Author Topic: Case Study - To Mega Backdoor Roth or Not?  (Read 5810 times)

kmt88

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Case Study - To Mega Backdoor Roth or Not?
« on: March 19, 2015, 10:39:07 PM »
Hi all!  Excited and nervous to post a case study here.  I just discovered MMM and FIRE late last year.  Before that I was keeping all of my savings in cash!  Since then I have been moving my money more into investments and I would like y'alls help.  My employer offers everything I need to do a mega backdoor Roth - so should I do it?  I've read religiously all the threads discussing the finer points of Go Curry Cracker's anti-Roth arguments and tax diversification.  I ended up choosing to throw my bonus into a Roth IRA, but deciding on the future is a much more difficult task.  Please help!

Me: 26, single, southern california, engineer.  Ideal ER goal: ~35-37 years old.  Definitely before 40 years old!  I plan to travel in low cost areas cheaply immediately after retirement to keep those initial expenses low.  And/or do a thru-hike.  No house and no intention of owning.  No intention of kids.  I want to be location independent.  ER expenses between 30,000-40,000.  I have some chronic health problems that will likely be expensive as I age.  How do you plan for that anyway?  I will err on assuming larger annual expenses before I retire from the job.

OK so, I'm working on my expenses.  Ideally I want to get them down to $2,000 a month for basic costs + some float money for travel.  I will solicit additional help on the expenses later in a separate post.

I'm more interested in how to invest what money I do save.

I'm 10% cash and 90% stock - either some form of VTSAX or VIIIX as offered in my 401(k).  Some company shares from the employer match are around - I plan on moving them when they aren't at their current market low.  Market timing, sure, but I have plenty of time and my industry is in a rut right now.

Since I'm 10 years out from retirement, I'm hard pressed to care much about bonds right now when interest rates are so low.  Maybe in five years I'll adjust my 401(k) asset allocation to include 10-20 to smooth the ride.  My job is stable and I expect it to be around through the next market crash.

So, my 2015 savings plan is roughly this:
Max out 401(k) -> 18000
Discretionary savings -> minimum 12,000

(before you ask - I have a full PPO healthplan because of my health concerns, and no HSA.  Maybe next year, but probably not.)

That discretionary savings is at least 1,000/month and hopefully closer to 1,500/month as I tighten down my expenses.  But where should I put it?

Right now I have an automatic deposit into my Vanguard taxable brokerage account.  Should I put some or all of this automatic deposit into the after tax portion of my 401(k), and roll it into my Roth?  I know the Roth growth will be shielded from taxes, and that this is a very unique opportunity.  I also know that I have 10 years of upcoming taxes on my taxable account.  I was into the 28% tax bracket last year, and my salary will only go up until retirement.

But what about the flexibility of accessing my money pre five year conversion?  What can I count on touching, exactly, before my Roth Pipeline comes through?  Is there really an advantage if I keep my income low after retirement?

I've read a lot about this on the forum and elsewhere, and now I'm finally asking for your opinion based on my situation.  I hope it's not too much of a cop-out :)  Many thanks in advance!!

**made some edits to remove specific asset/income numbers.  I realized I can be rather identifiable on this forum for those that know me in real life!
« Last Edit: April 01, 2015, 11:41:31 AM by kmt88 »

Rein1987

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #1 on: March 19, 2015, 10:51:19 PM »
I had this similar question a few weeks ago. My answer for myself is take advantage of Mega backdoor Roth. In the worst case, you can take your contribution out, and pay the capital gain based on income. Since your ER expense is low, income tax is not much.

YTProphet

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #2 on: March 20, 2015, 06:27:09 AM »
I would do it. I think the concerns about the government doing away with Roth IRA's are somewhat legit, but that would create an absolute shitstorm from the voters if Congress decided to do it. That being the case, I'm not that concerned. Plus, you can't live life assuming the worst scenario is going to transpire.

I haven't read Go Curry Cracker's post you reference, but I don't see what his point is. There are basically four ways for your retirement money to be taxed: (1) Not on the front end, not during its growth, and not on the back end (HSA); (2) On the front end, not during its growth, but not on the back end (Roth IRA); (3) Not on the front end, not during its growth, but on the back end (401k); and (4) On the front end and at various times during its growth, if applicable (regular brokerage account). Obviously, Option 1 is by far the best, but you're very limited on how much you can contribute. Options 2 and 3 are the next best, because even in a worst case scenario where their tax benefits are removed, they just end up equal to Option 4.

nereo

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #3 on: March 20, 2015, 07:12:24 AM »
Just a few thoughts...
I've read up some on Mega-backdoor Roths, but since it doesn't apply to my current situation (no 401(k) option I'm far from an expert and won't comment extensively about the pros/cons.
However - a few things to consider:
1) what will have the greatest impact on your time to FI with your high salary is lowering your monthly expenses and increasing total monthly contributions.  This is especially important right now when you are still towards the left-side of the wealth-accumulation-curve.  Finding the most tax-effective strategy will help, but not nearly as much as simply saving more.
2) Since you are planning on retiring early with a substantial amount in taxable-investment accounts (quick calculation shows you could easily have an additional $200k in taxable accounts in 10 years, although it very easily could be a lot more), you would be a prime candidate for a roth-ladder conversion.  This could be an extremely effective way of keeping your tax burden extremely low during your retirement.  To that end it may not matter whether or not you do a mega-backdoor roth now or a roth-ladder later... you'll wind up pretty much in the same place choosing either path.
3) medical costs in the future is one of the "known-unknowns".  It sounds like you may have more extensive needs than most.  FireSIM can allow you to run simulations where you increase your spending down the road (e.g. add $5,000+/yr starting at age 50) to see how portfolios have held up historically.  You can also estimate current medical costs by going to healthcare.gov, but anyone who tells you it can accurately predict what costs will be 15+ years down the road is either ignorant or biased. 

hope that helps some
N

chops

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #4 on: March 20, 2015, 07:46:10 AM »
YTProphet - My understanding of HSAs are that you are taxed on the back end if you take out the $ for any non-medical expenses (and that it works similarly to a Trad IRA).  If you use HSA $ for medical expenses, then you are correct, the $ is never taxed.  Of course, if you can keep your income low enough (below 15% tax rate levels) in ER you are all set and would also not be taxed.

OP - So using HSAs may be able to help you (and all of us) with medical expenses in ER as whatever $ you can put into HSAs that is used for medical expenses is never taxed (not initially, not during growth, and not upon using it in ER future for med. expenses).  Also, if you do need to use the HSA $ for non-medical expenses, you just have to pay income taxes on it (which in ER may be zero as long as you stay below the 15% tax rate level).

 - Chops

kmt88

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #5 on: March 24, 2015, 11:18:51 AM »
Thank you all for the responses!  For reference, here are a few of the other threads I read prior to this post:
http://forum.mrmoneymustache.com/investor-alley/go-curry-cracker-roth-vs-taxable/
http://forum.mrmoneymustache.com/investor-alley/any-reason-*not*-to-contribute-to-roth/
http://forum.mrmoneymustache.com/investor-alley/potentially-all-savings-into-401kafter-tax-but-how-much-into-taxable/

Yes, the HSA could be nice but I am reluctant to hold a HDHP for right now.  I have at least one anticipated medical procedure that would kick me over the deductible already.  I kind of want my fancy healthcare plan until I have a better handle on my issues.  Maybe it's an emotionally driven decision though.  I haven't done a lot of calculations.  Thanks for the heads up on FireSIM having an 'increased annual cost' option so I can play around.

Definitely planning on the Roth conversation ladder (this is the same as the 401(k) -> Roth IRA pipeline, correct?).  Perhaps since I have ~10 years until retirement, the money I potentially put in my backdoor Roth now can be counted towards my 5 year waiting period funds?  So I'd use a combination of Roth principle + taxable accounts until my conversion is five years old?
I need to save annual expenses*5 years in accessible accounts over the next ten years. 

What do you think?  split the difference?  Get (annual expenses*5 years)/10 years into taxable and put the rest into my after tax contributions to put into Roth?  or vice versa?  Does it even matter?!

Rein1987, I think we are in similar situations and I appreciated your posts.  Did you decide to put everything into your mega backdoor Roth?  I'm not sure I understand your comment about paying capital gains on contribution if I take it out early - does early mean before 5 years?  Or am I missing something?

Thanks again everyone.



« Last Edit: April 01, 2015, 11:43:55 AM by kmt88 »

Rein1987

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Re: Case Study - To Mega Backdoor Roth or Not?
« Reply #6 on: March 24, 2015, 03:30:12 PM »

Rein1987, I think we are in similar situations and I appreciated your posts.  Did you decide to put everything into your mega backdoor Roth?  I'm not sure I understand your comment about paying capital gains on contribution if I take it out early - does early mean before 5 years?  Or am I missing something?

Thanks again everyone.

Yes, I decided to put everything into my mega backdoor roth, at least give this year a try.

If you take your capital gains out early, your gain will be taxed as income. I think it's after 5 years but before 59.5. For example, you contribute 10k to roth, and 6 years later you withdraw 20k. The first 10k is free. The second 10k will be taxed as if you have 10k income. I'm not 100% sure, but if you take it out before 5 years, you need to pay 10% penalty.

Roth conversion ladder for pre-tax 401k has 5 years waiting rule before you can withdraw the principle, and it's first come first out rule. In other words, for the money you convert to roth, you need to wait for 5 years before withdraw that money. But, if there are other contribution in roth earlier than that, you withdraw the earlier money first.




 

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