ROTH and Backdoor ROTH – The Ugly – The Good, The Bad, and The Ugly

This week I’m writing all about the good, the bad, and the ugly of a ROTH IRA or ROTH 401k. If you missed Part 1, the good, or Part 2, the bad, be sure to go back and check them out.

So now you know all about the good and the bad parts of choosing a ROTH IRA or 401k to invest your money. You might feel that now you have a more balanced perspective of when it can be a great idea, a so-so one, or a bad one. But we’re not done yet. Today I will talk about the top three ugly gotchas you need to look out for yourself, or warn friends about, when looking into a ROTH.

I’m not the only one who doesn’t think the ROTH is a magical, mystical investment that will bring you nothing but tax-free riches. Go Curry Cracker has a great breakdown of when (and why) a ROTH is a bad idea, and Financial Samurai is passionate about the ROTH being a vehicle for government malfeasance.

Too often, I’ll read click-bait style headlines on investment vehicles that read like they’re always great, or always terrible. But every investment option (even whole life!) has some circumstances where it makes sense for someone. What you need to figure out is whether you’re the kind of person it makes sense for. I hope by presenting some of this information, I can help you figure out what’s best for you.

So without further ado, the ugly parts of a ROTH.

Good bad ugly

ROTH – The Ugly

  • High earning years – Remember the discussion in the last post about how if the tax rates are equal in your contributing and withdrawal years, the ROTH and the Traditional come out exactly the same? It was important that you know this, because I see people recommending ROTHs to people in their highest earning years. And that’s just not a good idea, unless you’ve already maxed out your pre-tax investment space.
    • Do people really do this? In a word, yes. I have a friend that earns a high income (probably 250k per year household income) who was not maxing out his traditional 401k, but was playing around with doing a backdoor ROTH because he heard Jim Cramer talking about what a great idea it was. I’ve also seen people in online forums talking about how they’re trying to get their parents who are about to retire to contribute to a ROTH. Said parents are not high income earners, didn’t max out pretax, and will be likely living off of social security and minimal savings in retirement. Meaning they’re going to be in a lower tax bracket.
    • For a high earner who will likely be in a lower bracket in retirement, you need to max out your pretax investment options before starting to think about a ROTH. After you’ve maxed pretax, ROTH can be a great option. Or if you’re early in your career and your income will just go up, you’re good to go. But if you’re in your highest earning years, don’t go straight to the ROTH.
  • Backdoor Gotchas – Same friend who watches Jim Cramer wasn’t aware of the biggest backdoor ROTH gotcha. You can’t really do it if you have any traditional IRA’s hanging around.
    • OK, you actually can do it, but you need to watch out. If you have any traditional IRA’s, the IRS says that you can’t just convert your after-tax IRA. No, you have to act as if your conversion comes from all your IRA’s.
    • Lets say you have $95,000 in a traditional IRA, and $5,000 in an after tax IRA. You can’t just tell the IRS you want to convert your $5,000 to the ROTH. No, the IRS will tell you that 95% of your conversion will be treated like it came from your traditional, so you have to pay taxes on it. Only 5% of your contribution will be treated for tax purposes like it came from the after-tax IRA
    • Is there a way around this? Yes, you can roll your traditional IRA into your companies 401k, assuming that you’re currently employed. Then you’ll be clear to do your conversions. Check out this Forbes article for more info.
    • Inheritance-The original version of this article had a disadvantage to inheriting a ROTH as I had understood you couldn’t spread withdrawals over your lifetime, like you can with a traditional. After a comment from a reader I checked all the rules again and found out you can spread it. See this link from Schwab for more details.

So What To Do?

The answer is simple – it depends. When it comes to personal finance and investing, there unfortunately is rarely a perfect, one-size-fits-all answer. It’s actually one of the things people find frustrating. They may want a clear-cut, yes or no answer, or someone to just tell them what to do so they can go do it.

But there’s no right answer. You have to evaluate your specific situation-your income, future income prospects, retirement strategy, age, net worth, etc. – and the pros/cons of different investment options to make the most optimal decision in your specific situation. If you don’t want to do this for yourself, you’re best off hiring a fee-only financial planner to ask them to do it for you.

What I would ask of you is if you read a simple article that seems to be saying there’s some magical, perfect investment that will save taxes, grow your wealth exponentially, and make you a beautiful supermodel (OK, probably not the last one) you dig deeper to find the downsides. They’ll be there, and you don’t want to get hit with a surprise gotcha just because someone online wrote a too-simplified piece of advice.

Remember, if you missed Part 1 – The Good, or Part 2 – The Bad, you need to check them out!

So what do you think of the ugly parts? Anything surprising in here, or did you already know about them? I hope you enjoyed the series! Let me know in the comments.

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chiefmomofficer

IT professional, MBA, working mother of three, avid reader, geek and personal finance nerd

16 thoughts on “ROTH and Backdoor ROTH – The Ugly – The Good, The Bad, and The Ugly

  • December 1, 2017 at 12:58 pm
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    This was very insightful, CMO. There were so many things you noted that I wasn’t familiar with. Thanks for sharing!

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  • December 1, 2017 at 1:16 pm
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    Didn’t know the inheritance thing was only five years. I mean it’s still cool and all but I can imagine that being stressful if you don’t talk about it with the person who’s going to inherit the thing 🙂

    Overall I like Roth IRA’s as a potential tool but after reading this series and the Go Curry Cracker post I’ll likely rethink exactly how much I want to put into them.

    In general I think most folks forget a few things:

    – Marginal tax rate now vs effective tax rate in retirement
    – Cost of contributions (ie you pay taxes on the Roth contributions as you outlined so you can’t just compare 5500 vs 5500)

    Thanks for the good series!

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    • December 1, 2017 at 1:19 pm
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      I think they can be a great tool too, as long as you do the analysis on the right uses for it. It’s odd to me just how often people don’t talk about the downsides or potential pitfalls. And yes it’s still great to inherit a tax free account! But if the inheritee is really young, they might be better served by inheriting a traditional and taking only their RMD for decades.

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  • December 1, 2017 at 1:36 pm
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    Are you sure about the 5 year deadline on ROTH withdrawals when inheriting? I “thought” that the whole idea behind inheriting a ROTH was that you could stretch out the payouts, even extending them to grandchildren. There is a 5 year limit on regular IRA’s, but that’s an option, depending on how you retitle the inherited IRA–my understanding from reading other financial blogs/sites

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    • December 1, 2017 at 1:56 pm
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      Thanks so much for the comment-my original research showed that wasn’t an option for the Roth, but after you posted this I went to look again and found it. I’ve updated the article-thanks again!

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  • December 1, 2017 at 1:47 pm
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    Hi Liz, this was probably the best piece in the series. For me that’s because I didn’t know about the inheritance gotcha! Speaking of the pro-rata rule, do you know if this applies to the MEGA backdoor? I think it doesn’t, but I thought I would ask.

    Lastly, here is one of the used book stores that I was mentioning. I may have to stop by this myself in the future: https://www.yelp.com/biz/house-of-our-own-philadelphia

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    • December 1, 2017 at 2:26 pm
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      I updated the inheritance part, made a mistake there 😞 But big thanks to a reader for commenting to have me do more digging!

      I personally find the mega-backdoor ROTH auto be confusing. First, I don’t really know of any employers that let you do in-service withdrawals (although I know there are some). And the IRS guidance looks like you do have to take out your pretax at the same time, which means the pro Rata rule applies to your 401k. Which might be OK if you have zero pretax but I would think most high earners have significant pretax 401k savings. https://www.irs.gov/retirement-plans/rollovers-of-after-tax-contributions-in-retirement-plans

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      • December 1, 2017 at 2:29 pm
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        Ah, thanks for letting me know! 🙂 This stuff is confusing, that’s why we are all helping each other out!

        Megabackdoors make my head hurt. But the last conversation I had with my 401 admin, was that since late 2015, if your company allows it (read pays for extra accounting) then you can only roll after-tax. I think that you pretty much have to work for mega corp, investing in mega 401 provider to have this option right now.

      • December 1, 2017 at 2:42 pm
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        I’ve only worked for mega corps, and neither one has let you do an in-service withdrawal. The IRS guidance seems to specifically say about mid-way down that you CANNOT just roll your after tax.

      • December 1, 2017 at 4:42 pm
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        Whew, you really got me going this morning with your comment. After some long calls to my admin, the conclusion is that it depends on your plan. Your company has wide latitude on the rules.

  • December 1, 2017 at 2:29 pm
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    You make an excellent point about PF articles that will oversimplify financial products and investment vehicles. Like you said, articles of that nature are ubiquitous. Probably because people just want binary guidance. It’s either good or bad. Do this, don’t do that. The challenge is actually weighing the pros and cons and considering how they fit into your own life. It’s nice to see you’ve taken the time to approach the Roth IRA question from a variety of angles. I enjoyed this series and learned quite a bit!

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    • December 1, 2017 at 2:43 pm
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      You’re right, people usually want a black/white answer when really things are more grey. Glad you’ve enjoyed the series!

      Reply
  • December 2, 2017 at 1:33 pm
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    I 100% agree it is best to use tax advantage accounts first. One friend who asked me about investing bartends, so no 401k available. She is also in a place where while she might not max 5500, the wiggle room of a relative chipping in could be advantageous. A former coworker is another person who asked for info, and is younger than me (it was her 1st job out of college). The discussion was, 401k to the match first, and this is what a Roth is. She had been 100% just employee stock purchase plan. Some people don’t know about the differences or options.
    Early on I personally found a 401k daunting because your money is ‘locked away’, and for someone new to investing or early in their career, 18k is daunting too. That could be the replacement car for the one you are driving that keeps stranding you at really bad times. I figure if my friends are interested enough I’ll present both 401k (and the idea of solo 401k/ Sep IRA if appropriate), and the Roth. It is still personal finance, I just want them to have the info. 🙂

    Reply
    • December 2, 2017 at 1:38 pm
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      Makes sense to me! I think the 401k to the match and then the ROTH aka the best strategy when you’re right out of college, and of course if you don’t have a 401k or match a different strategy makes sense. That’s actually why I don’t like articles that say “X investment strategy is the way to go!” like it’s a black and white answer. The answer is almost always “it depends”-on your current and future income, current and future tax projections, what investment options you have available, whether or not you have a match, etc. I think that’s one of the reasons people find personal finance so complex, they need to do a lot of self-education before knowing the path to take. And their path needs to change over time.

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    • December 2, 2017 at 4:49 pm
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      Thanks! I’m glad it was helpful. The backdoor pro-Rata rule is something that people sometimes forget to talk about when they discuss the backdoor ROTH. I know my friend was totally unaware until I told him about it.

      Reply

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