Mega Backdoor Roth vs Student loans-6 month update

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civex
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Mega Backdoor Roth vs Student loans-6 month update

Post by civex » Wed Feb 04, 2015 6:38 pm

Providing a six month update. I have currently been following my plan to contribute as much as I can to my after tax option, and roll it over into my Roth IRA. I did a test run in March with $3.5k successfully. I will be completing my second quarterly contribution following payday, rolling over ~$11k from the after tax portion of my 401k. I found out that the after tax contribution will not be available to me in 2016 due to HCE status, so I'm glad I chose this option. If I do not modify my current contribution amounts, the mega Roth will have allowed me access to an additional ~$30k of Roth space.

While I am excited to basically double my current Roth balance ($13->$24k) in one swoop, the potentially high/flat market makes me a bit nervous. I'm planning on staying the course, though. The last 6 months have highlighted the power of forced high savings-since January I have been contributing 15% and 25% of my gross to my 401k and after tax fund respectively. I doubt I would be doing this without what I've learned from this forum, so thank you!


Hi,
Just wanted to begin by thanking the members of this forum for all of the information I have gained; without this forum, I would not even be aware of the mega backdoor Roth, or have found it as an option in my companies retirement plan. As the post title suggests, I have access to the mega backdoor Roth, which would allow me to put sock an additional 25k+/year into my Vanguard Roth IRA. My problem is I'm not sure where the mega backdoor Roth falls in regards to priority within investments. I am currently contributing to the max for my 401k and Roth IRA, and had planned on after using up that tax advantaged space to target my student loans. I have ~$88k @ 5.01% fixed in student loans, set on a 25 year repayment plan. So, I'm not sure if I should follow my original plan, or take a new course now that I am am aware of the mega Roth option.

Potentially pertinent info:
Age:26
Income:$120k->$135K
Debt: $88k@ 5.01% (student loans)
Current portfolio value: ~$25k->$50k
Emergency fund=4-5 months :)

Original Plan
1. Max 401k
2. Max Roth IRA
3. $1000/month extra towards student loan principle
4. Contribute excess funds to emergency fund until it reaches a $10k balance (currently $2.5k)

Mega Backdoor Roth Option?
1. Max 401k
2. Max Roth IRA
3. Contribute at least $1.5k/month (possibly more) to after tax plan option, and convert quarterly to Vanguard IRA
a. I doubt I have the ability to maximize the Mega Backdoor Roth, as doing so, plus the my regular contribution would be roughly 50% of my gross income

The reason I am not looking at taking a middle ground approach, is that there is less than a 50% chance that in 2016 I will qualify for the after tax contribution (and the Mega Roth) to my 401k plan because this plan option excludes highly compensated individuals. So, what would a Boglehead do :) ?
Last edited by civex on Fri Jun 05, 2015 4:56 pm, edited 1 time in total.

retiredjg
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Re: Mega Backdoor Roth vs Student loans

Post by retiredjg » Wed Feb 04, 2015 6:54 pm

Is your student loan interest tax deductible?

Is your income still going up steeply or has it leveled off?

Topic Author
civex
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Re: Mega Backdoor Roth vs Student loans

Post by civex » Wed Feb 04, 2015 6:57 pm

retiredjg wrote:Is your student loan interest tax deductible?

Is your income still going up steeply or has it leveled off?
My income disqualifies me for the student loan interest deduction and my income will likely remain the same, or go down if I take a lower stress position in the future. Let me know if there is any other info you need; thanks for your input!

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gnosis
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Re: Mega Backdoor Roth vs Student loans

Post by gnosis » Wed Feb 04, 2015 7:00 pm

Your E fund is only 2% of your gross annual income, so I would either defer MBD Roth until the E fund is much larger, or ditch the concept of having a separate E fund and just use your Mega Roth fund as a your E fund.

retiredjg
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Re: Mega Backdoor Roth vs Student loans

Post by retiredjg » Wed Feb 04, 2015 7:17 pm

The correct answer is that you should not be contributing to an after-tax account (over and above the 401k and Roth IRA) while you have outstanding debts. In fact, some would say to contribute enough to meet your employer match and put everything else toward the debt. If you have an inadequate emergency fund, this is even more true. If the debt were higher interest or lower interest, it would be somewhat clearer.

Unfortunately, humans are hard-wired to want that which is unavailable. If the after-tax mega back door will not be available in the future, it is even more attractive than it would otherwise be.

I don't see a lot of harm in doing the after-tax mega back door for one year. This will get your Roth assets off to a very good start. I would not go beyond that. After one year, I'd jack up the loan payments to whatever it takes to get them paid off sooner rather than later. That would be a 5.01% return guaranteed - something you cannot get if you invest that money instead of paying off the loans.

retiredjg
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Re: Mega Backdoor Roth vs Student loans

Post by retiredjg » Wed Feb 04, 2015 7:20 pm

If your current emergency fund is not adequate, you could temporarily exchange some or all of your Roth IRA contributions to a low risk investment such as money market or short term bonds to serve as an emergency fund. This preserves your Roth space while giving you almost immediate access to cash.

Roth contributions (not earnings) are available any time without tax or penalty. This can be somewhat different if you are making your Roth IRA contributions through the back door.

Topic Author
civex
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Re: Mega Backdoor Roth vs Student loans

Post by civex » Wed Feb 04, 2015 7:51 pm

retiredjg wrote:The correct answer is that you should not be contributing to an after-tax account (over and above the 401k and Roth IRA) while you have outstanding debts.
I understand this as a general principle, but my hang up is that once the after tax money is rolled into the Roth, it is no longer a taxable investment; it has become tax advantaged.
retiredjg wrote:If your current emergency fund is not adequate, you could temporarily exchange some or all of your Roth IRA contributions to a low risk investment such as money market or short term bonds to serve as an emergency fund. This preserves your Roth space while giving you almost immediate access to cash.
I do think this could be a very good solution/compromise and I believe you hit the nail on the head. In the short term, I'm not overly concerned with either the 5% interest I am paying on the loans or the potential growth of money in the retirement accounts, I'm most concerned with maximizing my usage of this tax advantaged space. I am trying to look at the long term; over a lifetime the student loan and hopefully a years contributions will be (hopefully) fairly negligible, I just want to seize any tax advantaged space, since it is very finite.

Thank you for your thoughtful and informative posts; feel free to keep contributing. :thumbsup

retiredjg
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Re: Mega Backdoor Roth vs Student loans

Post by retiredjg » Wed Feb 04, 2015 8:59 pm

civex wrote:
retiredjg wrote:The correct answer is that you should not be contributing to an after-tax account (over and above the 401k and Roth IRA) while you have outstanding debts.
I understand this as a general principle, but my hang up is that once the after tax money is rolled into the Roth, it is no longer a taxable investment; it has become tax advantaged.
This answer indicates you missed my point. It has nothing to do with taxable investments or tax-advantaged investments. If you have debt, you should not be investing unless you know the investment will make more than the debt drains.

Some people would say that you should only invest money that will be matched in a 401k. Some would say reduce your taxable income as much as you can by filling the pre-tax 401k, then put all the other money toward debt. Some would say to fill a 401k and a Roth IRA and put everything else toward debt.

What you are considering is filling a pre-tax 401k, filling a Roth IRA, putting $25k in an after-tax account....and then putting money toward the debt that is draining your assets at 5.01%. See the difference?

A 5.01% debt that is not deductible is a significant drain on your assets. You cannot be assured that anything you invest in will break even (return more than 5.01%) or do better than paying off the debt. So investing money that could pay off debt may actually reduce your net worth rather than increase it.

Again, I understand your desire to use the after-tax mega back door now if you will lose it in the future. But that 5.01% will keep on building interest payments until you pay it off. That's why I suggested doing 1 year of after-tax mega back door if you really feel you must, then just buckle down and pay off the debt.

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market timer
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Re: Mega Backdoor Roth vs Student loans

Post by market timer » Wed Feb 04, 2015 10:18 pm

To me, it is not a very straightforward answer as to whether you should contribute to your backdoor Roth or pay down student loans more aggressively. You have to weigh the cost of paying 5% interest (fairly high compared to risk-free investment alternatives) against the benefit of having extra Roth space for life. The calculus depends on all sorts of assumptions about your future income, tax rates, and investment returns. Personally, I'd probably pay the minimum on student loans and contribute as much as possible to the backdoor Roth, and hope to earn enough income in the next few years to pay down the student loans more aggressively. The repayment terms for student loans offer valuable flexibility--if you lose your job, you can get an immediate forbearance, and the government will even pay interest on subsidized loans. That kind of flexibility is valuable if have little liquidity outside of retirement accounts. You can view the loans as offering free life, disability, unemployment, and underemployment insurance (via IBR/PAYE).

While I think you could go either way on Roth vs. student loans, there are some actions that seem more clearly advantageous to me:
1. Keep your emergency fund low ($2.5K seems reasonable), and use your Roth IRA as an emergency fund. Contributions can be withdrawn penalty-free.
2. Take out a 401K loan to pay down your student loans more aggressively or fund your backdoor Roth.
3. Get a 0% interest credit card (or balance transfer to one) for your next year's spending, freeing up additional cash for student loan repayment or funding your backdoor Roth. When I was paying down my student loans, I routinely floated $50-80K at 0% interest on credit cards.
4. Ask a family member for a 2% interest 5-year loan to pay down your student loans.

DVMResident
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Re: Mega Backdoor Roth vs Student loans

Post by DVMResident » Wed Feb 04, 2015 11:52 pm

Are your loans really 5.01% or they a mix of lower- and higher-interest rates?

It is unusual to have $88k of student loans at one interest rate. Most people end up with a rainbow of interest rates spread across government and private sources.
If there is a range of interest rates, it may change the advice you get.

Topic Author
civex
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Re: Mega Backdoor Roth vs Student loans

Post by civex » Thu Feb 05, 2015 7:41 am

DVMResident wrote:Are your loans really 5.01% or they a mix of lower- and higher-interest rates?

It is unusual to have $88k of student loans at one interest rate. Most people end up with a rainbow of interest rates spread across government and private sources.
If there is a range of interest rates, it may change the advice you get.
I consolidated/refinanced my loans to the current rate; they were originally a mix of 6-6.8%.

elchris
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Re: Mega Backdoor Roth vs Student loans

Post by elchris » Thu Feb 05, 2015 8:10 pm

market timer wrote: 3. Get a 0% interest credit card (or balance transfer to one) for your next year's spending, freeing up additional cash for student loan repayment or funding your backdoor Roth. When I was paying down my student loans, I routinely floated $50-80K at 0% interest on credit cards.
Could you elaborate on this method a bit more? I have been thinking of this as a possibility for once I graduate (to pay less interest while still paying loan off aggressively) but haven't been able to come up with a stepwise plan yet.

Much appreciated!

JLJL
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Re: Mega Backdoor Roth vs Student loans

Post by JLJL » Thu Feb 05, 2015 8:36 pm

I just think that's pretty expensive tax-advantaged space. You recognize that it is a long-term move to save that space and keep the loans, meaning you have to invest and hold that money to improve your odds of beating that real 5%. With a long-term outlook the decision is not easy. The short-term outlook seems easier. Imagine $75K in an IRA after 3 years that becomes $50K by the 4th in a bad period, with say $70k still outstanding on the loans and $90K+ paid in. I'd rather have no loan and a little cash. Of course it could go the other way, or you would just need the constitution to wait and look back after 20-25 years and say "yup, that was the right move" once you see the huge pile you've accumulated in the IRA. I'm not that patient.

If I have some kind of project, I have to clear the work bench/kitchen counter/desk first and get everything organized, then go to work. Other people can dive in despite the clutter. My choice was to tackle our student loans, then turn to the mega option.

I don't know what YMMV stands for, but people tend to write that at times like these. So, YMMV.

retiredjg
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Re: Mega Backdoor Roth vs Student loans

Post by retiredjg » Thu Feb 05, 2015 9:17 pm

elchris wrote:
market timer wrote: 3. Get a 0% interest credit card (or balance transfer to one) for your next year's spending, freeing up additional cash for student loan repayment or funding your backdoor Roth. When I was paying down my student loans, I routinely floated $50-80K at 0% interest on credit cards.
Could you elaborate on this method a bit more? I have been thinking of this as a possibility for once I graduate (to pay less interest while still paying loan off aggressively) but haven't been able to come up with a stepwise plan yet.

Much appreciated!
This is just a bad idea. Sure it will be fine if all works according to plan. But what if Mr. Murphy shows up? Why risk getting yourself in a mess when you don't even need to?

You make a lot of money. Your loans are not that big. Just pay them off the old fashioned way. When you are finished paying them off, start saving more for retirement.

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market timer
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Re: Mega Backdoor Roth vs Student loans

Post by market timer » Thu Feb 05, 2015 9:26 pm

elchris wrote:
market timer wrote: 3. Get a 0% interest credit card (or balance transfer to one) for your next year's spending, freeing up additional cash for student loan repayment or funding your backdoor Roth. When I was paying down my student loans, I routinely floated $50-80K at 0% interest on credit cards.
Could you elaborate on this method a bit more? I have been thinking of this as a possibility for once I graduate (to pay less interest while still paying loan off aggressively) but haven't been able to come up with a stepwise plan yet.

Much appreciated!
Many credit cards offer signup incentives with low interest rates, such as 0% APR for the first 12 months on purchases or balance transfers. This group changes regularly, so you should check out some of the various credit card blogs for the latest offers. Some cards regularly offer such balance transfer promotions to existing cardholders. A typical credit card would offer me a $10K-25K credit line, so it only takes like four cards to float $50-80K. When you carry that much credit card debt regularly, it will reduce your FICO score substantially while you are holding it--an effect that goes away after repaying the debt. The FICO reduction makes it difficult to roll over debt from one card to another, so you should expect you'll need to find a way to pay off the entire float for a month, before loading up on debt again. I tried to time this reset with cash inflows, such as bonuses from work or taking out 401K loans (I'd contribute the max to my 401K every year when working, then borrow the max possible). My income was fairly high, and I generally didn't float more than 1/3rd my income. Someone starting out at $60K, say, should probably not try to float $80K in credit card debt--there is the potential for not being able to manage the roll over successfully, and being stuck with $80K of credit card debt at higher rates, like 15%.

Topic Author
civex
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Re: Mega Backdoor Roth vs Student loans

Post by civex » Sat Feb 07, 2015 9:23 pm

market timer wrote: While I think you could go either way on Roth vs. student loans, there are some actions that seem more clearly advantageous to me:
1. Keep your emergency fund low ($2.5K seems reasonable), and use your Roth IRA as an emergency fund. Contributions can be withdrawn penalty-free.
This seems reasonable and I'm thinking of taking retiredj's advice and holding a portion in a MMA within the Roth-to preserve an emergency fund and maximize Roth space
2. Take out a 401K loan to pay down your student loans more aggressively or fund your backdoor Roth.
I've thought about this, but everything I have read has been against it
3. Get a 0% interest credit card (or balance transfer to one) for your next year's spending, freeing up additional cash for student loan repayment or funding your backdoor Roth. When I was paying down my student loans, I routinely floated $50-80K at 0% interest on credit cards.
I understand the potential benefit of doing this, but I'm too risk adverse of a person to do this. I couldn't sleep at night..I've never had a credit card
4. Ask a family member for a 2% interest 5-year loan to pay down your student loans.
This would be great, but impossible
I am currently leaning towards diverting any further contributions to my savings or student loan principle to the Mega Roth for one year, reassessing 1/1/16, and likely moving towards a more balanced approach with paying of my SL if the Mega Roth is still available to me, or just concentrating on my SL. I will have the opportunity this year to make an extra $10-15k which will help.

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civex
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Re: Mega Backdoor Roth vs Student loans-6 month update

Post by civex » Fri Jun 05, 2015 5:02 pm

6 month update added/edited original post.

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