Without the Backdoor, Aftertax IRA Contributions Don't Add Up

Prior to 2010, high earners who were unable to make tax-deductible or Roth IRA contributions because of the income limits had but one option if they wanted to get money into an IRA: They could contribute aftertax dollars to their accounts. The investment earnings would be taxed as ordinary income in retirement, but the funds would enjoy tax-deferred compounding along the way.

When the income limits on IRA conversions were dropped in 2010, the so-called backdoor Roth IRA sprang into existence. By contributing aftertax dollars to traditional IRAs and then converting to Roth, high-income investors could indirectly get into Roths. But as the backdoor Roth IRA loophole may be closing soon, higher-income investors are again confronting the possibility that their only IRA option may be to contribute aftertax dollars and let the funds ride into retirement.

The question is: Is that even worth doing? I'd argue no in most situations, especially given low yields and the tax efficiency of other options. By investing wisely in a taxable account, investors can obtain a decent level of tax deferral as well as capital gains treatment on their withdrawals, along with some flexibility they wouldn't get with an IRA.

Is the Backdoor About to Slam?

The Build Back Better tax proposals advanced by the House Ways and Means Committee in September includes several provisions that would increase taxes on high earners. Some of these increases are overt tax hikes--for example, a 39.6% income-tax rate and a top capital gains rate of 25%. Other provisions are loophole closers that would prevent high-income taxpayers from taking advantage of tax breaks. That's where the closure of the backdoor Roth loophole comes in. Under the proposal, conversions of aftertax contributions to IRAs and 401(k)s would no longer be allowed starting in 2022.

Of course, nothing is final yet. Morningstar director of policy research Aron Szapiro has noted that closing the backdoor doesn't appear to add a lot of revenue to the budget, so it's too early to sound the death knell. But the backdoor Roth, if executed correctly, entails little in tax outlays. That put it in Congress' sights, in that it's a loophole that doesn't bring taxes in the door and reduces taxes due later on, too, because qualified Roth withdrawals are tax-free. Tax experts have argued that of the components of the tax package, the elimination of aftertax conversions is among the most likely to garner bipartisan support.

What Should High Earners Do?

If the backdoor loophole does indeed close, high earners will still be able to fund 401(k)s and other company retirement plans, as well as retirement accounts like SEP-IRAs and solo 401(k)s. Health savings accounts are also a superb ancillary retirement savings vehicle without income limits. And none of these changes apply to people whose incomes allow them to make tax-deductible or Roth IRA contributions. The rule change would only matter for people who are shut out of traditional deductible or Roth contributions because they're over the income thresholds.

Will it still be worth it for such people to make those aftertax IRA contributions, though? I'd say no and that most investors should opt for a taxable account instead, for four key reasons.

Capital Gains Tax Treatment Beats Ordinary Income Tax Treatment

The first is pretty obvious: Capital gains tax rates, which holders of taxable accounts pay on their gains when they sell investments, are substantially lower than the ordinary income tax rates that apply to withdrawals of investment earnings (as well as any tax-deductible contributions) from IRAs. To use a simplified example, let's say an investor put $300,000 of aftertax dollars into a total market index fund inside of a traditional IRA 15 years ago. (Never mind that contribution limits would preclude such a big one-time investment; I told you it was simplified!) It has been an awfully good 15 years, so at the end of the period his account is worth $1,326,897. $300,000 of that withdrawal consists of his own contributions--he paid taxes on that money before putting in the account, so he won’t owe taxes on that amount again. But the other $1,026,897 is taxable at his ordinary income tax rate. If he's in the 32% tax bracket for ordinary income taxes, his aftertax proceeds will be $998,290 (the $300,000 he put in plus his investment earnings less his $328,607 in taxes).

By contrast, if he had used a taxable account instead of an IRA, his tax bill on the sale would be less because capital gains taxes are lower. Assuming the same fact pattern--$300,000 in initial contributions of aftertax dollars and $1,026,897 in investment gains--but instead with a taxable account wrapper and assuming a 15% capital gains tax rate--his aftertax proceeds would be $1,172,862 (his initial $300,000 contribution plus his investment earnings less $154,035 in taxes). His tax bill would be less than half of what it was from his IRA withdrawal.

Need for Tax Deferral Is Less

Of course, that's a simplified example because we're not giving the IRA any credit for the tax deferral it offered along the way. If his holdings kicked off substantial income or capital gains during that 15-year period, holding the investments inside of an IRA would have shielded the investor from any taxes associated with those distributions, provided he left the money inside of the IRA. The less tax-efficient his holdings were--if he held high-yield bonds and REITs, for example--the bigger the advantage for the IRA.

That's nothing to sneeze at, but the composition of investment returns has changed over the years. That, in turn, has reduced the benefits of tax deferral that one obtains by holding assets in a traditional nondeductible IRA (that is, contributing aftertax dollars). The big reason is that prevailing yields have changed: While the dividend yield on the S&P 500 is about the same as it was in 2010, bond yields have dropped through the floor. The 10-year Treasury yield was nearly 4% in 2010, and it was nearly 6% in 2000. Today, the 10-year Treasury yield is about 1.5%. In other words, most investments just aren't distributing that much in gains for investors to benefit from the tax deferral that an IRA wrapper affords. Without the sweetener of deductible contributions or tax-free withdrawals, which is what contributors of aftertax funds to an IRA could be left with in a post-backdoor Roth world, the benefits of tax deferral have shrunk in importance.

Highly Tax-Efficient Options Have Emerged

In addition to the tax deferral becoming less valuable because organically generated yields have shrunk, tax-efficient alternatives have proliferated over the past few decades--specifically equity exchange-traded funds. With more than 30 years' worth of tax-efficiency data on ETFs, we can now see just how effectively ETFs reduce the drag of taxes on an ongoing basis. Over the past 15 years, many large-blend ETFs, including widely owned funds like Vanguard Total Stock Market VTI and iShares Core S&P Total U.S. Stock Market ITOT have tax-cost ratios of just 40 or 50 basis points. (Those tax costs owe to the dividend payments that the funds have made rather than capital gains payouts.)

If we add those ongoing tax costs into the calculation, the taxable account still appears to be the better bet on an aftertax basis. To go back to the preceding example but docking the taxable account by a 50-basis-point tax-cost ratio per year to account for the ongoing tax drag of distributions, the taxable accountholder would have $1,098,637 upon distribution after taxes. (I assumed a 15% capital gains tax rate on withdrawals.) That's still meaningfully ahead of the aftertax amount that the investor would have with an IRA ($998,290). (The taxable account would actually be even a bit further ahead because of the step-up in cost basis received to account for annual distributions; I didn't include that in my back-of-the envelope calculation.)

Of course, the tax advantage would be less if the investor had invested in something tax-inefficient in a taxable account--a junk bond or REIT fund, for example. Indeed, to the extent that investors want to hold high-income-producing assets, using an IRA makes more sense, even if only aftertax contributions are available. But for investors who are buying and holding plain-vanilla equity funds, especially ETFs without a dividend focus, the taxable account is hard to beat.

Flexibility, Estate Planning Benefits Better With Taxable Assets

Moreover, taxable accounts carry other important advantages relative to IRAs--namely, no contribution, income, or withdrawal limits. Taxable accounts also have an important advantage in that heirs receive a step-up in cost basis upon the death of the account owner, effectively washing out the tax burden associated with the appreciation of the investment.

On the flip side, there are creditor protections that come along with the IRA wrapper; those aren't to be taken lightly, especially for people who work in careers where there's a risk that they may be sued. But if high-income savers can only make aftertax IRA contributions beginning in 2022, that increasingly seems like a niche strategy that won't add up for most.