Riding Out a Mega Backdoor Roth IRA
A few months ago, we put up a post that highlighted how it is possible for families to setup a Tax Free Mega Backdoor Roth IRA. If you have not read that yet, you should check it out before reading this one because the intent is to build off that foundation. This topic is one of my favorites because it highlights the plan that my wife and I intend to execute at the end of this year when our house is paid off.
While the concept is really cool, one of the re-occurring questions that keeps getting brought up is “will this supplement Early Retirement for long enough to bridge the gap to 59.5 yrs old so that no penalties have to be paid?”. Today we will look at a drawdown strategy and see if the process can last someone until retirement.
Before we get started, here is another place to learn about the Mega Backdoor Roth IRA (MBDR) and below is a quick visual recap of the process:
Setup:
In order to setup this conversation, we will highlight 2 different scenarios:
Scenario 1: An ultra-saver who starts investing at 22 and maxes out the Mega Backdoor Roth IRA immediately. This individual will do no additional investing outside of the MBDR. They will continue the path until 34 yrs old and then 100% retire living off of these savings.
Scenario 2: Aggressive saver who maxed out the 401k from 22-30 but then upped the game from 30 – 35 to max out the mega backdoor Roth. They will then retire at 35 living off of their savings.
Assumptions:
- 401k limits will be frozen at 2021 limits for all years going forward
- Total contribution limits will be frozen at 2021 limits for all years going forward
- No employer match will be given to retirement accounts
- Rate of return on all investments will be 8%
- The Roth conversion ladder will be done at a fixed rate of $3500/month
- Drawdown will be fixed at $3500/month = $40k/yr. I did not use the standard 4% methodology adjusting for inflation over time because there is a circular reference in excel sheet that needs a solver macro. I am trying to avoid macros right now for simplicity…
- Upon retiring, both individuals will follow the same order of operations in their drawdown until those buckets are spent. They will then move to the next bucket:
- Equity portion of the MBDR conversion
- Equity portion of the 401K conversion ladder
- Interest that has been accrued in the Roth (this would be penalized if drawn out before ager 59.5)
Scenario 1:
As stated above, we will use Scenario 1 to see the results of an ultra-saver who starts investing at 22 yrs old. This individual starts out with a well-paid job and immediately maxes out the Mega Backdoor Roth IRA. They will do no additional investing outside of the MBDR and will continue the path until 34 yrs old. At that point, they will retire and 100% of living expenses will be funded from their savings.
The chances that this individual already has the income level as well as enough dependents to accomplish this process tax free may be a far stretch; however, we wanted to setup a scenario that has spans a long early retirement. Even if they are not able to get to a 0% tax rate, the same results can be accomplished if we assume that the individual’s salary is high enough that it accounts for the taxes on top of this investment path.
While building this, I had a hard time fact checking the model to make sure all of the phases hit correctly. To simplify it, I ran the model with 0% rate of return. I wanted to include it here because it is a great visual for how the mechanics of this process will work.
Chart 1:
In the chart you can see this saver is stashing their cash from 22 – 34 yrs old. Because this version of the model uses 0% rate of return, the total savings is $58k * 12 yrs = $696k. Once again, this was setup just to fact check the mechanics of the model.
- Red / Green Line – Represents the money going into the MBDR. The reason they overlap is because the red line is the principal portion and the green line is the total value including returns. Because returns are currently modeled at 0%, the values are the same. This bucket is drawn down to $0 value as the individual uses this money to cover the expenses in retirement.
- Purple Line – This represents the money that is saved in the 401k. Upon retiring, the money immediately begins a conversion ladder process of $3500/month so that it can begin aging.
- White/Orange line – is the converted side of the ladder. The money from the purple line is transferring into this bucket as part of the conversion ladder process. You can also see that once the 401k is fully converted, the value holds flat until the MBDR fund runs out. Once the MBDR has been used up, the retiree begins drawing out of this bucket and the value begins to drop.
- Blue Line – Represents the total value of the individuals net worth. Basically, this is just the total value of all of the accounts. In this chart, our early retiree runs out of money around 50 yrs old because he did not earn any returns on his investments.
Ok, looks like the model is responding the way it is supposed to. So, let’s complicate it and add in the 8% rate of return:
Chart 2:
First off, notice that we have no more overlap in the principal and total values:
- Red Line – MBDR principal still builds up until retirement. At retirement, it begins the linear drawdown until it runs out at ~45yrs old. The reason that process didn’t change, is because this is the principal portion only. The gains cannot be touched until after 59.5 without paying the 10% penalty.
- Green Line – This actually represents the total value of the Mega Backdoor Roth. Notice that its growth slows during the MBDR drawdown (34 – 45 yrs) due to the removal of principal as highlighted by the red line. Despite the slowdown, it does continue to grow as the remaining principal and returns continue to compound. Finally, at age 45, the drawdown in this bucket is over and the remaining returns continue to compound in the background.
- Purple Line – Represents the 401k. It grows until retirement and then is immediately laddered out to a Roth IRA until it is fully converted. The reason that the max value is more, and the laddering process is longer than in the first chart, is because of the 8% returns. It now takes until ~50yrs of age to fully convert vs ~40 yrs in first chart.
- White Line – is the conversion from the 401k. This represents the portion that is accessible (after a 5yr hold time). Notice that it flatlines around 45 yrs. What is the reason for this? It is because the MBDR has run out of principal to access so the 401k is laddering in at the same time the retiree is drawing it down. Because we assumed the ladder out would be the same amount as their living expenses, the net change to that bucket is zero. You can also see that once the purple conversion ladder runs to completion, (~50yrs) the white line starts to drop as the retire continues to use this bucket as the drawdown point.
- Orange Line – Represents the total value in the Roth conversion ladder bucket. It includes principal from the white line as well as the returns that are accrued over time.
- Blue Line – Represents the total value of the individuals net worth. Basically, this is just the sum of all of the accounts. 100% of this can be accessed without penalty after 59.5 yrs old.
Scenario 2:
Ok so maybe Scenario 1 seems a little extreme because of the aggressive timing to start the process (I will remind you the FIRE crowd isn’t your normal group of people though 😉). Let’s review what a less aggressive strategy would look like. In this case, we will use a saver who maxed out the 401k from 22-30 but then upped the game from 30 – 35 to max out the MBDR. This means that their first 8 years were spent on maxing their 401k, paying off any debt they have (student loans, mortgage, cars, etc), and starting the family that allows for the credits to do the process tax free.
I am not going to repeat the 0% chart that I have above because this scenario follows the same model. The only tweaks that have to be made is are:
- Starting age 30 for the model
- Starting 401k balance of $220k (8 years of $19.5k/yr @ 8% rate of return).
Chart 3:
- Red Line – MBDR principal value builds up until retirement. At retirement, it begins the linear drawdown until it runs out at ~39 yrs old.
- Green Line – This represents the total value of the Mega Backdoor Roth. Notice that in this scenario, the value of the bucket starts to drop (35 – 39 yrs) due to the fact it was not allowed to grow large enough to be able to sustain itself in drawdown. At age ~39, the drawdown is over and the remaining investment continues to compound in the background.
- Purple Line – Represents the 401k including the $220k that was saved before starting the MBDR process. It continues to grow until retirement and then is immediately laddered out to a Roth IRA until it is fully converted.
- White Line – is the Roth conversion from the 401k. This represents the portion that is accessible (after a 5yr hold time). Notice that it flatlines around 39 yrs. This is because the MBDR drawdown is over, so the 401k conversion is now the one funding retirement. During this timeframe, the laddering is occurring at the same time as the retiree is drawing it down. Just like the previous scenario, we assumed the ladder out would be the same amount as their living expenses. For this reason, the net change to that bucket is zero. You can also see that once the purple ladder conversion runs to completion (~57yrs) the white line starts to drop as the retire continues to use this bucket in drawdown. This covers the retiree well past the 59.5 age requirement.
- Orange Line – represents the total value the in the Roth conversion ladder bucket. It includes principal from the white line as well as the returns that are accrued over time.
- Blue Line – Represents the total value of the individuals net worth. Basically, this is just the sum value of all of the accounts. 100% of this can be accessed without penalty after 59.5 yrs old.
Summary:
The main question that we have received about the MBDR post is “Will the MBDR plan supplement Early Retirement for long enough to bridge the gap to 59.5 so that no penalties have to be paid?”. Based on these 2 scenarios, it definitely appears to be the case. It also provides a way to bridge the gap to accessing the Roth conversion ladder which is something we forgot to mention in the Tax Free Mega Backdoor Roth IRA post. The MBDR ages during working years. The 401k conversion ladder does not start aging until the conversions start. This presents a problem because most 401ks are locked until the person leaves the company and therefore cannot be rolled out until they hit early retirement. This is often bridged with an after-tax account but the MBDR solves with problem completely.
The more I dig into this process, the more excited I get about the MBDR. I think we have covered enough information for todays post but I have been challenged to do a side-by-side comparison of a MBDR+401k ladder to an after-tax Account/401k ladder to see how they compare. We will save that one for the future!
Until Next time, continue to Choose Beta
– Chris
