ROTH Conversion
5 Year Rule
One factor that may push you to do a Backdoor Roth IRA earlier is the five-year rule. Now, there are at least three five-year rules related to IRAs, but the main one to pay attention to here is the five-year rule after a Roth conversion. This rule determines whether the withdrawal of principal from the account prior to age 59 1/2 will be penalty-free. The five-year period starts on January 1 of the year you do the conversion, so it could be a little less than five years. Roth IRA principal generally comes out tax- and penalty-free (it is only the earnings that may be subject to penalties), but that is only the case after the five-year rule has been fulfilled.
In essence, if you do a conversion of a Roth IRA at age 51, you can then withdraw the principal tax- and penalty-free starting at age 56 rather than age 59 1/2. This can provide funding for living expenses to early retirees. If you do a Roth conversion at age 57, you still get access to that principal (and earnings) tax- and penalty-free at age 59 1/2. So, it's five years or age 59 1/2, whichever comes first.
Pros of a Backdoor Roth
The main benefit of a Backdoor Roth IRA is that it provides you with another retirement account. Via the Backdoor Roth IRA process, you can continue to contribute to a Roth IRA even after your earnings rise above the income limit for direct Roth IRA contributions. Retirement accounts eliminate the tax drag that applies in a taxable, or non-qualified account, reducing your taxes and allowing your investment to grow at a higher rate so you can reach your goals sooner.
How much can that tax protection be worth compared to a taxable account? It depends on the return of the underlying investment, its tax efficiency, and the amount of time the money is left in the account. At my marginal tax rate, $10,000 earning 8% in a tax-inefficient investment over 50 years would grow to $469,000 in a Roth IRA but only $88,000 in a taxable account. More realistically, over 30 years, the use of a Roth IRA vs. a taxable account for a tax-efficient investment would still result in 29% more money.
Roth money is tax-free forever, so by continuing to contribute each year, you can increase tax diversification in retirement.
Cons of Backdoor Roth Conversion
Roth IRAs, even when you contribute via the Backdoor Roth IRA process, are still retirement accounts with all of their downsides. Retirement accounts limit the investments you can put in them and prohibit the use of margin investing. If you withdraw Roth IRA earnings prior to age 59 1/2 without an approved exception, you will owe a 10% penalty.
Due to the pro-rata rule (see below), the Backdoor Roth IRA process requires you to either convert or roll over into a 401(k) any traditional IRAs, SEP-IRAs, and SIMPLE IRAs you may have.