Backdoor Roth or Taxable?

[joemandadman189]

I have a question on the proposed investment order which is presented below and our situation in RED

WHAT           
0. Establish an emergency fund to your satisfaction      - More or less DONE      
1. Contribute to your 401k (traditional or Roth - see "Why #4" below) up to any company match    - DONE       
2. Pay off any debts with interest rates ~5% or more above the current 10-year Treasury note yield.     - No Debts      
3. Max Health Savings Account (HSA) if eligible. - DONE
4. Max Traditional IRA or Roth (or backdoor Roth) based on income level        - QUESTION
5. Max 401k (if    - DONE
    - 401k fees are lower than available in an IRA, or
    - you need the 401k deduction to be eligible for (and desire) a tIRA deduction, or
    - you earn too much for an IRA deduction and prefer traditional to Roth, then
    swap #4 and #5)           
6. Fund a mega backdoor Roth if applicable.         - Not Available
7. Pay off any debts with interest rates ~3% or more above the current 10-year Treasury note yield.       - Mortgage is 2.875%
8. Invest in a taxable account and/or fund a 529 with any extra.    - We currently fund a Taxable Account

My question is, is it worth it to start IRAs and do the back door conversion to Roth IRAs or just fund a Taxable account?
We currently don't have IRAs and our marginal tax rate is 35%

[dandarc]

A Roth IRA, whether using the regular or back door technique, is categorically better than taxable in terms of minimizing your tax bill over time.

In either case the income is taxed before you put in - so you have the same amount of money to invest.  But, with a taxable account, any dividend or capital gains distributions will be taxed along the way and you'll owe capital gains tax down the road at withdrawal time if the investments have grown. Qualified Roth withdrawals result in tax-free growth as well as at withdrawal time.

The main reason to prioritize taxable over a Roth IRA would be if you need better withdrawal flexibility in the short term, although then the question might be whether you should be investing vs. finding a savings account or other very low-volatility thing to park the money in.  Also if you've got existing tIRA money out there that you cannot roll into a 401k or similar to set up for backdoor Roth technique.

But from what you've listed here, you currently are going all the way down to "invest in taxable" - seems likely to me that you're just leaving tax advantaged space on the table for no good reason. Roth contribution is relatively low amount of money at $6,000 (plus possible catch-up depending on your age) per person for 2022 - surely in the 35% bracket you can afford to make this contribution and also make some taxable investments as well, no?

[joemandadman189]

A Roth IRA, whether using the regular or back door technique, is categorically better than taxable in terms of minimizing your tax bill over time.

In either case the income is taxed before you put in - so you have the same amount of money to invest.  But, with a taxable account, any dividend or capital gains distributions will be taxed along the way and you'll owe capital gains tax down the road at withdrawal time if the investments have grown. Qualified Roth withdrawals result in tax-free growth as well as at withdrawal time.

The main reason to prioritize taxable over a Roth IRA would be if you need better withdrawal flexibility in the short term, although then the question might be whether you should be investing vs. finding a savings account or other very low-volatility thing to park the money in.  Also if you've got existing tIRA money out there that you cannot roll into a 401k or similar to set up for backdoor Roth technique.

But from what you've listed here, you currently are going all the way down to "invest in taxable" - seems likely to me that you're just leaving tax advantaged space on the table for no good reason. Roth contribution is relatively low amount of money at $6,000 (plus possible catch-up depending on your age) per person for 2022 - surely in the 35% bracket you can afford to make this contribution and also make some taxable investments as well, no?

After doing some more reading i realized that because we don't currently have any IRAs we can make non-deductible contributions to a traditional IRA then convert the whole amount and only pay tax on the change in value over the day or two the money is in the account. For some reason i thought we had to pay tax to convert from traditional to Roth at our marginal tax rate, which doesn't appear to be the case. this is why i never considered it.

we are early 40's with about 10-12 years to get to FI so it makes sense to put 120-144k into this backdoor Roth account

[dandarc]

Right - that is the key point there. You're not taxed again on the contribution if you do the backdoor Roth technique properly. And you're set up well to for that.

One thing on withdrawals before 59.5 - these are conversions so not quite the same deal as "regular contributions can be withdrawn at any time, tax and penalty free". But because the taxable portion of the conversion is so small, pretty much the same end result. Be sure to keep good, detailed records so if / when an "early" withdrawal is happening you have the information readily available.

[ixtap]

Since you don't have an existing tIRA, yes the backdoor would be a good option for you. At $12k/ year it adds up and you will be saving on any dividends/capital gains distributions each year while you are in this high tax bracket.

We already had tIRA accounts when we found out about the backdoor. But we also had access to the mega backdoor Roth, so we weren't too concerned.

[seattlecyclone]

One thing on withdrawals before 59.5 - these are conversions so not quite the same deal as "regular contributions can be withdrawn at any time, tax and penalty free". But because the taxable portion of the conversion is so small, pretty much the same end result.

To elaborate...there's an ordering to early Roth IRA distributions. Direct contributions come out first, but you don't have any of these. Next are conversions. Conversions are grouped by year and are distributed in first-in, first-out order. Within a year's grouping of conversions the part you paid tax on when converting comes out first, and the already post-tax amount comes out next. Only the part you paid tax on is subject to an early withdrawal tax when withdrawn within five years.

So if you put $5,000 into your traditional IRA and it grew by $50 by the time you got around to converting to Roth, and you make a withdrawal within five years, the first $50 you withdraw will be subject to a $5 (10%) early withdrawal tax, and the next $5,000 comes out completely free. Not really significant in amount as long as you do the conversion promptly before much growth happens, but you will need to track these amounts for reporting later.

[nouseforausername]

In either case the income is taxed before you put in - so you have the same amount of money to invest.  But, with a taxable account, any dividend or capital gains distributions will be taxed along the way and you'll owe capital gains tax down the road at withdrawal time if the investments have grown. Qualified Roth withdrawals result in tax-free growth as well as at withdrawal time.

I never realized the importance of an investment growing tax free until I started paying this "carry cost" of qualified and temporarily non qualified DIV taxes on a taxable account.

My employer (govt. job) doesn't allow after tax 401k contributions. But, I was still letting $ unnecessarily fall to the bottom of the investment order.

The best remediation I can think of is to TLH from taxable accounts into a (for me) Roth IRA. Consider a 529. Finally get an HSA / otherwise capture those dollars higher on the investment order.

Just expressing appreciation for the minds who created the Investment Order.  It really is quite brilliant.

[dandarc]

In either case the income is taxed before you put in - so you have the same amount of money to invest.  But, with a taxable account, any dividend or capital gains distributions will be taxed along the way and you'll owe capital gains tax down the road at withdrawal time if the investments have grown. Qualified Roth withdrawals result in tax-free growth as well as at withdrawal time.

I never realized the importance of an investment growing tax free until I started paying this "carry cost" of qualified and temporarily non qualified DIV taxes on a taxable account.

My employer (govt. job) doesn't allow after tax 401k contributions. But, I was still letting $ unnecessarily fall to the bottom of the investment order.

The best remediation I can think of is to TLH from taxable accounts into a (for me) Roth IRA. Consider a 529. Finally get an HSA / otherwise capture those dollars higher on the investment order.

Just expressing appreciation for the minds who created the Investment Order.  It really is quite brilliant.

Yeah - one way to think about the tax drag along the way is that most folks understand the importance of minimizing fees. Taxes on dividends and any capital gains distributions you might receive along the way in a taxable account can easily cost you 0.25%-1% annually. To be fair, for many the tax rate on these distributions can be as low as zero at lower incomes if all dividends are qualified and capital gains being distributed are long-term, but OP here is decidedly not low-income, so likely not the case here. Prioritizing taxable before Roth is basically voluntarily signing up to pay an ER that would be scoffed at by most here.

Once you've filled up all the tax-advantaged buckets to the brim and still have money to invest, sure - taxable investing account still a good choice.