Author Topic: Mega Backdoor Roth/Roth IRA Conversion Pipeline Question  (Read 1463 times)

kasperle

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Mega Backdoor Roth/Roth IRA Conversion Pipeline Question
« on: November 10, 2017, 11:20:43 PM »
Hi Mustachians!

Although Iím many years away from FI, I want to make sure that I have the right understanding of some of the tools I plan to use once FIíd. Iíve been reading all day about the mega backdoor Roth and the Roth IRA Conversion pipeline, but I havenít been able to find an answer to one specific question.

The question is: after performing a Roth IRA pipeline conversion, and waiting 5 years, what happens if you let the money grow rather than withdrawing it immediately? Do the gains follow the same Roth IRA rules, or is that somehow exempt?

My current understanding is that the gains would not be exempt, and that you would have to pay taxes on them as well as the early withdrawal penalty of 10%. Is this right?

The reason I ask is that this seems to have implications for the Mega Backdoor Roth. The investment order post,

https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153

lists the mega backdoor roth above taxable plans. However, letís assume that Iím more than 5 years from FI, yet Iíve already started contributing through the Mega Backdoor Roth. As I understand it, the 401(k) in-plan Roth conversion also starts the conversion pipeline. In other words, if I have a $5k mega Backdoor contribution, then I can withdraw that $5k tax and penalty free 5 years later. But if Iím 10 years out from FI, then that money would actually sit for 10 years, and likely have some growth. If Iím only able to withdraw the initial $5k without paying taxes and penalties, then how is this approach better than a taxable account?

I feel like I must be missing some key piece of information here. Investment pros: what do you think?

Thanks for reading!

MDM

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Re: Mega Backdoor Roth/Roth IRA Conversion Pipeline Question
« Reply #1 on: November 11, 2017, 12:16:52 AM »
Hi Mustachians!

Although Iím many years away from FI, I want to make sure that I have the right understanding of some of the tools I plan to use once FIíd. Iíve been reading all day about the mega backdoor Roth and the Roth IRA Conversion pipeline, but I havenít been able to find an answer to one specific question.

The question is: after performing a Roth IRA pipeline conversion, and waiting 5 years, what happens if you let the money grow rather than withdrawing it immediately? Do the gains follow the same Roth IRA rules, or is that somehow exempt?

My current understanding is that the gains would not be exempt, and that you would have to pay taxes on them as well as the early withdrawal penalty of 10%. Is this right?
Yes.  If your cumulative withdrawal amount is less than or equal to the total of your contribution and 5+ year-old conversion amounts, however, you are deemed not to have withdrawn any gains.

Quote
The reason I ask is that this seems to have implications for the Mega Backdoor Roth. The investment order post,

https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153

lists the mega backdoor roth above taxable plans. However, letís assume that Iím more than 5 years from FI, yet Iíve already started contributing through the Mega Backdoor Roth. As I understand it, the 401(k) in-plan Roth conversion also starts the conversion pipeline. In other words, if I have a $5k mega Backdoor contribution, then I can withdraw that $5k tax and penalty free 5 years later. But if Iím 10 years out from FI, then that money would actually sit for 10 years, and likely have some growth. If Iím only able to withdraw the initial $5k without paying taxes and penalties, then how is this approach better than a taxable account?
Withdrawing every dollar prior to age 59.5 wouldn't leave much for the years after that.

Are you expecting to require withdrawal of more than the contribution+conversion amounts prior to age 59.5?

See Two 5-Year Rules For Roth IRA Contributions & Conversions for a good overview (except ignore the concern about the step transaction doctrine).

kasperle

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Re: Mega Backdoor Roth/Roth IRA Conversion Pipeline Question
« Reply #2 on: November 11, 2017, 03:34:28 PM »
I appreciate the thorough reply, MDM. That article you linked was very informative; easily the most detailed article Iíve read about this subject.

The part that surprised me is this relevation: given an investment that returns 7% year over year, and a 4% withdrawal, all pre-retirement age withdrawals from that investment will typically be covered within the principal. In hindsight, this makes sense, given that a 4% withdrawal rate on any invested amount gives you 25 years of withdrawals from that number, and 59.5 - 25 is a cool 34 1/2 years old.

The downside is that this only allows you to consider the principal in your 4% withdrawals. So if you contribute $100k through the Mega Backdoor Roth, and it balloons to $200k in value, you could blow through that $100k converted amount before 59.5 if you consider the entire $200k as what youíre withdrawing 4% from. It seems like a way around this is to weight the withdrawals from your accounts.

To put some more numbers behind that last paragraph, letís consider the example above where you converted $100k, and the value of the investment has doubled to $200k from gains. 4% of $200k is $8k, but youíll run out of your $100k converted principal after only 12 years with a withdrawal that high. So, if youíre 34 1/2, perhaps you withdraw only 2% from this account each year so that the principal lasts you those 25 years before youíre 59 1/2. And to offset the missing 2%, you would withdraw more than 4% from your other accounts.

Is this approach typically how someone makes this work?
« Last Edit: November 11, 2017, 03:58:24 PM by kasperle »

MDM

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Re: Mega Backdoor Roth/Roth IRA Conversion Pipeline Question
« Reply #3 on: November 11, 2017, 10:06:26 PM »
This particular post: What do people mean when they say their SWR is X% or they have X times expenses? - Bogleheads.org gives a defensible procedure:
Quote
If X is the before tax annual amount I need to have, Y is the number of years before I withdraw my social security (SS), then my Financial Independence amount would be:

FI = XY+33(X-SS)

You could make the formula more complicated to cover more scenarios including spousal benefits, pension, annuities, etc. Or change the withdrawal rate from 3% (or 33 in the formula) to 4% (or 25).

The rest of the thread gives examples of diversity of thought on this issue.

kasperle

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Re: Mega Backdoor Roth/Roth IRA Conversion Pipeline Question
« Reply #4 on: November 12, 2017, 09:55:31 AM »
Thanks for the link, MDM. Very helpful. Although Iím valuing Social Security at $0, I think a similar approach to the formula you posted would be useful for me.

I kept reading around to find more information about this issue, and I found these two posts to be useful. The first:

Drawdown Part 3: Strategy

includes a chart that seemed relevant:



This chart demonstrates that itís alright to pull money out of different sources throughout your early retirement. This was something I had already read was a typical part of utilizing the Roth IRA Conversion Pipeline, but visualizing it was useful to see, particularly the fact that the taxable account gets completely drained early on.

The second post I read that was helpful was:

Drawdown Part 2: Simulation

This one links out to FireCalc simulations. FireCalc makes the assumption that your entire portfolio is accessible prior to age 59 1/2, without any penalties (even if you go through roundabout systems like the Roth conversion pipeline). Mega Backdoor Roth gains donít fit into that category, because thereís no way to get them out without paying taxes on the gains plus the 10% penalty.

This could have consequences on some of the ďsuccessfulĒ simulations through FireCalc, I think. If a dip ever made it so that you have to withdraw a Mega Backdoor Roth contribution before 59 1/2, it would drain your stash much sooner than the FireCalc simulation shows. This adjustment becomes more important for folks who have larger percentages of their retirement in the Mega Backdoor Roth.

By my estimate, my own backdoor Roth contributions will make up about 10% of my stash post-FIRE. But some folks who follow the investment timeline linked in the opening post could have as much as a third. Consider someone who:

1. Invests $18k in a 401(k) pretax, with a $5k match from their job
2. Invests $5.5k in a traditional/Roth IRA
3. Invests $32k in a backdoor Roth to max out their 401(k) contributions
4. $0 in a taxable account, because they have no more money to invest

This would leave them with a portfolio that has 37% mega backdoor Roth contributions, assuming equal gains across these accounts. Iíd be curious to see if a modified FireCalc would succeed in fewer situations with this portfolio compared to someone who put at least some of that backdoor Roth into a ďregularĒ taxable account.

Maybe Iíll put that together a modified FireCalc that incorporates this.