One easy trick can save you millions of dollars in 5 minutes!

Let’s imagine that I make an after-tax contribution to a Traditional IRA in the amount of 3000 (perhaps a rollover from a previous employer or regular contribution if I am over the limit for a direct Roth IRA contribution).

Let’s further assume that I invest this in VTSAX and have a time horizon of 45 years that grows the investment to 63,000 dollars (21 times your money). When withdrawing this sum, I will thus be taxed on 60,000.

Less taxes, please

However, I can actually save nearly the entire amount I will pay in tax by converting to a Roth IRA. When withdrawing from a Roth IRA, the withdrawls are tax-free (assuming I follow the guidelines for withdrawl).

All I need to do is rollover my traditional IRA to a Roth IRA. This is called a backdoor conversion. Vanguard’s IRA accounts make this very easy - I can request a rollover with the click of a button and even invest the money in the market before it hits the Roth IRA. In under 5 minutes, I was able to request the rollover and designate what funds they will be invested into the Roth IRA.

When I rollover my IRA to a Roth IRA, I am of course taxed on the capital gains I have incurred so far. Note that this isn’t the entire 3000 principal. If I roll over the day I contribute to the Traditional IRA, my tax liability will be a couple of cents at most. The longer I wait to roll over, the higher my tax liablity is, so the sooner I rollover, the better (this also relates to the caveat below).

How much do I actually save??

In this hypothetical scenario, let’s assume that I withdraw at a rate of 100,000 a year in retirement and live in CA. With nearly zero effort, I have saved mt future self 29,000 in taxes according to this calculator by paying at most a couple of cents today.

Since I can make this move every year, it makes sense to extrapolate the total savings a Backdoor Roth can save over the years. Taking my mean time horizon until retirement as \(\frac{n(n+1)}{2n}\) with \(n = 45\), my mean time horizon is \(23\) which means I save 14,200 per year in expectation or a total of 639,000 in taxes (I didn’t do the math but my gut tells me this estimate is lower than the true value \(3000 \sum_{i=1}^{45}(1.07^i)) - 45*3000\).

One last thing…

The limit that you can rollover to a Roth IRA is actually 6000, not 3000. Therefore using the same exact strategy, one can save a whopping 1.56 million in taxes over the given time horizon. Due to inflation and catch-up contributions increasing this limit, this value is a lower bound in taxes saved.

Caveat

When conducting a Backdoor Roth IRA, I would need to be aware if I have transferred any previous employer’s 401(k)’s to a traditional IRA and let them grow over a few years. By the pro-rata rule this would subject me to present taxes. In particular, I would be taxed on 1 - the proportion of the total IRA that is rolled over (and your tax-deductible contributions count to this!!!!). This is why I strongly believe in not transferring your old 401(k)’s to an IRA.