in taxes over the given time horizon. Due to inflation and catch-up contributions increasing this limit, this value is a lower bound in taxes saved.

Caveat

When conducting a Backdoor Roth IRA, I would need to be aware if I have transferred any previous employer’s 401(k)’s to a traditional IRA and let them grow over a few years. By the pro-rata rule this would subject me to present taxes. In particular, I would be taxed on 1 - the proportion of the total IRA that is rolled over (and your tax-deductible contributions count to this!!!!). This is why I currently strongly believe in not transferring your old 401(k)’s to an IRA. But there could be other caveats or circumstances that I’m missing (for example if your previous employer’s 401k offered very limited, high cost funds, it might make sense to transfer to a TIRA).