028.Order of Operations.The Roth IRA

028 | Order of Operations | The Buckets | The Roth IRA

In today's podcast we discuss the four different “buckets” available to savers plus an in-depth look at the Roth IRA and the ‘Backdoor Roth.'

In Today’s Podcast we cover:

  • The order of operations for how you should approach the different “buckets” available to you both for retirement accounts and for your taxable savings
  • Four basic ways for your retirement and investment funds to be taxed
  • Best case is an account similar to the HSA which is not taxed when you put the money in nor when you pull it out
  • Option 2 is the Roth IRA which is taxed upfront but not when you pull the money out
  • Option 3 is a traditional IRA, 401k, etc. where it is not taxed when you contribute but is taxed when you withdraw
  • Option 4 is your regular savings/investment accounts
  • We focus mostly on tax-deferred retirement accounts because that is the best way to lower your taxable income in the current year and reduce your tax liability. Because of advanced FI concepts such as the ‘Roth IRA conversion ladder’ there is a chance you can pull this money out nearly tax free once you reach financial independence
  • You want to max out your tax-deferred options
  • The FI community looks at this problem differently than traditional financial planners and doesn’t focus on the Roth IRA generally
  • Roth IRA makes sense if you are nearly certain that your tax rate will be higher in retirement than it currently is now (think children under 18)
  • The issue is this is unknowable at the time of contribution (unless you are at a 0% rate)
  • You can pull out your Roth IRA contributions at any time tax and penalty free
  • Flexibility of your bucket #4 (taxable savings) is a big positive of that investing option over a Roth IRA
  • The concept of a marginal tax bracket and an understanding of how your income is taxed
  • Financial planners focus on the ‘tax diversity’ play of the Roth versus traditional retirement accounts
  • Income limitations do exist for the Roth IRA
  • There are also contribution limitations yearly for these accounts
  • How to reduce your Adjusted Gross Income on your tax return to qualify for a Roth IRA
  • The Backdoor Roth IRA option for high income individuals
  • Discussion of the White Coat Investor article on the Backdoor Roth IRA and how you can convert your money from a nondeductible traditional IRA to a Roth IRA (the ‘backdoor’ Roth)
  • Avoiding the pro-rata calculation
  • How to contribute to the traditional IRA account as a nondeductible contribution and then convert it to a Roth

Links from the show:

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13 thoughts on “028 | Order of Operations | The Buckets | The Roth IRA”

  1. Hi guys – is there a limit to the backdoor ROTH IRA contribution? It’s $5500 ($6500 for over 50) limit for “front door” ROTH IRA contributions, but I don’t think there’s a limit to the backdoor ROTH. Is that correct? Thanks!

  2. I found this very interesting, and although I did read the white coat investor tutorial article, I found it a bit over my head. Michael Kitces did a great job explaining it in case anyone else needs to hear it from another angle, as I did.
    I was hoping that the backdoor Roth would allow one to convert an old 401K, now an IRA rollover, into a backdoor Roth. That is, if I have a $30,000 IRA rollover, I would be able to convert it to the backdoor Roth ….or at least that’s what I was hoping!

    • The Rollover IRA could be converted to Roth, but you would owe taxes at your marginal tax rate to do so.

      Having the tax-deferred rollover IRA prevents you from being able to make a tax-free “Backdoor Roth” contribution due to the pro rata rule. I hope that helps.


  3. Hello gents- great episode! I think I may have discovered another potential tax advantaged bucket of sorts for those who itemize and donate large amounts annually with post-tax money- tell me what you think: When my tax rate was low, we filled Roth401k and RothIRA buckets first for both my wife and me. We are now knocking on the 28% tax bracket so we now fill Trad401k and TradIRAs first to decrease our taxable income as much as we can. Looking for another bucket at a high savings rate we started to fill a 529 for our kiddos but have not liked the fees and strings attached. Here is our new play: we have opened a classic brokerage account at Vanguard and plan to do two things annually: 1) donate any investment gains to our charity (which we would have done anyway with post-tax cash regardless of market conditions), and 2) in any loss year harvest the losses or offset future gains. If I am thinking correctly, our brokerage account would need to be quite large before we would ever truly have to pay taxes for gains. For a normal market year with, say 6% returns, this account could be as large as ~$300k before we would have returns that would not go to charity. I think we may have discovered another bucket for our particular lifestyle where both we and our charity benefits. It only applies to big donors but seems to be a new bucket for us – any thoughts?

    • You can start a donor advised fund with Vanguard Charitable with $25,000, which makes it really easy to donate, but the cost of entry is higher as compared to Fidelity Charitable and Schwab Charitable (at $5,000 to start). Fees are similar among all three ($100 or 0.6% plus expense ratios of the funds you select). The latter two also let you give smaller grants ($50 versus Vanguard’s $500 minimum).

      I’ve written several posts on the topic linked here: http://www.physicianonfire.com/the-donor-advised-fund-a-win-win/

      Also, understand that you can’t donate only the capital gains. You want to select Specific ID as your cost basis and donate the lots that have the most gains, but you’ll be donating both your basis and the gains when you send it to the donor advised fund.


  4. Want to compliment y’all in putting the discussion in perspective, i.e., Brad’s acknowledgement of how us geezer laymen rationalized the Traditional (TIRA) vs Roth (RIRA) choice in the early 1990s. You’ve even included some broader perspective on federal tax policy, possible tax reform, etc. Good on ya.

  5. Hi guys – I’m going to be the special case where our taxable income is in the 25% bracket but it makes the most sense to do all Roth (incl 401k) at the moment. Here’s why: we have a 52K fed tax credit that can be carried forward for only 5 years, and there’s no way we will incur the tax necessary to use it all under normal circumstances. So since I’ll be paying $0 fed tax either way, the Roth is the play. And I’ll likely convert traditional IRA to Roth to create a taxable event to get the full benefit of the credit.

    Note: Credit comes from adopting kids from foster care, which cost us almost nothing out of pocket. Now THAT is a life hack.

  6. Although you mention that the Roth IRA contribution limit is $5,500 per year, the Roth 401K limit is $18,000 per year for those that have that option and choose to use it instead of the 401K IRA option.

  7. You mention the 186k limit for contributions to the Roth IRA. Also important is the 99k (phased out up to 119k) limit for the traditional IRA if either spouse is covered by a retirement plan at work. For the married couples in between these income points, the Roth is the only real option for an IRA contribution.

  8. What are you thoughts about the Roth vs Traditional with a defined pension plan? I was waiting and hoping that scenario would come in the podcast, but alas it did not. Although our numbers are small, there are still folks working towards FI who will have a guaranteed pension for the rest of their lives therefore it is an income stream. This has been my challenge when trying to figure out where to put my money. My pension adjusts for inflation and also has a COLA adjustment, so as time progresses my pension will go up which I assume would increase my tax burden. I’ve contributed to both the Roth and Traditional, but I’m focusing on the traditional right now because my income will continue to increase before I can FIRE in 6 years. I already listened to the podcast with Grumpus, but he didn’t get into the details on asset allocation during working years knowing there will be guaranteed income from a pension. Would love to hear any thoughts you might have on this. The Millionaire Educator podcast is not relevant in this case since I (and many others – think federal service and military) don’t have access to that particular account that was mentioned. Nor do we have access to HSA’s because we have Tricare. Thanks!

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