Retirement: Holy Grail of Investing - Roth IRA
Take Advantage of Tax Free Returns in Retirement
I’ve always maintained that a tiny bit of financial engineering can make you 20-30% richer in retirement and that “financial engineering” is something as simple as contributing to a Roth IRA.
Holy Grail of Investing:
I pride myself in my ability to find critical, high impact ideas that can deliver outsized returns. I am continuously reading and trying to learn more to find an edge. I am testing multiple strategies at any given moment. And in my years of persuasion, I found what I consider to be the Holy Grail of investing: Tax Free Returns thanks to Roth IRA.
I had known about Roth IRAs for a few years when in late 2021, Congress tried to pass a bill that would kill the Mega Backdoor Roth. This created a sense of urgency for me and I put in the time to understand it and have since built a pretty good Roth IRA portfolio. 10% of my retirement money is invested in a Roth IRA.
What is a Roth IRA?
A Roth IRA is an individual retirement account (IRA) that allows you to contribute after-tax dollars and enjoy tax-free growth and withdrawals when you qualify.
You can withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free.
However, you may have to pay taxes and penalties on earnings in your Roth IRA, unless you are at least 59½ years old and have owned the Roth IRA for at least five years.
So, theoretically let’s say for 30 years you invested $100K in a Roth IRA and it grows 10x to $1 Million when you are 60. You will pay NO TAXES on the entire $1 Million.
The $100K you invested, you already paid taxes on it when you invested it, and
You don’t pay a dime for the rest of the $900K
And that is the Holy Grail of investing!
Who is eligible for a Roth IRA?
Generally only taxpayers whose modified adjusted gross incomes (MAGI, i.e., AGI adding back certain deductions and exclusion) are below statutory ceilings—$228,000 for married couples and $153,000 for single taxpayers in 2023—are permitted to create a Roth IRA and can contribute $6,500/year ($7,500/year if you're age 50 or older).
Mega Backdoor Roth:
However, in reality, there are a variety of ways in which taxpayers whose incomes exceed the limit can find legal routes to benefit from Roth vehicles. One such way is using the Mega Backdoor Roth.
Whether you are eligible for a Backdoor Roth or Mega Backdoor Roth depends on your employer and your retirement plan. You need to be able to do two things:
Your retirement plan should allow you to contribute to your Post-Tax 401(k)
Your retirement plan should allow a Roth 401(k) with the option for in-plan Roth conversion and/or In-service withdrawal of after tax contribution (plus attributable prorated earnings).
If you have the ability to do these two steps, you NEED TO start building your Roth portfolio now.
Two Steps To Get Started:
Start contributing to your Post Tax 401(k) and
Turn on automatic rollover to Roth
How Much Can You Contribute towards Roth IRA using the Mega Backdoor Roth?
In 2023, you can contribute a maximum of $66,000 towards retirement (if you are under age 50) (or $73,500 if 50 or older). So technically, after maxing out your 401(k), in 2023, you could contribute 43,500 towards your Post-tax 401(k) which will roll over to Roth IRA.
Source: Fidelity
401(k) Vs Roth IRA:
The most common argument for investing in a Roth IRA is that taxes are likely to be higher in the future and if that is indeed the case then paying taxes on your incomes and letting it compound for decades is recommended. However, this can differ on a case by case basis. If you don’t see your taxes higher in the future, then Roth IRA might not be the best bet for you.
Please consult a certified financial advisor to help you decide what’s best for your individual circumstances.
A second thing to take into consideration is your employer match. If your employer is giving a good match on your pre-tax 401(k), then that is where your $$ should be flowing first. I would say anything close to or above 10% might be worth taking, given that is the long term average returns the stock market has delivered. You are essentially getting that money for free.
For anything below 10%, given that this money is going to be locked up till retirement and will compound for decades (depending on how long you want to stay exposed to the markets), I'd rather have a higher percentage of my retirement money go into a Roth IRA.
I would also be careful to not conflate Roth IRA with your normal brokerage account. You cannot access the earnings you put in your Roth IRA until you are 59.5 years of age and have had your money invested in the Roth IRA for at least 5 years, without taxes and penalties (You can however withdraw contributions you made to your Roth IRA anytime, tax- and penalty-free). So, if you will need liquidity before you reach 59.5 years of age, make sure to take that into consideration.
I prefer having a balance between my pre-tax and tax-free retirement accounts instead of having all my money in one because I don’t know what my tax situation in the future will be and I want to have optionality.
How to Maximize Your Roth IRA Returns:
Given how strategic Roth IRAs are, I’ve also developed a few types of investments that can help maximize returns given the returns are tax free. (This is by no means an exhaustive list, just some ideas I found useful).
REITs: REIT’s often payout non-qualified dividends which are taxed as ordinary income. In a world where I could benefit from capital gain, I don’t want to pay ordinary income tax. Which is why experts recommend holding REITs in tax-free accounts. I did an analysis where I compared REITs and mREITs to find the best Real Estate Equities and ETFs: Real Estate Investment - Without The Baggage.
Small Cap High Growth Stocks: If you have an instrument that promises you tax free returns, it would be a shame to not put some portion of that money towards high conviction growth picks. Something you think could go 10x or even 100x by the time you retire. After all, that is where you might get the most juice from. But be careful, there is no tax-loss harvesting in Roth IRA, so not losing money in a Roth IRA account is priority #1. I write about secular growth and you can access all my picks from here for free (Free at the time of publishing, could change in the future).
Short Term Trades: If you run multiple strategies like me, then you have some high conviction picks that eventually pay off but are almost always short dated and therefore not eligible for capital gains. I avoid options in my Roth IRA because it is hard to not lose money in options and not losing money is priority #1. I often use leveraged tickers in a long only strategy. I haven’t written about this yet, will link to it if I do in the future.
Mega Backdoor Roth Is Legal, For Now
As mentioned earlier, there have been attempts in the past (most recently in 2021), when a proposal to remove the Backdoor Roth was part of the Build Back Better Plan that passed the House in 2021 but never passed out of the Senate.
The 2024 Biden budget includes the language: “Prevent excessive accumulations by high-income taxpayers in tax-favored retirement accounts and make other reforms”
Source: 2024 Biden Budget - Page 162
I would not be surprised if the Mega Backdoor is removed in the future. However, as long as it exists, I would encourage you to take advantage of it and build a balance between your Tax Deferred and Tax-Free Retirement Portfolios.
Difference Between Backdoor Roth and the Mega Backdoor Roth
The backdoor Roth IRA is best for converting money from a traditional account to a Roth. Meanwhile, the mega backdoor Roth is most suitable for high earners who want to contribute more than the typical contribution limit.
My Retirement Positioning:
As mentioned earlier, over the last 2 years, I have increased the Roth IRA share of my retirement account to 10% and will continue to grow it. I don’t mind it if it can get to 50% of my retirement, given I invest a very tiny amount of my income to my Roth IRA today.
This article is 1 of 2 a part series on retirement. I recently learned shocking details about my retirement income which led me to make some big changes to how I manage my retirement account. I will elaborate more on this in my next article.
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Please take note that some of these are taxable events and please consult your tax consultant and certified financial planner before making any changes to your account. This is not investment or tax advice.