In a nutshell, their thesis is as follows. Consider buying and holding an index fund in taxable. Tax is due when selling it, but you can precisely cover this tax by leveraging your investment by a factor of 1/(1-MarginalTaxRate). Which means your after-tax dollars-in-pocket at the end of the day are the same as if you made the same (unleveraged) investment in a Roth account. This is true regardless of market movement.
But how can it be? Leverage is notoriously dangerous, while Roth is a nice safe tax-advantaged account that of course you should use (unless paying debt or tax-deferred tIRA/401(k) are even better for you), so how can they be equivalent?
My intuition is Roth does carry more risk than taxable, because taxes cushion your losses. It's easiest to see in the extreme were your investment's value drops to zero: in Roth, you've lost it all. In taxable, you recognize a deductible loss, so you get some of your money back. So you could leverage taxable by just the right fraction so that if value drops to zero, you'd really lose all of this investment post-tax, but (crucially!) no more.
With this in mind, leveraging in taxable by a factor of 1/(1-MarginalTaxRate) is just saying: "yes I really am willing to put all of this money at risk on this investment, I don't want your stinkin' cushion for losses, just give me the full upside and downside". Same as Roth.
So, wouldn't it be rational to frame our our asset allocations in terms of such "true after-tax exposure", and then legitimately use any combination of Roth and leveraged taxable to achieve it? Especially in high tax brackets, where this really matters?
And if backdoor Roth is so great but contributions are capped at $6000 or $7000 a year, then if you have more to invest, why not go wild and establish an uncapped amount of synthetic Roth?
I made numerous assumptions and simplifications in the above. Some caveats and notes:
- This assumes that the costs of leverage (compared to the fees in your Roth account) are small enough. Using futures as the leverage vehicle, EarlyRetirementNow estimated a drag of 0.14%/annum, back in 2016.
- This assumes a constant, known tax marginal bracket on your leveraged investment. But if your marginal brackets changes over time, you can adjust your leverage to recover the Roth-like 100% exposure. But large unexpected changes (e.g., windfall or market crash) could skew things and in particular cause the leverage to temporarily exceed your tax cushion.
- In particular, if market movements can cause your marginal tax bracket to change, then your expected after-tax return drops below Roth (because your leverage will be either too much for the low tax bracket deduction in case of loss, or too little for the high tax bracket owed in case of gain, or both).
- If using futures, margin (collateral) requirements can also cause trouble and tax implications in case of large, sudden market movements.
- There's the complexity of maintaining leverage. In particular, futures (which seem to be the lowest cost method for retail investors) requires quarterly rolling. (But then, you no longer have to bother doing the annual Backdoor Roth ceremony.)
- Cheap leveraging is available only for a relatively small choice of assets. Fortunately, these include the Bogleheads-favorite major indices.
- There's some risk inherent in using the leveraging mechanisms (e.g., you'd become exposed to disruptions in the futures market, or to changes in collateral margin requirements). This risk seems minor if you stick to well-established instruments like E-Mini S&P 500 futures.
- I ignored tax on dividends. But that's OK, because if you leverage using futures or options, you won't see them directly anyway; they'll just be embedded in your capital gain.
- You can TLH the leveraged taxable against other investments, which you can't do with Roth.
- The tax cushion on losses is effective only if you have enough capital gain to deduct the loss from (on other investments in the same year, or soon enough that interest on the deferred deduction is not significant). Plus the $3,000 that's deductible from ordinary income.
- As EarlyRetirementNow discusses, if you leverage using futures, the growth of your futures is effectively reduced by the risk-free interest, but you have (most of) your cash available for interest-bearing investments that roughly cancel this out. This opens opportunities. For example, if you're in a high tax bracket, you could use the cash to buy tax-free munis, thereby doing a tax arbitrage (you gain tax-free interest on the munis, but the corresponding interest expense embedded in the futures reduces your taxable income). Likewise for high state tax: earn interest on treasuries (no state tax) and "pay" the equivalent interest embedded in the futures (which reduces your state tax).
- Unlike Roth, you can "withdraw" the full account balance from leveraged taxable at any time, with no penalties.
- Unlike Roth, leveraged taxable has no RMDs when inherited.
- Leveraged taxable seems less sensitive to future changes in tax code, because you always keep your basis close to FMV. They could cancel the step-up in basis, they could eat into Roths, they could require more RMDs, you still wouldn't care if you basis is already at FMV.
- Roth has some creditor protection
- Roth is sheltered in computing FAFSA college financial aid
(My personal circumstances, which are when all of these indeed matters, are: high federal and state tax brackets, and relatively tiny tax-advantaged space even though currently maximizing 401(k), backdoor Roth, state-deductible 529, I-bonds and some DAF.)