Roth backdoor - Withdrawing money before retirement

Submitted by Share_noob t3_127ye8d in personalfinance

I've been looking at Roth IRA backdoor for a while as it's been recommended a lot on this sub. I don't have any other IRA besides employer sponsored 401k plan so I think conversion shouldn't be a problem. I'm an expat so I'll likely withdraw the money before retirement though. Here's my understanding so far:

  • After 5 years, I can withdraw money without taxes and penalty. This will save me 15% capital gains taxes.

  • Before 5 years, I'll need to pay taxes on earnings and 10% penalty.

I'm debating whether it's worth going route of Roth backdoor or if I'm better just investing cash in my taxable brokerage account. At first, 15% tax saving definitely seems like a good option but I also don't want money to be locked for decades. Is my understanding correct? Does anyone have any recommendations? Thanks in advance.

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DeluxeXL t1_jeged32 wrote

> * After 5 years, I can withdraw money without taxes and penalty. This will save me 15% capital gains taxes. > * Before 5 years, I'll need to pay taxes on earnings and 10% penalty.

Incorrect.

  1. You already paid tax when you earned the income.
  2. When you contribute to traditional IRA, you do not take a tax deduction, making the contribution "nondeductible".
  3. When you convert to Roth IRA, you won't pay any more tax since the entire IRA is filled with only nondeductible contribution. The only exception is if you allow the earnings to pile up before converting.
  4. Since the conversion was not taxable, you don't need to wait 5 years to withdraw.
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Share_noob OP t1_jegfn6p wrote

Are you sure that's the case? I found this on investopedia

>If you meet the five-year rule:

>Under age 59½: Earnings are subject to taxes and penalties. You may be able to avoid taxes and penalties if you use the money for a first-time home purchase (a $10,000 lifetime limit applies), if you have a permanent disability. If you pass away and your beneficiary takes the distribution, taxes and penalties may also be avoided. 

>If you don’t meet the five-year rule:

>Under age 59½: Earnings are subject to taxes and penalties. You may be able to avoid the penalty (but not the taxes) if you use the money for a first-time home purchase (a $10,000 lifetime limit applies), qualified education expenses, unreimbursed medical expenses, if you have a permanent disability, or if you pass away and your beneficiary takes the distribution. 

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DeluxeXL t1_jegh5g1 wrote

You quoted the rules for withdrawing earnings. Conversions are not earnings.

If you contributed $12000 directly to Roth IRA, you can withdraw $12000 any time.

If you converted $6000 from a 100% nondeductible traditional IRA to Roth IRA, you can withdraw $6000 any time after you have already withdrawn the $12k Roth contributions.

Contributions and conversions are always withdrawn first before earnings are withdrawn.

Refer to Form 8606 lines 22 (for direct contributions) and 24 (for conversions).

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Share_noob OP t1_jegi0uj wrote

I guess my question wasn't clear in the OP. I was debating on whether it's better to use taxable brokerage account than Roth IRA if I'm pretty sure I'll withdraw all money from them before retirement.

Sounds like on brokerage account, I'll just pay 15% long term capital gains tax while in IRA it'll be 15% taxes + 10% penalty.

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DeluxeXL t1_jegk5lf wrote

There is no capital gain tax treatment in a retirement account. If a portion of withdrawal is subject to tax, it is going to be ordinary income tax.

  1. Withdrawing contributions: No tax, no penalty.
  2. Withdrawing taxable conversions: No tax. 10% penalty within 5 years.
  3. Withdrawing nontaxable conversions: No tax, no penalty.
  4. Withdrawing earnings: Taxed as income. 10% penalty for unqualified withdrawal.

How much do you expect the Roth IRA to grow before you withdraw?

Also, are you going to become "nonresident alien"?

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Share_noob OP t1_jegpi74 wrote

Thanks a lot for your responses. Appreciate it.

Yes, I'll become non-resident alien. And these are just estimates but looking at average 7% return on SPY, I expect those to grow by ~40% in 5 years. Say I invested total $10000, it might grow to $14000 by the time I withdraw. Assuming ordinary tax bracket of 25%, sounds like I'll need to pay 25% tax + 10% penalty on earnings of $4000.

That basically leaves me with 5% gain.

Instead if I invested same $10000 in taxable brokerage, I'll have to pay 15% taxes on earnings of $4000.

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DeluxeXL t1_jegq5ma wrote

Depends on when you become NRA.

Tax on NRA is different.

  • No standard deduction
  • No tax on capital gain if you aren't in the US for 183 or more days
  • 15-30% tax on dividends depending on the tax treaty with your home country.
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Share_noob OP t1_jegynna wrote

Interesting.. Didn't know about the capital gains tax as NRA. Definitely going with taxable brokerage account then. Thanks again for your inputs!

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