Maybe the last ten individual tax returns I’ve signed? They all included a backdoor Roth IRA.
That got me thinking: How much tax do you really save with a backdoor Roth? And the answer: Probably not as much as you hope.
But let’s start with an overview of how Roth IRAs work. And then I’ll show you how a tax accountant calculates the tax benefits of a Roth IRA conversion, aka a “backdoor Roth.”
First a Quick Explanation
A Roth IRA lets you contribute money to a special version of an IRA, or individual retirement account. You don’t get a tax deduction in the year you make a contribution to a Roth IRA. But as long as you follow the rules, you don’t ever pay income taxes on your Roth IRA’s earnings. Or when you draw money from the account.
You do not, for example, pay income taxes when/if your Roth IRA earns dividends and capital gains that first year, the second year, and so on.
Even better? In retirement, so maybe two or three decades from now, you do not pay income taxes as you draw the money you contributed. Or draw the profits your investment earned over the years.
That all sounds good. But not every taxpayer gets to make regular contributions to a Roth IRA. For 2023, a single taxpayer can’t earn more than $138,000 and a married couple can’t earn more than $218,000 and make a full Roth IRA contribution. (In 2024, those limits rise to $146,000 and $230,000.) Also as you cross those income limits, the amount you can contribute to a Roth IRA phases out. (More details here.)
Which is where the backdoor Roth IRA comes in…
How Backdoor Roth IRA Works
If high income taxpayers can’t contribute directly to a Roth IRA, they usually can contribute money to a nondeductible IRA. Even if they have a regular retirement plan at their job.
They then can convert that non-deductible, non-Roth-IRA account to a Roth-IRA account. And that two-step dance allows a higher-income taxpayer to get money into a Roth IRA. Thereby dodging the income limits I mentioned earlier.
A final important point: As long as the person doesn’t hold other traditional non-Roth-IRA IRA balances? She or he moves the money into a Roth-IRA account without paying any income taxes.
Calculating the Front-end Annual Tax Savings
But the idea doesn’t work as well as you might hope. Most people don’t save much tax during the years they work using a Roth IRA. Or using a backdoor Roth IRA.
Let’s look at the numbers for 2023 for a typical taxpayer aged 49 or younger who can “backdoor” $6,500 into a Roth IRA and then avoid income taxes on the earnings.
While the $6,500 might earn, say, five percent or $325 the first year? An investor investing outside of a Roth IRA wouldn’t have gotten taxed on the full $325. Rather, she or he gets taxed on just the dividends and realized capital gains. And probably that fraction of the return? Only lightly taxed.
Note: I use five percent as the rate of return because after rounding the Vanguard Group expects that return over the next decade.
The taxed dividend yield on a US stock market index fund like Vanguard’s Total Stock Market, probably runs roughly 1.8%. On a $6,500 Roth IRA, that means taxable income of maybe $117 the first year.
Most taxpayers won’t even pay taxes on that income. But at a 15% qualified dividend tax rate—so for example married people making more than $123,500 adjusted gross income in 2024—the first year savings equal about $18.
That annual savings amount grows over time if someone keeps on “backdooring”: $36 in year two, $55 in year three, $75 in year four, and so on.
After two decades of steady backdoor Roth IRA contributions, the annual tax savings might be $500 to $600 annually. Which is pretty good. But maybe not great.
You would not want to pay an accountant $200, $300 or $400 an hour or pay a financial planner 1/2% or 1% fee to help you harvest these sorts of modest savings.
Calculating Back-end Roth IRA Tax Savings in Retirement
Fortunately, the back-end tax savings of a Roth IRA look better. Use a Roth IRA and in retirement, you won’t pay income taxes when drawing down the money.
An example illustrates this: Say someone saving $6,500 annually faces two choices: Invest money using a backdoor Roth IRA or invest money using a regular old taxable account. To keep this all apples-to-apples, assume something like the Vanguard Group’s Total Stock Market Fund.
If the investor earns five percent return annually and pays a 15% tax rate, they end up with almost identical balances after two decades. The Roth-IRA balance equals $226,000 and the taxable account balance equals $219,000. (The $7000 difference reflects that annual income tax bill. And, yes, I’m rounding.)
But here’s the thing: The Roth-IRA investor can draw the entire $227,000 balance without paying income taxes.
In comparison, if the “taxable account” investor draws the $219,000? She or he may trigger long-term capital gains taxes on the unrealized gains, or appreciation, in the account. Those unrealized gains which may get taxed equal roughly $53,000 using the assumptions provided earlier.
How much tax would someone pay on $53,000 of long-term capital gains in retirement? You have to do the accounting carefully.
A middle-class taxpayer and even some upper-class taxpayers might pay zero taxes, as noted earlier. And so most people, especially in retirement, could draw down a large taxable account without paying income taxes. Especially if they drain the account over multiple years.
A high-income taxpayer, in contrast, might potentially pay a 15% or even 20% capital gains tax. She or he probably also will pay the 3.8% Obamacare tax. That would mean an $8,000-ish to $13,000-ish total tax bill.
But often even these folks have good ways to dodge this tax bill. Spreading realization of the gain over a few years. Using some of these funds for charitable contributions. Leaving the money for their heirs which would let them entirely avoid paying taxes on the gain.
Closing Comments and Caveats
Given the above? I don’t find backdoor Roth IRAs particularly compelling. Sorry. But, three final thoughts:
First, if you expect higher returns? Or if inflation runs hot? (The inflation rate embedded in that five percent return from Vanguard runs between two and three percent, by the way.) In those scenarios, the tax savings from a Roth IRA get better.
Second, I think you don’t do this for only a year or two. Rather, you do something like this over decades. That’s the way to snowball the benefits. You’re working the compound interest engine when you do this.
Third, finally, this awkward acknowledgement. Most people don’t earn enough or accumulate enough to pay the sorts of taxes a Roth-IRA account saves. Especially in retirement. Therefore, backdoor Roth IRAs really only make sense for high-income taxpayers who can confidently look forward to high-income lifestyles in the final chapters of their lives.
Note: We’ve got several blog posts that describe the economics of what one might label, ‘”Frontdoor” Roth IRAs and Roth 401(k)s: Are Roth IRAs and 401(k)s Really a Good Deal?, Worst-case Scenarios for Roth-style Accounts, and The Only Times You Want to Use a Roth-style Account. If you found this blog post interesting, you might also find those interesting too.