The Back Door

Not to be redundant, but if you want to retire young you’ve got to save a large proportion of your income. That’s rule number one, two, and three.

I shouldn’t say it like that because saving money is actually quite fun once you get started. Investing your savings is even more fun.

And you will be surprised at all the fat you can trim from your life without losing any happiness at all.

But I digress.

The purpose of this post is to discuss what vehicles you should put your valuable savings into and in what order.

Step one: Pay down any high-interest debt. We’re talking credit card bills, floating-rate subprime mortgages, anything with an interest rate above 6%.

If you got any of these: emergency!! You shouldn’t even be thinking about retirement until you stop financing your banker’s retirement.

Pay That stuff down. Then come back and read the rest of this post. You will essentially be getting a guaranteed 6-20% return on that money in the form of interest rates that you will not have to pay in the future.

It would be advisable to ignore step number 1, just trust us on this one

Step two: Max out your employer-based retirement plan. If you think your tax rate will be higher in retirement than it is now then contribute to a Roth (after tax) plan. If not then contribute to a standard  tax deductible plan.

Either way this money will grow tax-free and this is a huge advantage. All of your dividends and fixed income interest will grow without a 15 to 35% hit in the form of taxes. If a 1% increase in mutual fund expense ratios means a loss of 33% of your portfolio in 40 years, then imagine how much this tax savings will mean to your future portfolio growth.

Step three: You’re not done yet. If you’re serious about saving, you will likely have more money to save.

So where do you put this?

You put it in an IRA. After maxing out your employer plan you can contribute an additional $5500 per person or $11,000 per married couple into an IRA. You’ll not get to put in pre-tax dollars, and you’ll pay income tax when you pull out the money in retirement, but this money will still grow tax-free. Very valuable.

Step four: hold on a sec….

Time for a major “I’m only a doctor,” disclaimer.

Do not do this step without consulting with your tax advisor.

As I understand it, through a quirk in the tax code, although high income earners are not able to contribute to Roth IRAs, they are able to roll over post-tax IRA contributions into Roth IRAs accounts.

This means that the day after contributing your $11,000 to your IRA, you can roll it over into a Roth IRA with no tax penalty!

This is called a “backdoor Roth.”

Not only will this money now grow tax-free but it can be pulled out tax-free in retirement. Talk about free money.

The major caveat here is that if you already have an IRA, then the IRS sees all of your IRA money as one lump sum.

So if your other IRA money is worth $90,000 pretax dollars, and your recent post-tax contribution is worth $10,000, then when you try to rollover the $10,000, the IRS will count it as only 10% post-tax dollars allowing you to rollover only $1000 tax-free, while paying taxes on the other $9000.

The way around this is to roll over your IRA money into your employment based retirement accounts so that all you have are post tax (Roth) IRA accounts.

Now we can talk about the morality of this another time.

I’m as progressive as they come.

But when it comes to planning for retirement it’s best to think like a tax dodging venture capitalist.

Worthy of Emulation

Once we’ve retired we’ll have plenty of time to pen letters to our congressman advocating for a less labyrinthine, and inequitable tax code.

Step five: consider enrolling in a high deductible health care plan, and investing money in a health care savings account.

This is known as a “stealth IRA.” But that’s seriously a topic for another day.

Step Six: open a taxable investment account. And invest in tax efficient funds.

I’m sure I’m missing about a hundred steps, but I think this is a pretty good blueprint for simpletons like me!

If you have any other angles, please fire off a comment.