There are generally two types of retirement accounts in the U.S. The first are accounts that allow you to contribute pre-tax dollars (which can be deducted) such as 401(k)s and Traditional IRAs. Gains within the account are not taxed. All distributions from the account will be taxed at your ordinary income rate at the time of distribution.
The second are accounts that allow you to contribute post-tax dollars such as a Roth IRA. Gains within the account are not taxed. The benefit of the Roth account is that no distributions are taxed (including any embedded gains).
A lot of sites will run numbers to help determine which account is right for you. That will depend on your current tax rate (the higher it is, the more advantageous to use a 401(k) or Traditional IRA so you can contribute pre-tax dollars) and your expected tax rate in retirement when you start getting distributions (the higher it is, the more advantageous to use a Roth IRA so you can tax distributions tax free). It will also depend on your expected investment return, because a key advantage of the 401(k) and Traditional IRA is that you are able to capture decades of investment returns on the amount that would have been payable to the government in taxes in the year earned.
These comparisons often miss the obvious point that the optimal strategy may be to contribution a portion of your retirement savings to both types of plans so that you are reducing the amount of income you have at your top marginal income tax rate both now and in retirement. All things being equal, it’s better to reduce income at the top marginal income tax rate than at lower rates.
The problem then is that you can only contribute to a Roth IRA if your modified adjusted gross income is less than $135,000 (single) or $199,000 (married filing jointly) in 2018. There is a workaround, however, called the “Backdoor Roth”. This allows you to contribute up to $5,500 ($6,500 if you are over 50) to a non-deductible Traditional IRA and then immediately convert that IRA into a Roth IRA. Presto, you have a Roth IRA. Do this every year and you will build up a nice sized balance (and remember, the original contribution amount in a Roth IRA can be withdrawn without penalty if you need it in early retirement!).
I don’t have any idea why Congress would put income limits on the ability to contribute to a Roth IRA and then permit them to be evaded so easily, but there you have it.
The key to the Backdoor Roth is that you don’t have any other IRA accounts at the time of conversion. If you do, the rules require that you calculate the conversion amount pro-rata amongst all of your IRAs, which is no good.
In a subsequent post I’ll explore some less widely understood ways to get money out of your IRA early without paying the penalty.
As always, please note that I am not a tax professional and have no idea what I’m talking about. Please consult your tax advisor.